check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.
check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.
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.
check mark whether the registrant has submitted electronically and posted on
its corporate Website, 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).
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
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.
Indicate by check mark whether
the registrant is a shell company (as defined in Rule 12b-2 of the Act).
The aggregate market value of the Common Stock held by non-affiliates of the Registrant as of December 31, 2010 was approximately $18,460,401 based upon the closing price of the Registrants Common Stock on such date.
There were 8,101,085 shares of the registrants common stock outstanding as of August 31, 2011.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement for the registrants Fiscal 2012 Annual Meeting of Shareholders, to be filed within 120 days of June 30, 2011, are incorporated by reference into Part III of this Form 10-K.
INFORMATION REGARDING FORWARD LOOKING STATEMENTS
Some of the statements in this report may contain forward-looking statements 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 relate to the following: our business strategy, including our intended level of investment in research and development and marketing activities and our expectations with respect to earnings and sales growth, industry relationships, marketing strategies and international sales; our business strengths and competitive advantages; our expectation that our products will continue to qualify for reimbursement and payment under government and private insurance programs; the expected impact of applicable regulations on our business; our belief that our current facilities are adequate to support our growth plans; our intended use of proceeds from our initial public offering; our intent to enter into a separation agreement and release with our Chief Financial Officer; our expectations with respect to ongoing compliance with the terms of our credit facility; our intent to renew our line of credit; and our anticipated revenues, expenses, and capital requirements. Many of these forward-looking statements are located in this report under Item 1. BUSINESS; Item 2. PROPERTIES and Item 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, but they may appear in other sections as well. These statements involve known and unknown risks, uncertainties and other factors that may cause our results or our industrys 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 managements 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 may differ materially from those set forth in the forward-looking statements for many reasons, including events beyond our control and assumptions that prove to be inaccurate or unfounded. We cannot provide any assurance with respect to our future performance or results. Our actual results or actions could and likely will differ materially from those anticipated in the forward-looking statements for many reasons, including the reasons described in this report. These factors include, but are not limited to:
Electromed, Inc. (we, us, Electromed or the Company) was founded by Mr. Robert D. Hansen and Mr. Craig N. Hansen and incorporated in Minnesota in 1992. In August 2010, we completed an initial public offering (IPO) of 1,700,000 shares of our common stock. In September 2010, the underwriter in the IPO acquired an additional 200,000 shares pursuant to the exercise of a portion of its over-allotment option. Our common stock is traded on the NASDAQ Capital Market under the ticker symbol ELMD.
We manufacture, market and sell products that provide airway clearance therapy, including the Electromed SmartVest® Airway Clearance System (Electromed SmartVest System) and related products, to patients with compromised pulmonary function. The Electromed SmartVest System generates High Frequency Chest Wall Oscillation (HFCWO), also known as High Frequency Chest Compression, a technique for airway clearance therapy. HFCWO facilitates airway clearance by loosening and mobilizing respiratory secretions in a patients lungs. A vest is worn over the torso that repeatedly compresses and releases the chest at frequencies from 5 to 20 cycles per second. Each compression (or oscillation) produces pulsations within the lungs that shear secretions from the surfaces of the airways and propels them toward the mouth where they can be removed by normal coughing. Unlike traditional chest physio-therapy, which must be performed on the patient while he or she is placed in a series of often uncomfortable positions, HFCWO can be performed with the patient sitting upright.
Studies show that HFCWO therapy is as effective an airway clearance method for patients who have cystic fibrosis or other forms of compromised pulmonary function as traditional chest physio-therapy administered by a respiratory therapist. However, HFCWO can be self-administered, relieving a caregiver of participation in the therapy, and eliminating the attendant cost of an in-home care provider. We believe the treatments are cost-effective primarily because they reduce a patients risk of respiratory infections and other secondary complications that are associated with impaired mucus transport. Secondary complications, such as pneumonia, may be serious or life-threatening and often result in costly hospital visits.
The Electromed SmartVest System is a portable, programmable, and multi-positional airway clearance machine that generates HFCWO and has been approved by the Food and Drug Administration (FDA) to treat the condition of excess lung secretions. Consequently, it may be prescribed to patients suffering from cystic fibrosis, chronic obstructive pulmonary disease, muscular dystrophy, post-surgical airway complications and a variety of other diseases and conditions associated with impaired lung and airway capacity. By clearing airways, patients are able to rid their lungs of retained secretions and are therefore less likely to develop lung infections such as pneumonia.
The Electromed SmartVest System features a programmable electro-mechanical pulse generator and a pneumatic therapy garment, which together provide safe, comfortable, and effective airway clearance therapy. We believe that the lightweight, portable design allows patients greater freedom to travel and enjoy activities of daily living, resulting in enhanced quality of life for patients using the Electromed SmartVest System. A broad range of vest sizes for children and adults allow for tailored fit and function. User-friendly controls allow children to administer their own daily therapy under adult supervision. Our goal has been to make the HFCWO airway clearance treatments as comfortable and convenient as possible so our patients can more easily tolerate their regimen and be able to perform their treatments as readily as possible.
In order to maintain and expand our position in the market for airway clearance therapy products, we have assembled an experienced team of employees with expertise in health care, product development, manufacturing, marketing, sales, and financial management. For example, approximately 28% of our employees are respiratory therapists. In addition, we engage over 300 respiratory therapists and health professionals on a non-exclusive independent contractor basis to educate and train customers on the Electromed SmartVest System. Our team also includes several consultants who advise us on quality assurance, product development, and financing, and who keep us apprised of industry developments and opportunities in Europe.
Our management team has significant business experience and has developed industry relationships, resulting from memberships in various respiratory care professional groups and attendance, sponsorship and participation in numerous medical conferences in the U.S., Europe, and Asia. In June 2011, we appointed Dr. James J. Cassidy to the newly-created position of Chief Operating Officer. Dr. Cassidy has extensive international management experience in the medical device industry.
