Electromed, Inc. - Quarter Report: 2019 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Commission File No.: 001-34839

Securities registered pursuant to Section 12(b) of the Act:

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

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes ☑   No ☐

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

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

There were 8,448,948 shares of Electromed, Inc. common stock, par value $0.01 per share, outstanding as of the close of business on November 8, 2019.

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

PART I – FINANCIAL INFORMATION

Item 1.       Financial Statements.

Electromed, Inc.

Condensed Balance Sheets

Electromed, Inc.

Condensed Statements of Operations (Unaudited)

Electromed, Inc.

Condensed Statements of Cash Flows (Unaudited)

Electromed, Inc.

Condensed Statements of Shareholders’ Equity (Unaudited)

See Notes to Condensed Financial Statements (Unaudited).  

Electromed, Inc.

Notes to Condensed Financial Statements

(Unaudited)

Note 1.  Interim Financial Reporting

Basis of presentation: Electromed, Inc. (the “Company”) develops, manufactures and markets innovative airway clearance products that apply High Frequency Chest Wall Oscillation (“HFCWO”) therapy in pulmonary care for patients of all ages. The Company markets its products in the U.S. to the home health care and institutional markets for use by patients in personal residences, hospitals and clinics. The Company also sells internationally both directly and through distributors. International sales were approximately $66,000 and $135,000 for the three months ended September 30, 2019 and 2018, respectively. Since its inception, the Company has operated in a single industry segment: developing, manufacturing and marketing medical equipment.

The accompanying unaudited condensed financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial statements and pursuant to the rules and regulations of the U.S. Securities and Exchange Commission. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments consisting of normal recurring adjustments necessary for a fair presentation of the Company’s financial position and results of operations as required by Regulation S-X. Interim results of operations are not necessarily indicative of the results that may be achieved for the full year. The financial statements and related notes do not include all information and footnotes required by U.S. GAAP for annual reports. This interim report should be read in conjunction with the financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2019 (“fiscal 2019”).

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

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

Net income per common share: Net income is presented on a per share basis for both basic and diluted common shares. Basic net income per common share is computed using the weighted average number of common shares outstanding during the period, excluding any restricted stock awards which have not vested. The diluted net income per common share calculation includes outstanding restricted stock grants and assumes that all stock options were exercised and converted into common stock at the beginning of the period, unless their effect would be anti-dilutive. Common stock equivalents excluded from the calculation of diluted earnings per share because their impact was anti-dilutive was 446,350 and 375,750 for the three months ended September 30, 2019 and 2018, respectively.

New accounting pronouncements:  In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-02, “Leases (Topic 842)” (“ASU 2016-02”).   This standard requires the recognition of all lease transactions on the balance sheet as a lease liability and a right-of-use asset (as defined in ASC 2016-02). ASU 2016-02 to Topic 842 – Leases (“ASC 842”) became effective for the Company on July 1, 2019 and was applied retrospectively to all periods presented.  The Company applied the practical expedient to calculate the present value of the fixed payments without having to perform an allocation to lease and non-lease components.  Additional information and required disclosures are included in Note 9.

Impact on Previously Reported Results:

The following table presents a recast of selected unaudited statement of operations line items after giving effect to the adoption of ASC 842:

The following table presents a recast of selected unaudited balance sheet line items after giving effect to the adoption of ASC 842:

The following table presents a recast of selected unaudited statement of cash flow line items after giving effect to the adoption of ASC 842:

Note 2.  Revenues

Revenue is measured based on consideration specified in the contract with a customer, adjusted for any applicable estimates of variable consideration and other factors affecting the transaction price, including noncash consideration, consideration paid or payable to customers and significant financing components.  Revenue from all customers is recognized when a performance obligation is satisfied by transferring control of a distinct good or service to a customer, as further described below under Performance obligations and transaction price. 