In addition to relationships developed at the management level, our staff and contractors, who often play a key role in the education of current and potential customers, have developed trusted relationships across the U.S. with physicians and other caregivers over the course of their careers. Approximately 28% of our full-time employees, including our entire Patient Services Department and approximately half of our sales representatives, are respiratory therapists. Many of these individuals have extensive experience in the field of respiratory care, and their relationships and experience are of great worth to us. These individuals maintain a dialogue with clinics, patients, patient families, and respiratory therapist trainers to ensure that our products are being properly operated and are performing effectively. Additionally, our sales representatives participate in various events, such as family days held by the Cystic Fibrosis Foundation for cystic fibrosis patients, at which they have an opportunity to demonstrate the effectiveness of the Electromed SmartVest System and further develop relationships with patients, patient families, physicians and hospitals.
In order to ensure the efficient production of high-quality products, we employ experienced personnel in our Engineering and Manufacturing Departments and work with an established network of vendors who permit us to integrate all assembly and quality assurance on a single campus.
Our products are primarily used in the home health care market. We also sell our products for use in hospitals, which we refer to as institutional sales. Accordingly, our points of contact are home health care use, hospitals, clinics, and pulmonary rehabilitation centers, both domestically and internationally. The Electromed SmartVest System is a doctor-prescribed therapy and, depending on the circumstances of the patient, its cost to an individual is generally reimbursable by Medicare, Medicaid, private insurance, or a combination of the three. We have received clearance from the FDA to market our products.
The Electromed SmartVest System
The Electromed SmartVest System consists of a pneumatic therapy garment, an electronic pulse generator for creating and controlling force pulses, and a single hose which extends the force pulses from the generator to the pneumatic vest. The Electromed SmartVest System is a portable airway clearance therapy system that gives the patient direct control over the most difficult and time-consuming aspects of respiratory therapy, and provides caregivers an easier and more reproducible means of administering therapy to disabled or bedridden patients. The Electromed SmartVest System also has other appealing practical features, including improved ease of use and a non-clinical appearance. We believe these attributes particularly appeal to children, teenagers and young adults who represent the majority of the cystic fibrosis patient population. Our system allows the patient to be relatively mobile while therapy is being given, unlike manual chest physical therapy in which the patient must remain in a fixed position.
The Electromed SmartVest System therapy garment offers the following features:
The Electromed SmartVest Systems electronic pulse generator features the following important aspects:
We market the Electromed Single Patient Use Vest (SPUV) and Electromed SmartVest Wrap® to health care providers, particularly those working in intensive care units. Hospitals issue the SPUV or Electromed SmartVest Wrap to one patient for the duration of his or her stay. Both products facilitate continuity of care because they introduce the patient to our product line and may encourage use of the Electromed SmartVest System for home care, which can be provided to the chronic condition patient upon discharge. Both products provide full coverage pulsation. The SPUV is a full-sized vest that is often used for patients undergoing institutional treatment who are already accustomed to using an Electromed SmartVest System. The SPUV is intended for short-term, in-patient use and allows the patient to avoid contaminating his or her home-use vest while continuing treatment in a hospital or other facility.
The Electromed SmartVest Wrap, which we introduced in 2007, is lightweight, convenient, and well-suited for patients recovering from surgery and short-term illnesses. We believe that the design of the Electromed SmartVest Wrap, which lacks a vest outer shell, makes it easy for the health care professional to operate because it does not need to go over the patients head, minimizing the need to move post-surgical patients and avoiding interference with other apparatuses the patient may be using. In addition, the wrap is reversible, which allows the air pulse generator to be aligned on either side of a hospital bed. We believe that our ability to provide a relatively more comfortable therapy alternative to patients results in a higher likelihood of patient cooperation and consistent use.
We have designed and patented a mobile pedestal, which we manufacture and provide with sales of our institutional models of the Electromed SmartVest System. The mobile pedestal allows for easy transport within the medical facility. This unit includes a pneumatic feature, permitting ease of movement in raising and lowering the vertical position of the generator.
We market our HFCWO products to a broad patient population. For patients with a chronic pulmonary condition, many hours per day may be dedicated to a variety of treatments. The Electromed SmartVest System provides effective airway clearance therapy in a comfortable and portable design which allows patients greater independence and speed of treatment. Building from a foundation of product quality, as well as our dedication to customer service, our goal is to be a consistent innovator in providing airway clearance therapy to patients with compromised pulmonary function.
Because sale of the Electromed SmartVest System is by physicians prescription only, we market to health care professionals, such as doctors, nurses, respiratory therapists, and clinic coordinators. However, with respect to both our in-home and institutional products, the health care professionals decisions may be based on preferences expressed by patients. Therefore, we believe that it is also important to market our products to patients and caregivers. In addition, because the availability of reimbursement is an important consideration for health care professionals and patients, we must also prove the effectiveness of our product to public and private insurance providers.
The Electromed SmartVest System is currently prescribed to patients who suffer from cystic fibrosis (CF), chronic obstructive pulmonary disease (COPD), bronchiectasis, neuro-muscular disorders or post-surgical complications and patients who are ventilator dependent or have other conditions involving excess secretion and impaired mucus transport. When we entered the market in 2000, we focused on providing our product to CF patients because we felt those individuals could greatly benefit from treatment from our HFCWO system and it was the indication most likely to qualify for reimbursement at that time. Over time, we have expanded our focus to include post-surgical and intensive care patients at risk of developing pneumonia, patients with end-stage neuromuscular disease, and ventilator-dependent patients.
The essential requirements that make a patient a candidate for airway clearance therapy are compromised respiratory function with a need to:
The Electromed SmartVest System is designed to meet the individual patients needs by providing a therapy that is efficient, is easy to administer, and can be performed independently. Electromeds established marketing and product support services provide education, training, and follow-up with the patient population to insure the product is integrated into their daily treatment regimen. We believe advantages of the Electromed SmartVest System to the independent patient include:
Marketing, Sales and Distribution
During our 2011 fiscal year, we worked to expand and reposition our domestic sales force. We believe these efforts contributed to our revenue growth in fiscal 2011. We expect to achieve future earnings and sales growth through focusing on continuing educational opportunities and industry relationships, building distributor relationships in Europe and Asia, and maintaining leadership in product innovation.
We participate in medical conferences and maintain industry contacts in order to increase the visibility of our products and acceptance by physicians and health care professionals, as well as patients. In addition , we have a designated marketing department and place advertisements in leading medical magazines and journals in the U.S. and Europe. We also believe that the Internet has provided us with a marketing benefit in recent years, as several overseas distributors have contacted us after visiting our website.
North American Marketing
Approximately half of our domestic sales representatives are respiratory therapists. Each sales representative, or Clinical Area Manager (CAM), is responsible for introducing our products, principally the Electromed SmartVest System, to clinics and hospitals within a specific geographical area, and are also able to provide training and continued support to customers. As of June 30, 2011, we had 28 total sales representatives, including a national sales manager, 3 regional sales managers, and 24 CAMs. Collectively, our sales force covers the entire United States and portions of Canada, which we have divided into West, Midwest, and East regions. Each clinical area manager is assigned to a particular territory within one of the three regions. We have also developed a network of over 300 respiratory therapists and health care professionals to assist with training patients across the U.S. on a non-exclusive independent contractor basis. We believe that the professional knowledge of the CAMs and trainers demonstrates our commitment to customer service and facilitates sales.
In fiscal 2011, our international sales comprised approximately 3.2% of net revenue. Internationally, we have made sales in fifteen different countries. In addition to sales made in Canada, the principal countries in which we have made sales internationally, and the countries in which our principal distributors are located, are Italy, Japan and Taiwan. We are actively identifying distributors and other international sales opportunities.
Our historical practice and continued intent includes developing long-term relationships with distributors who have knowledge and experience in serving respiratory physicians and patients in the host country. Units are sold at a consistent price with payment made directly from the distributor, rather than allowing payments consistent with reimbursement procedures as is the case for domestic sales. For all international sales, our Quality Assurance Department and Chief Financial Officer monitor pricing, payments and conforming regulatory practice. Our Chief Executive Officer and Marketing Director oversee the growth and performance of international sales.
HFCWO was first developed for CF patients at the University of Minnesota. The purpose of HFCWO is to provide more effective mucus clearance in a form that could be performed independently of a caregiver. The original technology was licensed to American Biosystems, Inc. (now Advanced Respiratory, Inc. (ARI), part of Hill-Rom Holdings, Inc., a publicly traded company) which, until the introduction of our original MedPulse Respiratory Vest System® in 2000, was the only manufacturer of this technology. All of ARIs products use a two-hose, closed-loop system, in contrast to the single-hose, flow-through system that we designed, which we believe provides greater ease of use and patient comfort. In 2005, Respiratory Technologies, Inc., a privately held company doing business as RespirTech, received FDA clearance to market their inCourage system (the inCourage System), which includes a HFWCO vest. Like the Electromed SmartVest System, ARIs The Vest and RespirTechs inCourage System are cleared for market by the FDA.
From a clinical performance perspective, all HFCWO products meet a common standard of substantial equivalence. As a result, features and benefits such as number of hoses required to deliver the therapy (one hose versus two hoses), construction quality, appearance of the generator, reputation for patient services, and sales effectiveness of field personnel have become key variables. We believe that the product features of the Electromed SmartVest System enable us to compete effectively, particularly when health care professionals, patients, and caregivers are provided with demonstrations of product choices prior to committing to a specific product. We often provide demonstration units to encourage such comparisons. Unlike our competitors products, the Electromed SmartVest System has a single-hose, flow-through system design and an adjustable vest made from soft, breathable and washable fabric. We use Velcro in our patented vest to provide a tailored fit, as opposed to an inflatable fit model. In addition to product features, our focus on providing exemplary customer training and service, along with our commitment to engage and retain highly motivated employees and contractors, many of whom are medical professionals, provides a valuable competitive advantage.
Alternative products for administering pulmonary therapy include:
Physicians may prescribe some or all of these devices and techniques, depending upon each patients health status, severity of disease, compliance, or personal preference. We believe our primary competitive advantage over alternative treatments is patient comfort, ease of use, and the effectiveness of HFCWO treatment as compared to CPT and other alternative treatments. Because HFCWO is not technique dependent, as compared to most other pulmonary therapy products, therapy begins automatically once power is provided and remains consistent and controlled for the duration of the session. We strive to make the Electromed SmartVest System an increasingly attractive and comfortable form of HFCWO therapy. We believe that HFCWO therapy generally, and the Electromed SmartVest System in particular, produces less interference with daily activities, which increases the likelihood of regular use. We believe these advantages encourage physicians to prescribe and patients to request the Electromed SmartVest System for pulmonary therapy. Reimbursement for the diverse patient populations for each of these pulmonary therapies varies greatly because a patients medical care costs are typically addressed by a combination of private insurance and government benefit schedules, as well as state health care policies and programs.
Research and Development
In addition to the 21 U.S. patents and 7 foreign patents that we currently hold, we have a number of pending patent applications domestically and internationally.
As of June 30, 2011, our research and development staff consisted of three full-time employee engineers. We also receive engineering support from several consultants, including Mr. Craig N. Hansen, pursuant to an agreement with Hansen Engine Corporation. See Part III, Item 13, Certain Relationships and Related Transactions, and Director Independence. Our team, the majority of whom have experience in respiratory therapy and medical device development, has a demonstrated record of developing new products which receive the appropriate product approvals and regulatory clearances, with our products having been approved or cleared in the U.S., Canada, and the member countries of the European Economic Area.
During the fiscal years ended June 30, 2011 and 2010 we incurred research and development expenses of $1,034,000 and $601,000, respectively. As a result of our expected investments in enhancing the Electromed SmartVest System, we intend to spend at least 5% of net revenue on research and development activities for the foreseeable future.
As of June 30, 2011, we held 21 issued U.S. patents and 7 foreign patents covering the Electromed SmartVest System and its underlying technology, and had 32 pending U.S. and foreign patent applications. These patents and patent applications offer coverage in the field of air pressure pulse delivery to a human in support of airway clearance. Our first U.S. patent expires in 2013 and in Canada in 2016.
We generally pursue patent protection for patentable subject matter in our proprietary devices in foreign countries in which we make regular sales. We have been granted patent protection in Canada, New Zealand and South Africa. We have additional patent applications pending in Canada, Japan, and South Korea and with the European Patent Organization, whose member states include Spain, Croatia, Greece, Italy, Portugal, and Romania.
We have also received the following U.S. trademark and service mark registrations: MEDPULSE, MEDPULSE RESPIRATORY VEST SYSTEM, SMARTVEST, SMARTVEST WRAP, SMARTWRAP, FACT, SOFT START, TRIMLINE, and CREATING SUPERIOR CARE THROUGH INNOVATION.