Individual promised goods and services in a contract are considered a performance obligation and accounted for separately if the individual good or service is distinct (i.e., the customer can benefit from the good or service on its own or with other resources that are readily available to the customer and the good or service is separately identifiable from other promises in the arrangement).  If an arrangement includes multiple performance obligations, the consideration is allocated between the performance obligations in proportion to their estimated standalone selling price, unless discounts or variable consideration is attributable to one or more but not all the performance obligations. Costs related to products delivered are recognized in the period incurred, unless criteria for capitalization of costs under FASB Accounting Standards Codification (“ASC”) 340-40, “Other Assets and Deferred Costs” (“ASC 340”), or other applicable guidance are met.

The Company includes shipping and handling fees in net revenues. Shipping and handling costs associated with the shipment of the Company’s SmartVest^® Airway Clearance System (“SmartVest System”) after control has transferred to a customer are accounted for as a fulfillment cost and are included in cost of revenues.

The timing of revenue recognition, billings and cash collections results in accounts receivable on the condensed balance sheets as further described below under Accounts receivable and Contract assets.

Disaggregation of revenues.  In the following table, revenue is disaggregated by market:

In the following table, homecare revenue is disaggregated by payer type:

Revenues in the Company’s home care, home care distributor and international markets are recognized at a point in time when control passes to the customer upon product shipment or delivery.  Revenues in the Company’s institutional market include sales recognized at a point in time upon shipment or delivery as well as revenues recognized over time under operating leases.

Performance obligations and transaction price.  A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of account under ASC 606, “Revenue From Contracts With Customers” (“ASC 606”). A contract’s transaction price is allocated to each distinct performance obligation in proportion to the standalone selling price for each and recognized as revenue when, or as, the performance obligation is satisfied.  The Company’s performance obligations and the timing or method of revenue recognition in each of the Company’s markets are discussed below: 

Home care market.  In the Company’s home care market, its customers are patients who use the SmartVest System.  The various models of the SmartVest System are comprised of three main components - a generator, a vest and a connecting hose that are sold together as an integrated unit.  Accordingly, in contracts within the home care market, the Company regards the SmartVest System to be a single performance obligation.

The Company makes available to its home care patients limited post-sale services that are not material in the context of the contracts, either individually or taken together, and therefore does not consider them to be performance obligations. The costs associated with the services are accrued and expensed when the related revenues are recognized.  As such, transactions in the home care market consist of a single performance obligation, the SmartVest System.

Home care patients generally will rely on third-party payers, including commercial payers and governmental payers such as Medicare, Medicaid, and the Veteran’s Administration to cover and reimburse all or part of the cost of the SmartVest System.  The third-party payers’ reimbursement programs fall into three types, distinguished by the differences in the timing of payments from the payer, consisting of either (i) outright sale, in which payment is received from the payer based on standard terms, (ii) capped installment sale, under which the SmartVest System is sold for a series of payments that are capped not to exceed a prescribed or negotiated amount over a period of time or (iii) installment sale under which the SmartVest Systems are paid for over a period of several months as long as the patient continues to use the SmartVest System.

Regardless of type of transaction, provided criteria for an enforceable contract are met, it is the Company’s long-standing business practice to regard all home care agreements as transferring control to the patient upon shipment or delivery, in spite of possible payment cancelation under government or commercial programs where the payer is controlling the payment over specified time periods. For home care sales that feature installment payments, the ultimate amount of consideration received from Medicare, Medicaid or commercial payers can be significantly less than expected if the contract is terminated due to changes in the patient’s status, including insurance coverage, hospitalization, death, or otherwise becoming unable to use the SmartVest System.  However, once delivered to a patient who needs the SmartVest System, the patient is under no obligation to return the SmartVest System should payments be terminated as a result of the described contingencies.  As a result, the Company’s product sales qualify for point in time revenue recognition.  Control transfers to the patient, and revenue is recognized upon shipment of the SmartVest System.  At this point, physical possession and the significant risks and rewards of ownership are transferred to the patient and either a current or future right to payment is triggered, as further discussed under Accounts receivable and Contract assets below.