Our headquarters in New Prague, Minnesota include a dedicated manufacturing and engineering facility of more than 10,000 square feet. Our site has been regularly audited by the FDA, in accordance with FDA practices, and we maintain our operations in a manner consistent with FDA requirements for a medical device manufacturer. Our manufacturing processes emphasize simplicity, cost-effectiveness, and a capacity to realize increases in production volume with escalation in demand. All employees are responsible for maintaining specific manufacturing and quality standards, which are monitored by our quality assurance manager under an extensive system designed to satisfy FDA and International Organization for Standardization (ISO) standards.
Our staff is responsible for manufacturing each Electromed SmartVest System. While components are outsourced based upon detailed specifications, each Electromed SmartVest System is assembled, tested, and approved for final shipment at our manufacturing site in New Prague, Minnesota, under careful control consistent with FDA, Underwriters Laboratory (UL), and ISO standards. While all third-party vendors present some degree of risk of supply or impairment issues, many of our vendors are located within 100 miles of our headquarters, which enables us to closely monitor the supply chain. We maintain at least a two-month supply of all of our critical components, and the materials used in the Electromed SmartVest System are generally available from a number of suppliers.
A rigorous quality standard is applied to components received from vendors. Any adverse findings result in the quarantine of any out of specification components. Before an Electromed SmartVest System is shipped to a patient, rigorous testing is again applied to match the performance of the air pulse generator with the particular vest size stipulated for the patient.
Our business is not materially affected by seasonality.
We provide a warranty on the Electromed SmartVest System that covers the cost of replacement parts and labor, or a new Electromed SmartVest System in the event we determine a full replacement is necessary. For Electromed SmartVest Systems initially purchased and currently located in the United States and Canada, we provide a lifetime warranty to the individual patient for whom the system is prescribed. For products sold to patients in Greece, we provide a five-year warranty. For sales to institutions within the United States and Canada, and for all other sales to individuals and institutions made outside of the United States, Canada and Greece, we provide a three-year warranty. Our warranties provide that if a newer model of our systems has been developed and sold between the time of purchase of the original system and we determine the need for replacement, we may replace the system with a newer model at our discretion.
In the U.S., individuals who use the Electromed SmartVest System will generally rely on third-party payers, including private payers and governmental payers such as Medicare and Medicaid, to cover and reimburse all or part of the cost of using the Electromed SmartVest System. Reimbursement for HFCWO therapy and the Electromed SmartVest System varies among public and private insurance providers.
Most patients are able to qualify for reimbursement and payment from Medicare, Medicaid, private insurance or combinations of the foregoing. We expect that subsequent generations of HFCWO products will also qualify for reimbursement under Medicare Plan B and most major health plans. However, some third-party payers must also approve coverage for new or innovative devices or therapies before they will reimburse health care providers who use the medical devices or therapies. In addition, we face the risk that new or modified products could have a lower reimbursement rate, or that the levels of reimbursement currently available for our existing products could decrease, which would hamper our ability to market and sell that product. Consequently, our sales will continue to depend in part on the availability of coverage and reimbursement from third-party payers, even though our devices may have been cleared for commercial distribution by the FDA. The manner in which reimbursement is sought and obtained varies based upon the type of payer involved and the setting in which the procedure is furnished. The nature of any future legislation is uncertain, making it difficult for us to predict the impact of cost-containment trends on operating results.
A key element in our customer support strategy has been achieved by establishing an effective reimbursement department to seek insurance authorization and process claims on behalf of the patient. The skill and knowledge gained and offered by our reimbursement department is an important factor in building our revenue and serving patients financial interests. Our payment terms allow patients to acquire the Electromed SmartVest System over a period of 1 to 15 months, which is consistent with reimbursement procedures followed by Medicare and other third parties. The amount we receive for any single unit is based on reimbursement schedules and may vary based on a number of factors, including Medicare and third-party reimbursement processes and policies. The patient maintains the risk of reimbursement to the Company in the event of non-payment by third-party payers.
Payments for overseas sales are made directly by the distributors, and we are not involved in the reimbursement process. Overseas sales were approximately 3.2% of our net revenue in fiscal 2011.
Medicare and Medicaid
Recent government and private sector initiatives in the U.S. and foreign countries are aimed to limit the growth of health care costs, including price regulation, competitive pricing, coverage and payment policies, comparative effectiveness of therapies, technology assessments, and managed-care arrangements, and are causing the marketplace to put increased emphasis on the delivery of more cost-effective medical devices. Government programs, including Medicare and Medicaid, have attempted to control costs by limiting the amount of reimbursement they will pay for particular procedures or treatments, restricting coverage for certain products or services, and implementing other mechanisms designed to constrain utilization and contain costs. In addition, many private insurance programs look to Medicare as a guideline in setting their coverage policies and payment amounts. This has created an increasing level of price sensitivity among customers.
Our medical devices are subject to regulation by numerous government agencies, including the FDA and comparable foreign agencies. To varying degrees, each of these agencies requires us to comply with laws and regulations governing the development, testing, manufacturing, labeling, marketing, and distribution of our medical devices. Since inception, management has retained the necessary clinical, medical and legal expertise to support required clearances and approvals to market our products. A full-time quality assurance manager as well as a consulting regulatory and clinical expert provide detailed oversight of their respective areas of responsibility. The Companys Chief Operating Officer provides oversight with respect to the manufacturing, quality assurance, research and development, and product development activities of the company.
We have received clearance from the FDA to market our products, including the Electromed SmartVest System, as a powered percussor. On April 7, 2004, our Model 2000ez SMARTVEST was cleared to market by the FDA pursuant to a 510(k) submission.
We obtained ISO 9001 Certification in January 2005, which demonstrates to our international distributors and customers that our products conform to uniform standards for manufacturing quality and that our business meets certain professional standards. In addition, we obtained clearance to use the European Union CE Mark on our products in April 2005. The CE Mark is required for medical device sales in countries within the European Economic Area, which includes the twenty-seven member countries of the European Union as well as Iceland, Liechtenstein, Norway, Switzerland, Turkey, and other European countries that may adopt EU standards voluntarily. Renewal of the CE Mark is required every five years, and our notified body performs an annual audit to ensure that we are in compliance with all applicable regulations. We have maintained our CE Mark in good standing since originally receiving it and most recently renewed it in January 2010. We also require all of our distributors to comply with their home country regulations.