The Company’s contractually stated transaction prices in the home care market are generally set by the terms of the contracts negotiated with insurance companies or by government programs.  The transaction price for the Company’s products may be further impacted by variable consideration. ASC 606 requires the Company to adjust the transaction price at contract inception and throughout the contract duration for the estimated value of payments to be received from insurance payers based on historical experience and other available information, subject to the constraint on estimates of variable consideration. Transactions requiring estimates of variable consideration primarily include (i) capped installment payments which are subject to the third-party payer’s termination due to changes in insurance coverage, death or the patient’s discontinued use of the SmartVest System, (ii) contracts under appeal and (iii) patient responsibility amounts for deductibles, coinsurance, copays and other similar payments.

Although estimates may be made on a contract-by-contract basis, whenever possible, the Company uses all available information including historical collection patterns to estimate variable consideration for portfolios of contracts.  The Company’s estimates of variable consideration consist of amounts it may receive from insurance providers in excess of its initial revenue estimate due to patients meeting deductibles or coinsurance during the payment duration, changes to a patient’s insurance status, changes in an insurance allowable, claims in appeals with Medicare and amounts received directly from patients for their allowable or coinsurance. The Company believes it has representative historical information to estimate the amount of variable consideration in relevant portfolios considering the significant experience it has with each portfolio and the similarity of patient accounts within a portfolio.  The analysis includes steps to ensure that revenue recognized on a portfolio basis does not result in a material difference when compared with an individual contract approach.  The Company also leverages its historical experience and all available relevant information for each portfolio of contracts to minimize the risk its estimates used to arrive at the transaction price will result in a significant reversal in the amount of cumulative revenue recognized when the uncertainty associated with the variable consideration is subsequently resolved.  Variable consideration is included in the transaction price if, in the Company’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur.

For example, for contracts in which the Company believes the criteria for reimbursement under government or commercial payer contracts have been met but for which coverage is unconfirmed or payments are under appeal, the Company has significant observable evidence of relatively consistent claims recovery experience over the prior three to five years. The Company believes the low volatility in historical claims approval rates for populations of patients whose demographics are similar to those of current patients provides reliable predictive value in arriving at estimates of variable consideration in such contracts.   Similarly, historical payment trends for recovery of claims subject to payer installments and payments from patients have remained relatively consistent over the past five years.  No significant changes in patient demographics or other relevant factors have occurred that would limit the predictive value of such payment trends in estimating variable consideration for current contracts.  As a result, the Company believes its estimates of variable consideration are generally not subject to the risk of significant revenue reversal.

For each type of variable consideration discussed above, there are a large number of contracts with similar characteristics with a wide range of possible transaction prices.  For that reason, the Company uses the probability-weighted expected value method provided under ASC 606 to estimate variable consideration.

The Company often receives payment from third-party payers for the SmartVest System sales over a period of time that may exceed one year. Despite these extended payment terms, no significant financing component is deemed to exist because the purpose of such terms is not to provide financing to the patient, the payer or the Company.  Rather, the extended payment terms are mandated by the government or commercial insurance programs; the fundamental purpose of which is to avoid paying the full purchase price of equipment that may potentially be used by the patient for only a short period of time.

Home Care Distributors.  Sales to distributors, who sell direct to patients, are made at fixed contract prices and may include tiered pricing structures or volume-based rebates which offer more favorable pricing once certain volumes are achieved per the negotiated contract.  The distributor’s purchases accumulate to give the distributor a right to a higher discount on purchases in excess of the specified level within the contract period. As a result, to the extent the Company expects the distributor to exceed the specified volume of purchases in the annual period, it recognizes revenue at a blended rate based on estimated total annual volume and sales revenue. This effectively defers a portion of the transaction price on initial purchases below the specified volumes for recognition when the higher discount is earned on purchases in excess of specified volumes. Transfer of control of the products occurs upon shipment or delivery to the distributor as applicable.

Institutional market.  The Company’s institutional sales are made to hospitals and home health care centers, pulmonary rehabilitation centers and other clinics. Sales to these institutions are negotiated with the individual institution or with group purchasing organizations, with payments received directly from the institution.  No insurance reimbursement is involved.  Generators are either sold or leased to the institutions and associated hoses and wraps (used in institutional settings rather than vests) are sold separately. Accordingly, each product is distinct and considered a separate performance obligation in sales to institutional customers. The agreements with institutions fall into two main types, distinguished by differences in the timing of transfer of control and timing of payments:

International market.  Sales to international markets are made directly to a number of independent distributors at fixed contract prices that are not subject to further adjustments for variable consideration.  Transfer of control of the products occurs upon shipment or delivery to the distributor as applicable.

Product Warranty.  The Company offers warranties on its products. These warranties are assurance type warranties not sold on a standalone basis or are otherwise considered immaterial in the context of the contract, and therefore are not considered distinct performance obligations under ASC 606.  The Company estimates the costs that may be incurred under its warranties and records a liability in the amount of such costs at the time the product is sold.

Accounts receivable.  Accounts receivable include amounts billed to customers and third-party payers, for which only the passage of time is required before payment of consideration is due. Amounts due are stated at their net estimated realizable value.

Contract assets.  Contract assets include amounts recognized as revenue that are estimates of variable consideration for Medicare appeals where the final determination of the insurance coverage amount is dependent on future approval of an appeal, or when the consideration due to the Company is dependent on a future event such as the patient meeting a deductible prior to the Company’s claim being processed by the payer. Contract assets are classified as current as amounts will turn in to accounts receivable and be collected during the Company’s normal business operating cycle.  Contract assets are reclassified to accounts receivable when the right to receive payment is unconditional.

Incremental costs to obtain a contract. Sales incentives paid to sales representatives are eligible for capitalization as they are incremental costs that would not have been incurred without entering into a specific sales arrangement and are recoverable through the expected margin on the transaction. However, the recovery period is less than one year as the performance obligation is satisfied upon shipment or delivery. Consequently, the Company applies the practical expedient provided by ASC 340 and expense sales incentives as incurred. These costs are included in selling, general and administrative expenses in the Company’s condensed statements of operations.

Contract balances. The following table provides information about accounts receivable and contracts assets from contracts with customers:

Significant changes in contract assets during the period are as follows:

Note 3. Inventories

The components of inventory were approximately as follows:

Note 4. 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 $1,040,000 and $1,010,000 at September 30, 2019 and June 30, 2019, respectively.

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

Note 5. Warranty Liability

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

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

Note 6. Income Taxes

On a quarterly basis, the Company estimates its effective tax rate for the full fiscal year and records a quarterly income tax provision based on the anticipated rate. As the year progresses, the Company refines its estimate based on the facts and circumstances by each tax jurisdiction. Income tax expense was estimated at approximately $374,000, and the effective tax rate was 26.9% for the three months ended September 30, 2019. Income tax expense was estimated at $58,000 and the effective tax rate was 27.0% for the three months ended September 30, 2018.

Note 7. Financing Arrangements

The Company has a credit facility that provides for a revolving line of credit and a term loan. Effective December 18, 2018, the Company renewed its $2,500,000 revolving line of credit. There was no outstanding principal balance on the line of credit as of September 30, 2019 or June 30, 2019. Interest on borrowings under the line of credit, if any, accrues at the prime rate (5.00% at September 30, 2019) less 1.00% and is payable monthly. The amount eligible for borrowing on the line of credit is limited to the lesser of $2,500,000 or 57.00% of eligible accounts receivable and the line of credit expires on December 18, 2019, if not renewed. At September 30, 2019, the maximum $2,500,000 was eligible for borrowing. The line of credit is secured by a security interest in substantially all the tangible and intangible assets of the Company.

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

Note 8. Stock-Based Compensation

In November 2017, the Company’s shareholders approved the 2017 Omnibus Incentive Plan (the “2017 Plan”) which supersedes the 2014 Equity Incentive Plan (the “2014 Plan”). The 2017 Plan allows the Company’s Board of Directors (“the Board of Directors”) to grant stock options, stock appreciation rights, restricted stock, restricted stock units and other stock-based awards, as well as cash incentive awards to all employees, non-employee directors, and advisors or consultants of the Company. The vesting schedule and term for each award are determined by the Board of Directors upon each grant. The maximum number of shares of common stock available for issuance under the 2017 Plan is 900,000. There were 490,750 stock options granted under the 2014 Plan and prior plans outstanding as of September 30, 2019. There were 315,600 stock options and 82,500 shares of restricted stock issued under the 2017 Plan outstanding and 500,400 shares available for grant under the 2017 Plan as of September 30, 2019.