FDA Approval Requirements
If we develop new medical devices or modifications to existing products that would affect the products safety or effectiveness, we may be required to obtain FDA clearance before marketing the new or modified product in the U.S., either through the 510(k) clearance process or the more complex Premarket Approval Application process. The application process may be time consuming and expensive, particularly if clinical trials are required. Failure to obtain such clearances or approvals could adversely affect our ability to grow our business. Delays in receipt or failure to receive clearances or approvals, the loss of previously received clearances or approvals, or the failure to comply with existing or future regulatory requirements could have a material adverse effect on our business.
Continuing Product Regulation
In addition to its approval processes for new products, the FDA may require testing and surveillance programs to monitor the effects of previously approved products that have been commercialized, and may prevent or limit further marketing of products based on the results of these post-marketing programs. At any time after approval of a product, the FDA may conduct periodic inspections to determine compliance with both the FDAs Quality System Regulation (QSR) requirements and/or current medical device reporting regulations. Product approvals by the FDA can be withdrawn due to failure to comply with regulatory standards or the occurrence of unforeseen problems following initial approval. The failure to comply with regulatory standards or the discovery of previously unknown problems with a product or manufacturer could result in fines, delays or suspensions of regulatory clearances, seizures or recalls of products (with the attendant expenses), the banning of a particular device, an order to replace or refund the cost of any device previously manufactured or distributed, operating restrictions and criminal prosecution, as well as decreased sales as a result of negative publicity and product liability claims.
We are required to register with the FDA as a device manufacturer and, as a result, we are subject to periodic inspection by the FDA for compliance with the FDAs QSR requirements, which require manufacturers of medical devices to adhere to certain regulations, including testing, quality control and documentation procedures. In addition, the federal Medical Device Reporting regulations require us to provide information to the FDA whenever there is evidence that reasonably suggests that a device may have caused or contributed to a death or serious injury or, if a malfunction were to occur, could cause or contribute to a death or serious injury. Compliance with applicable regulatory requirements is subject to continual review and is rigorously monitored through periodic inspections by the FDA. We are also required to maintain certain certifications in order to sell products internationally, and we undergo periodic inspections by notified bodies to obtain and maintain these certifications.
Advertising and promotion of medical devices, in addition to being regulated by the FDA, are also regulated by the Federal Trade Commission and by state regulatory and enforcement authorities. Recently, promotional activities for FDA-regulated products of other companies have been the subject of enforcement action brought under health care reimbursement laws and consumer protection statutes. Competitors and others can also initiate litigation relating to advertising claims. If the FDA determines that our promotional materials or training constitutes promotion of an unapproved or uncleared use, it could request that we modify our training or promotional materials or subject us to regulatory or enforcement actions, including the issuance of an untitled letter, a warning letter, injunction, seizure, civil fine or criminal penalties. It is also possible that other federal, state or foreign enforcement authorities might take action if they consider our promotional or training materials to constitute promotion of an unapproved use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement.
Fraud and Abuse Laws
Federal health care laws apply when we or customers submit claims for items or services that are reimbursed under Medicare, Medicaid or other federally-funded health care programs. The principal federal laws include: the False Claims Act which prohibits the submission of false or otherwise improper claims for payment to a federally-funded health care program; the Anti-Kickback Statute which prohibits offers to pay or receive remuneration of any kind for the purpose of inducing or rewarding referrals of items or services reimbursable by a federal health care program; and health care fraud statutes that prohibit false statements and improper claims with any third-party payer. There are often similar state false claims, anti-kickback, and anti-self referral and insurance laws that apply to state-funded Medicaid and other health care programs and private third-party payers. In addition, the U.S. Foreign Corrupt Practices Act can be used to prosecute companies in the U.S. for arrangements with physicians, or other parties outside the U.S. if the physician or party is a government official of another country and the arrangement violates the law of that country. Enforcement of all of these regulations has become increasingly stringent, particularly due to more prevalent use of the whistleblower provisions under the False Claims Act, which allow a private individual to bring actions on behalf of the federal government alleging that the defendant has submitted a false claim to the federal government and to share in any monetary recovery. If a governmental authority were to conclude that we are not in compliance with applicable laws and regulations, we and our officers and employees could be subject to severe criminal and civil penalties including substantial penalties, fines and damages, and exclusion from participation as a supplier of product to beneficiaries covered by Medicare or Medicaid.
HIPAA and Other Fraud and Privacy Regulations
Federal and state laws protect the confidentiality of certain patient health information, including patient records, and restrict the use and disclosure of such information. In particular, the U.S. Department of Health and Human Services has issued patient privacy and security standards for electronic health information under the Health Insurance Portability and Accountability Act of 1996 and its implementing regulations (HIPAA).
The HIPAA privacy and security standards govern the use and disclosure of protected health information by covered entities, which are healthcare providers that submit electronic claims, health plans and healthcare clearinghouses. Because we provide our products directly to patients and bill third-party payers such as Medicare, Medicaid, and insurance companies, we are a covered entity and must comply with these standards. The government intended this legislation to reduce administrative expenses and burdens for the health care industry; however, our compliance with certain provisions of these standards entails significant costs for us. Failure to comply with HIPAA or any state or foreign laws regarding personal data protection may result in significant fines or penalties and/or negative publicity. In addition to federal regulations issued under HIPAA, some states have enacted privacy and security statutes or regulations that, in some cases, are more stringent than those issued under HIPAA. In those cases, it may be necessary to modify our planned operations and procedures to comply with the more stringent state laws. If we fail to comply with applicable state laws and regulations, we could be subject to additional sanctions.
The HIPAA health care fraud and false statement statutes also prohibit, among other things, knowingly and willfully executing, or attempting to execute, a scheme to defraud any health care benefit program, including private payers, and knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement or representation in connection with the delivery of or payment for health care benefits, items or services.
We are also subject to various environmental laws and regulations both within and outside the U.S. Like other medical device companies, our operations involve the use of substances regulated under environmental laws, primarily manufacturing and sterilization processes. To the best of our knowledge at this time, we do not expect that compliance with environmental protection laws will have a material impact on our consolidated results of operations, financial position, or cash flows.