The Company recorded approximately $210,000 and $257,000 of compensation expense related to current and past grants of stock options and restricted stock for the three months ended September 30, 2019 and 2018, respectively. This expense is included in selling, general and administrative expense. As of September 30, 2019, approximately $1,254,000 of total unrecognized compensation expense related to non-vested equity awards was expected to be recognized over a weighted average period of approximately 0.9 years.

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

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

Stock Options

The Company issued 149,300 stock options pursuant to the 2017 Plan during the three months ended September 30, 2019. Stock option transactions during the three months ended September 30, 2019 are summarized as follows:

The intrinsic value of an option is the amount by which the fair value of the underlying stock exceeds its exercise price. At September 30, 2019, the weighted average remaining contractual term for all outstanding stock options was 7.21 years and their aggregate intrinsic value was approximately $2,046,000. Outstanding at September 30, 2019 were 806,350 stock options issued to employees, of which 504,174 were exercisable and had an aggregate intrinsic value of approximately $1,679,000.

Restricted Stock

The 2017 Plan also permits the grant of other stock-based awards, including shares of restricted stock. Historically, the Company makes restricted stock grants to key employees and non-employee directors that vest over six months to three years.

During the three months ended September 30, 2019, the Company issued restricted stock awards to employees totaling 32,500 shares of the Company’s common stock, with a vesting term of one to three years and a fair value of $5.29 per share. The fair value per share or restricted stock represents the closing price of the Company’s common stock the on the NYSE American on the date of the grant. Restricted stock transactions during the three months ended September 30, 2019 are summarized as follows:

Note 9. Leases

The Company has four leases for office and warehouse space that require monthly payments. These leases have escalating payments ranging from approximately $450 to $4,400 per month which expire through July 2022 and are recognized on a straight-line basis over the life of the lease. The Company has a lease for office equipment that requires payments of approximately $1,500 per month through December 2022. All leases are classified as operating leases which do not include renewal options. The Company currently does not have any short-term or variable lease costs. The Company applied the practical expedient to calculate the present value of the fixed payments without having to perform an allocation to lease and non-lease components.

The Company has recognized a right of use assets associated with its operating leases of approximately $138,000 and $45,000 as of September 30, 2019 and June 30, 2019, respectively, which is included in other assets on the Company’s Condensed Balance Sheet. Operating lease liabilities were $138,000 and $45,000 as of September 30, 2019 and June 30, 2019, respectively, which are included in current maturities of long-term liabilities and other long-term liabilities on the Company’s Condensed Balance Sheet.

For the three months ended September 30, 2019, the Company has a weighted-average lease term of 0.9 years for its operating leases, which have a weighted-average discount rate of 4.0%. Operating lease payments of $22,000 are included in operating cash flows for the three months ended September 30, 2019.

Maturities of lease liabilities, which are included in current maturities of long-term liabilities and other long-term liabilities on the Company’s Condensed Balance Sheet, are as follows:

Note 10. Commitments and Contingencies

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

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed financial statements and related notes thereto included in Item 1 of Part I of this Quarterly Report on Form 10-Q and the audited financial statements, related notes thereto and Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contained in our Annual Report on Form 10-K for the fiscal year ended June 30, 2019, or “fiscal 2019.”