As of June 30, 2011, we employed 92 total employees, 85 of which are full-time employees. Of our 92 employees, approximately 28% are respiratory therapists who are licensed by appropriate state professional organizations, including all of the employees in our Patient Services Department and approximately half of our sales representatives. In addition, we retain as independent contractors several expert consultants, who assist with quality assurance, product development, marketing, and international opportunities. We also retain over 300 respiratory therapists and health care professionals on a non-exclusive independent contractor basis to provide training to our customers in the U.S. Approximately 85% of these independent contractors are credentialed by the National Board for Respiratory Care as either Certified Respiratory Therapists or Registered Respiratory Therapists. The remainder of these health care professionals are licensed in fields such as respiratory care, nursing or physical therapy. We believe that providing our customers with the opportunity to obtain support and training from health care professionals underscores our commitment to professional service and high quality.
None of our employees are covered by a collective bargaining agreement. We believe our relations with our employees are good.
Executive Officers of the Registrant
Set forth below are the names, titles, periods of service, and business experience of our executive officers.
Robert D. HansenChairman and Chief Executive Officer
Mr. Hansen co-founded Electromed in 1992 and is responsible for the strategic direction and development of the Company. Mr. Hansen is also a co-founder and is President and Chief Executive Officer of Hansen Engine Corporation, a research and development company that provides research and development services to Electromed. Mr. Hansen joined Hansen Engine Corporation in January 1983 and has over forty years of business leadership and investment industry experience. Mr. Hansen devotes approximately 5% of his time attending to matters related to Hansen Engine Corporation where he is primarily responsible for corporate governance matters through his service as a member of Hansen Engine Corporations board of directors. He was also the founder and CEO of LockerMate Corporation until January 1995. Mr. Hansen received a BA Degree from Dana College (1964), Masters of Arts Degree from the University of Cincinnati in U.S. History (1966), and a Masters of Divinity Degree (1976) from Luther Theological Seminary. He completed additional graduate studies in U.S. economic history and foreign policy at the University of Cincinnati. In 1996, Mr. Hansen was awarded a Mini-MBA in Managing Growing Companies from the University of St. Thomas. Among other attributes, skills, experiences and qualifications, our Board believes that Mr. Hansens history with Electromed and management and investment industry experience allow him to make a valuable contribution as a director. Mr. Hansen is the brother of Craig N. Hansen, one of our directors.
Terry M. Belford, CPA, CMAChief Financial Officer
Mr. Belford joined Electromed in January 2004 as its Chief Financial Officer. Before joining Electromed, Mr. Belford worked for seventeen years as an independent accountant and consultant, serving clients in the distributing, importing, and manufacturing industries. Prior to that he served for several years as a controller and chief financial officer for both established and start-up companies in the above mentioned industries. Mr. Belford earned a Bachelor of Science degree from the University of Missouri and also holds both CPA and CMA designations. He is a member of the American Institute of Certified Public Accountants, the Minnesota Society of Certified Public Accountants and the Institute of Certified Management Accountants. On August 19, 2011, we entered into a Transition Agreement with Mr. Belford, pursuant to which he will retire effective on the earlier of October 31, 2011 or the date on which our new Chief Financial Officer commences employment.
Dr. James J. CassidyChief Operating Officer
Dr. Cassidy was appointed by Electromed in June 2011 to the newly created position of Chief Operating Officer. Dr. Cassidy has extensive international management experience in the medical device industry. From March 2010 to May 2011, Dr. Cassidy offered business development and technology consulting services to the medical device industry through TransAtlantic Medical Device Consulting, LLC, an entity which he founded. Prior to that, Dr. Cassidy was the Chief Operating Officer of Vertebral Technologies, Inc. from June 2009 to February 2010 and the Vice President of Development for ApaTech, Ltd. from September 2004 to February 2009. Dr. Cassidy has also served as the Chief Executive Officer of successful start-up companies in the US (CERAbio) and Europe (Cartificial). In addition, Dr. Cassidy serves as a general partner of Epic BioVentures, LLC, a company that invests in and advises medical technology businesses. Dr. Cassidy has a doctorate in Biomedical Engineering from Case Western Reserve University and an MBA from the University of Memphis.
As a smaller reporting company, we are not required to provide disclosure pursuant to this item.
As a smaller reporting company, we are not required to provide disclosure pursuant to this item.
We own our principal headquarters and manufacturing facilities, consisting of approximately 24,000 total square feet, which are located on an approximately 2.3 acre parcel at 500 Sixth Avenue NW, New Prague, Minnesota 56071 and 502 Sixth Avenue NW, New Prague, Minnesota 56071. Effective July 1, 2011, we also began leasing approximately 20,000 square feet of warehouse space in a building adjacent to the manufacturing facilities. We are in the process of converting approximately 10,000 square feet of the newly leased building to office space. Management considers the current facilities to be satisfactory for our growth plans. In addition, we believe there is sufficient space within the lot in New Prague for additions to the most recently constructed building.
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 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.
Our common stock began trading on the NASDAQ Capital Market on August 13, 2010 under the symbol ELMD in connection with our initial public offering. The following table sets forth the high and low sales prices of our common stock by quarter during the 2011 fiscal year. Our stock was not publicly traded during fiscal 2010.
As of August 31, 2011, there were 163 registered holders of our common stock.
We have never paid cash dividends on any of our securities. We currently intend to retain any earnings for use in operations and do not anticipate paying cash dividends in the foreseeable future. Currently, the agreement governing our credit facility restricts our ability to pay cash dividends.
Recent Sales of Unregistered Equity Securities
In May 2011, we issued 600 shares of common stock to an existing shareholder pursuant to a warrant exercise, for aggregate cash consideration of $1,800. The transaction did not involve an underwriter. We believe the transaction was exempt from the registration requirements of the Securities Act of 1933, as amended, by virtue of Section 4(2) thereof, because the issuance did not involve a public offering, the recipient acquired the shares for investment and not resale, and we have taken appropriate measures to restrict transfer.
Purchase of Equity Securities by the Company
Use of Proceeds
We completed our initial public offering of shares of common stock, $0.01 par value (the IPO) during the first quarter of our 2011 fiscal year. The effective date of our registration statement relating to the IPO, filed on Form S-1 under the Securities Act of 1933 (File No. 333-166470), was August 12, 2010. Net proceeds from the IPO totaled approximately $5,946,000. We have used and intend to use the remainder of the net proceeds from the IPO to make payments on our existing indebtedness; add employees to our Reimbursement, Patient Services and Administrative Departments; add members to our sales force and further develop our focus on institutional sales; continue our research and development efforts; and for general corporate purposes, including to finance equipment purchases and other capital expenditures in the ordinary course of business and to satisfy working capital needs.
During the 2011 fiscal year, we used an estimated $3,097,000 from the net proceeds. We made net payments of approximately $436,000 on our line of credit and term debt with U.S. Bank, National Association. In addition, we used approximately $314,000 to fund the addition of employees to our Reimbursement, Patient Service, and Administrative Departments; approximately $380,000 to add members to our sales force; and approximately $335,000 for expenses associated with being a public company, such as legal, accounting, and other professional fees. Due to the increase in sales during our 2011 fiscal year, we estimate approximately $1,200,000 of the net proceeds were also used to finance the growth in accounts receivable. Finally, we used approximately $432,000 of the net proceeds from the IPO to fund our research and development efforts. A portion of this amount was paid to Hansen Engine Corporation, a research and development company that provides us with engineering services pursuant to a Letter Agreement dated February 16, 2010. Robert D. Hansen, Craig N. Hansen, and Thomas M. Hagedorn are shareholders and directors of Hansen Engine Corporation, and Robert D. Hansen serves as President and Chief Executive Officer of that entity. See Part III, Item 13, Certain Relationships and Related Transactions, and Director Independence.
As a smaller reporting company, we are not required to provide disclosure pursuant to this item.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the accompanying notes included elsewhere in this Report. The forward-looking statements include statements that reflect managements beliefs, plans, objectives, goals, expectations, anticipations and intentions with respect to our future development plans, capital resources and requirements, results of operations, and future business performance. Our actual results could differ materially from those anticipated in the forward-looking statements included in this discussion as a result of certain factors, including, but not limited to, those discussed in the section entitled Information Regarding Forward-Looking Statements immediately preceding Part I of this Report.
Electromed, Inc. (we, us, Electromed or the Company) was incorporated in 1992. We are engaged in the business of providing 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 (Electromed SmartVest System) and related products, to patients with compromised pulmonary function. Our products are sold for both the home health care market and the institutional market for use by patients in hospitals, which we refer to as institutional sales. For approximately eleven years, we have marketed the Electromed SmartVest System and its predecessor products to patients suffering from cystic fibrosis, chronic obstructive pulmonary disease (COPD), bronchiectasis and repeated episodes of pneumonia. Additionally, we offer our products to a patient population that includes post-surgical and intensive care patients at risk of developing pneumonia, patients with end-stage neuromuscular disease, and ventilator-dependent patients.
Because sale of the Electromed SmartVest System is by a physicians prescription only, we market to physicians and health care providers as well as directly to patients. In addition to distributors overseas, we have established our own domestic sales force, which we believe is able to provide superior support and training to our customers. In addition, we have non-exclusive independent contractor arrangements with over 300 respiratory therapists and health care professionals who also provide education and training to our customers. Further, although the reimbursement process is subject to many contingencies, the Electromed SmartVest System is often eligible for reimbursement from major private insurance providers, HMOs, state Medicaid systems, and the federal Medicare system, which is an important consideration for patients considering an HFCWO course of therapy.
For domestic sales, the Electromed SmartVest System may be reimbursed under the Medicare-assigned billing code for High Frequency Chest Wall Oscillation devices if the patient has cystic fibrosis, bronchiectasis (including chronic bronchitis or COPD that has resulted in a diagnosis of bronchiectasis), or any one of certain enumerated neuro-muscular diseases, and can demonstrate that another less expensive physical or mechanical treatment did not adequately mobilize retained secretions. Private payers consider a variety of sources, including Medicare, as guidelines in setting their coverage policies and payment amounts.
We have been generating revenue from the sale of the Electromed SmartVest System or its predecessor products since 2000 and have generated net income since the fiscal year ended June 30, 2006. For the fiscal year ended June 30, 2011, we generated revenue of approximately $19,004,000 and net income of approximately $1,056,000. Our sales growth rate was 32.9% for the 2011 fiscal year compared to the 2010 fiscal year and was 10.0% for the 2010 fiscal year compared to the 2009 fiscal year. Net income as a percentage of sales was 5.6% in 2011 compared to 6.4% in 2010. Management believes the increase in net income in dollars was primarily the result of the increased sales resulting from expansion of our sales force. The decrease in net income as a percentage of sales was the result of higher expenses from expansion of the sales force and higher direct sales and sales support expenses, along with increased expenses relating to being a public company.
Critical Accounting Policies and Estimates
During the preparation of our consolidated financial statements, we are required to make estimates, assumptions and judgments that affect reported amounts. Those estimates and assumptions affect our reported amounts of assets and liabilities, our disclosure of contingent assets and liabilities, and our reported revenues and expenses. We update these estimates, assumptions and judgments as appropriate, which in most cases is at least quarterly. We use our technical accounting knowledge, cumulative business experience, judgment and other factors in the selection and application of our accounting policies. While we believe the estimates, assumptions and judgments we use in preparing our consolidated financial statements are appropriate, they are subject to factors and uncertainties regarding their outcome and therefore, actual results may materially differ from these estimates. The following is a summary of our primary critical accounting policies and estimates. Please also refer to Note 1 to the Consolidated Financial Statements, included in Part II, Item 8 of this Report.
Revenue Recognition and Allowance for Doubtful Accounts
Revenues from direct patient sales are recorded at the amount to be received from patients under their arrangements with third-party payers, including private insurers, prepaid health plans, Medicare and Medicaid. In addition, we record an estimate for selling price adjustments which often arise from changes in a patients insurance coverage, changes in a patients state of domicile, insurance company coverage limitations or patient death. We periodically review originally billed amounts and our collection history and make changes to the estimation process by considering any changes in recent collection or sales allowance experience, but have not made material adjustments to previously recorded revenues and receivables.