Overview

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

We manufacture, market and sell products that provide HFCWO, including the SmartVest^® Airway Clearance System (“SmartVest System”) that includes our newest generation SmartVest SQL^® and previous generation SV2100, and related products, to patients with compromised pulmonary function. The SmartVest SQL is smaller, quieter and lighter than our previous product, with enhanced programmability and ease of use. Our products are sold in both the home health care market and the institutional market for use by patients in hospitals, which we refer to as “institutional sales.” The SmartVest SQL has been sold in the domestic home care market since our fiscal quarter ended March 31, 2014. In the fourth quarter of our fiscal year ended June 30, 2015, we launched the SmartVest SQL into institutional and certain international markets. In June 2017, we announced the launch of the SmartVest SQL with SmartVest Connect™ wireless technology, which allows data connection between physicians and patients to track therapy performance and collaborate in treatment decisions. SmartVest Connect is currently available to pediatric and cystic fibrosis patients and was made available to certain targeted adult pulmonary clinics starting in November 2017. Since 2000, we have marketed the SmartVest System and its predecessor products to patients suffering from cystic fibrosis, bronchiectasis and repeated episodes of pneumonia. Additionally, we offer our products to a patient population that includes neuromuscular disorders such as cerebral palsy, muscular dystrophies, amyotrophic lateral sclerosis (“ALS”), the combination of emphysema and chronic bronchitis commonly known as chronic obstructive pulmonary disease (“COPD”), and patients with post-surgical complications or who are ventilator dependent or have other conditions involving excess secretion and impaired mucus transport. During February 2017, we entered into an agreement with Monaghan Medical Corporation to distribute and sell the Aerobika^® Oscillating Positive Expiratory Pressure (“OPEP”) Device in the U.S. home care market. After over a year of offering Aerobika OPEP, we determined that continuing to offer the product direct to patients was unlikely to serve a broader patient population as originally planned. As a result, we discontinued our distribution of the Aerobika OPEP in November 2018.

The SmartVest System is often eligible for reimbursement from major private insurance providers, health maintenance organizations (“HMOs”), state Medicaid systems, and the federal Medicare system, which we believe is an important consideration for patients considering an HFCWO course of therapy. For domestic sales, the SmartVest System may be reimbursed under the Medicare-assigned billing code, (E0483), for HFCWO devices if the patient has cystic fibrosis, bronchiectasis (including chronic bronchitis or COPD that has resulted in a diagnosis of bronchiectasis), or any one of certain enumerated neuromuscular diseases, and can demonstrate that another less expensive physical or mechanical treatment did not adequately mobilize retained secretions. Private payers consider a variety of sources, including Medicare, as guidelines in setting their coverage policies and payment amounts.

Critical Accounting Policies and Estimates

For a description of our critical accounting policies, estimates and assumptions used in the preparation of our financial statements, including the unaudited condensed financial statements in this Quarterly Report on Form 10-Q, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Note 1 to our audited financial statements, included in Part II, Item 8, of our Annual Report on Form 10-K for fiscal 2019.

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. Among other factors, these judgments are based upon our historical experience, known trends in our industry, terms of existing contracts and other information from outside sources, as appropriate. We believe the critical accounting policies that require the most significant assumptions and judgments in the preparation of our financial statements, including the unaudited condensed financial statements in this Quarterly Report on Form 10-Q, include: revenue recognition and the estimation of variable consideration, allowance for doubtful accounts, inventory obsolescence, share-based compensation and warranty liability.

Results of Operations

Revenues

Revenue for the three-month periods ended September 30, 2019 and 2018 is summarized in the table below (dollar amounts in thousands).

Home Care Revenue. Home care revenue for the three months ended September 30, 2019 was approximately $7,491,000, an increase of approximately $769,000 compared to the same period in fiscal 2019, or 11.4%. Home care revenue increased year-over-year predominantly due to a higher average allowable due to payer mix, a greater referral to approval percentage and a higher number of referrals per field sales employee. At September 30, 2019 field sales employees totaled 38, of which 32 were direct sales, compared to 40 at the end of our fiscal year ended June 30, 2019, of which 34 were direct sales, and 49 at the end of the fiscal quarter ended September 30, 2018 of which 41 were direct sales.

Institutional Revenue. Institutional revenue for the three months ended September 30, 2019 was approximately $625,000, representing an increase of approximately $206,000, or 49.2%, compared to the same period in fiscal 2019. The increase in institutional revenue was primarily due to a higher selling price per device compared to the same period in the prior fiscal year and an increase in the number of devices sold. Institutional revenue includes sales to group purchasing organization (“GPO”) members, medical equipment rental companies that rent to long-term care facilities and other institutions.

Home Care Distributor Revenue. Home care distributor revenue for the three months ended September 30, 2019 was approximately $120,000. We began selling to home medical equipment distributors during the three months ended September 30, 2019, who in turn sell our SmartVest System in the U.S. home care market.

International Revenue. International revenue for the three months ended September 30, 2019 was approximately $66,000, representing a decrease of approximately $69,000, or 51.2%, compared to the same period in fiscal 2019. International sales are affected by the timing of distributor purchases that can cause significant fluctuations in reported revenue on a quarterly basis.

Gross profit

Gross profit increased to approximately $6,342,000, or 76.4% of net revenues, for the three months ended September 30, 2019, from approximately $5,543,000, or 76.2% of net revenues, in the same period in fiscal 2019. The increase in gross profit for the three months ended September 30, 2019 was primarily related to increases in home care revenue. The increase in gross profit as a percentage of net revenue was driven by a higher average allowable due to payer mix compared to the prior year.

Operating expenses

Selling, general and administrative expenses. Selling, general and administrative expenses were approximately $4,895,000 for the three months ended September 30, 2019, representing a decrease of approximately $378,000, or 7.2%, compared to the same period in the prior year.

Payroll and compensation-related expenses were approximately $3,138,000 for the three months ended September 30, 2019, representing a decrease of approximately $270,000, or 7.9%, compared to the same period in the prior year. The decrease in the current year period was due to a lower number of employees in sales and administrative roles, lower share-based compensation expense and a decrease in sales incentives. These decreases in payroll and compensation-related expenses were partially offset by annual salary increases and a higher management bonus accrual as compared to the prior year period. We anticipate payroll and compensation related expenses to increase as we plan to expand our direct sales staff to 38 from 32 at the end of the quarter.

Professional fees for the three months ended September 30, 2019 were approximately $412,000, a decrease of approximately $61,000, or 12.9%, compared to the same period in the prior year. These fees are primarily for services related to legal costs, shareowner services and reporting requirements, information technology (“IT”) security and backup, and consulting fees for sales training. The decrease in professional fees was primarily due to a decrease in IT costs compared to the prior year.

Recruiting fees for the three months ended September 30, 2019 were approximately $63,000, an increase of approximately $33,000, or 110.0%, compared to the same period in the prior year.  The increase in recruiting fees was due primarily to recruiting for vacant positions in sales and administrative roles compared to the prior year period.

Travel, meals and entertainment expenses were approximately $585,000 for the three months ended September 30, 2019, representing a decrease of approximately $24,000, or 3.9%, compared to the same period in the prior year. The decrease was due primarily to having fewer sales personnel.

Research and development expenses. Research and development (“R&D”) expenses were approximately $99,000 for the three months ended September 30, 2019, representing an increase of approximately $31,000 compared to the same period in the prior year. R&D expenses for the three months ended September 30, 2019 were 1.2% of net revenue compared to 0.9% of net revenue for the same period in the prior year. As a percentage of net revenues, we expect spending on R&D expenses to increase to 2-4% for the remainder of the fiscal year as we increase focus on development of a next generation device.

Interest income, net

Net interest income was approximately $40,000 for the three months ended September 30, 2019 compared to $13,000 in the comparable prior year period.  Increases in net interest income was primarily driven by higher rates earned on our cash deposits.

Income tax expense

Income tax expense was estimated at approximately $374,000 and $58,000, and the effective tax rate was 26.9% and 27.0%, for the three months ended September 30, 2019 and 2018, respectively.

Net income

Net income for the three months ended September 30, 2019 was approximately $1,015,000 compared to $157,000 for the same period in the prior year. The year-over-year increase in net income was driven primarily by higher revenue and lower payroll and compensation-related expenses.  

Liquidity and Capital Resources

Cash Flows and Sources of Liquidity

Cash Flows from Operating Activities

For the three months ended September 30, 2019, net cash provided by operating activities was approximately $629,000. Cash flows provided by operating activities consisted of net income of approximately $1,015,000, non-cash expenses of $395,000 and a decrease in accounts receivable of $41,000. These cash flows from operating activities were partially offset by a decrease in income taxes payable of $289,000, a decrease in accounts payable and accrued liabilities of $250,000, an increase in inventory of $119,000, an increase in prepaid expenses and other assets of $102,000, an increase in income taxes receivable of $50,000 and an increase in contract assets of $12,000.

Cash Flows from Investing Activities

For the three months ended September 30, 2019, cash used in investing activities was approximately $415,000. Cash used in investing activities consisted of approximately $405,000 in expenditures for property and equipment and $10,000 in payments for patent costs. 

Cash Flows from Financing Activities

For the three months ended September 30, 2019, cash provided by financing activities was approximately $13,000, which consisted of cash we received from the exercise of stock options.

Adequacy of Capital Resources

Our primary working capital requirements relate to adding employees to our sales force and support functions, continuing R&D efforts, and supporting general corporate needs, including financing equipment purchases and other capital expenditures incurred in the ordinary course of business. Based on our recent operational performance, we believe our working capital of approximately $21,757,000 as of September 30, 2019 and available borrowings under our existing credit facility will provide adequate liquidity for the next year.

Effective December 18, 2018, we renewed our credit facility, which provides us with a revolving line of credit. Interest on borrowings on the line of credit accrues at the prime rate (5.00% at September 30, 2019) less 1.00% and is payable monthly. There was no outstanding principal balance on the line of credit as of September 30, 2019 or June 30, 2019.  The amount eligible for borrowing on the line of credit is limited to the lesser of $2,500,000 or 57.00% of eligible accounts receivable, and the line of credit expires on December 18, 2019, if not renewed. At September 30, 2019, the maximum $2,500,000 was available under the line of credit. Payment obligations under the line of credit are secured by a security interest in substantially all of our tangible and intangible assets.

The documents governing our line of credit contain certain financial and nonfinancial covenants that include a minimum tangible net worth of not less than $10,125,000 and restrictions on our ability to incur certain additional indebtedness or pay dividends. We were in compliance with these covenants as of September 30, 2019.

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 any indebtedness, preventing access to additional funds under the line of credit, requiring prepayment of outstanding indebtedness, or refusing to renew the line of credit. If the maturity of the indebtedness is accelerated or the line of credit is not renewed, sufficient cash resources to satisfy the debt obligations may not be available and we may not be able to continue operations as planned. If we are unable to repay such indebtedness, the lender could foreclose on these assets.

For the three months ended September 30, 2019 and 2018, we spent approximately $405,000 and $10,000, respectively, on property and equipment. We currently expect to finance planned equipment purchases with cash flows from operations or borrowings under our credit facility. We may need to incur additional debt if we have an unforeseen need for additional capital equipment or if our operating performance does not generate adequate cash flows.

In September 2019, we completed a building expansion project at our New Prague, Minnesota facility. This building expansion commenced in April 2019 and the total cost of the project was approximately $1,500,000 and will save us over $130,000 in annual lease expense and provide us with sufficient infrastructure to support our long-term growth.

Off-Balance Sheet Arrangements

As of September 30, 2019, we had no off-balance sheet arrangements.

Cautionary Note Regarding Forward-Looking Statements

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

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

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

Item 3.       Quantitative and Qualitative Disclosures About Market Risk.

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

Item 4.       Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

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

Changes to Internal Control Over Financial Reporting

Effective July 1, 2019, we adopted Accounting Standards Codification Topic 842, Leases.  Changes were made to relevant business processes and the related control activities in order to monitor and maintain appropriate controls over financial reporting in accordance with the standard.  There were no other changes in our internal control over financial reporting that occurred during the three months ended September 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1.       Legal Proceedings.

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

Item 1A.    Risk Factors.

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

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

None.

Item 3.       Defaults Upon Senior Securities.

None.

Item 4.       Mine Safety Disclosures.

None.

Item 5.       Other Information.

None.

Item 6.       Exhibits.

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

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.