Other than the installment sales as discussed below, we expect to receive payment on the vast majority of accounts receivable within one year and therefore classify all receivables as current assets. However, in some instances, payment for direct patient sales can be delayed or interrupted resulting in a small portion of collections occurring later than one year. In the event receivables are expected to be paid over longer intervals than one year, we recognize revenue under the installment method.
Certain third-party reimbursement agencies pay us on a monthly installment basis, which can span from 18 to 60 months in the cases of Wisconsin, New York and Texas Medicaid, which constitute the majority of our installment method sales. Due to the length of time over which reimbursement is received, we believe that the inherent uncertainty of collection due to external factors noted above precludes us from making a reasonable estimate of revenue at the time the product is shipped. In certain circumstances, the patient must periodically attest that the unit continues to be utilized as a prerequisite to continued reimbursement coverage. Therefore, we believe the installment method is appropriate for these sales. If the third party reimbursement agency discontinues payment and we determine no further payments will be made from the patient, the carrying value of the account receivable is written off as a period adjustment against the previously recognized sales. Under the installment method, we do not record accounts receivable or revenue at the time of product shipment. We defer the revenue associated with the sale and, as each installment is received, that amount is recognized as revenue. Deferred costs associated with the sale are amortized to cost of revenue ratably over the estimated period in which collections are scheduled to occur.
Accounts receivable are also net of an allowance for doubtful accounts, which are accounts from which payment is not expected to be received although product was provided and revenue was earned. Management determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customers financial condition and credit history. Receivables are written off when deemed uncollectible. Recoveries of receivables previously written off are recorded when received.
We request that customers return to us previously-sold units that are no longer in use, in order to limit the possibility that such units would be resold by unauthorized parties or used by individuals without a prescription. The customer is under no obligation to return the product; however, we do reclaim the majority of previously sold units upon the discontinuance of patient usage. We have not obtained certification to recondition and resell returned units. Returned units are primarily used for warranty replacement parts and demonstration equipment. Returned products do not have significant value to us as the costs of becoming certified to resell, reclamation and reconditioning typically exceed the costs of producing a new unit.
Valuation of Long-lived and Intangible Assets
Long-lived assets, primarily property and equipment and finite-life intangible assets are evaluated for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. In evaluating recoverability, the following factors, among others, are considered: a significant change in the circumstances used to determine the amortization period, an adverse change in legal factors or in the business climate, a transition to a new product or service strategy, a significant change in customer base, and a realization of failed marketing efforts. The recoverability of an asset is measured by a comparison of the unamortized balance of the asset to future undiscounted cash flows. If we believe the unamortized balance is unrecoverable, we would recognize an impairment charge necessary to reduce the unamortized balance to the estimated fair value of the asset. The amount of such impairment would be charged to operations at the time of determination.
Property and equipment are stated at cost less accumulated depreciation. We use the straight-line method for depreciating property and equipment over their estimated useful lives, which range from 3 to 39 years. Our finite-life intangibles consist of patents and trademarks and their carrying costs include 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, using the straight-line method. During the years ended June 30, 2011 and 2010, we incurred legal defense costs associated with a trademark infringement lawsuit filed against us (see Note 9 to the Consolidated Financial Statements included in Part II, Item 8 of this Report). Such legal defense costs are being capitalized and amortized over the remaining useful life of the trademark. We expect future amortization expense to increase as we incur additional costs associated with our patents and trademarks.
Allowance for Excess and Slow-moving Inventory
An allowance for potentially slow-moving or excess inventories is made based on our analysis of inventory levels on hand and comparing it to expected future production requirements, sales forecasts and current estimated market values.
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. We provide a valuation allowance for deferred tax assets if we determine, based on the weight of available evidence, that it is more likely than not that some or all of the deferred tax assets will not be realized.
We provide a lifetime warranty on products sold to patients in the United States and Canada, a three-year warranty for institutional sales within the United States and Canada, a five-year warranty on products sold to patients in Greece, and a three-year warranty on all other sales to individuals and institutions outside of the United States, Canada and Greece. We estimate, based upon a review of historical warranty claim experience, the costs that may be incurred under our warranty policies and record a liability in the amount of such estimate at the time a product is sold. The warranty cost is based upon future product performance and durability, and is estimated largely based upon historical experience. We estimate the average useful life of our products to be approximately five years. Factors that affect our warranty liability include the number of units sold, historical and anticipated rates of warranty claims, the product useful life, and cost per claim. At our discretion, based upon the cost to either repair or replace a product, we have occasionally replaced such products covered under warranty with a new model. We periodically assess the adequacy of our recorded warranty liability and make adjustments to the accrual as claim data and historical experience warrant.
Share-based payment awards consist of warrants issued to employees for services, and to nonemployees in lieu of cash payment for products or services. Expense is estimated using the Black-Scholes pricing model at the date of grant and the portion of the award that is ultimately expected to vest is recognized on a straight-line basis over the requisite service or vesting period of the award. In determining the fair value of our share-based payment awards, we make various assumptions when using the Black-Scholes pricing model including expected risk free interest rate, stock price volatility, life and forfeitures.
Results of Operations
Fiscal Year Ended June 30, 2011 Compared to Fiscal Year Ended June 30, 2010
Revenue results for the twelve month periods are summarized in the table below (dollar amounts in thousands).
Home Care Revenue. Our home care revenue increased by 32.3% or approximately $4,239,000 in fiscal 2011 compared to fiscal 2010. This resulted from a 29.1% increase in referrals, from 2,076 in 2010 to 2,680 in 2011, and a 14.1% increase in approvals from third party payers, from 1,323 in 2010 to 1,510 in 2011. We attribute this increase primarily to an increase in productivity by our existing sales staff as they continued to expand and strengthen their relationships with customers. In addition, we employed 26 full time equivalents in sales in fiscal 2011 compared to 18 in fiscal 2010, an increase of 44.4%.
International Revenue. International revenue decreased by 6.0% in fiscal 2011, or $39,000. Revenue from sales in Asia and the Middle East in fiscal 2011 increased by approximately $98,000 and $12,000 respectively over fiscal 2010, while sales in Europe and Central/South America decreased by approximately $85,000 and $64,000 respectively over fiscal 2010. Sales to Europe continued to be negatively affected by the debt crises and austerity programs in many European countries.
Government/Institutional Revenue. Revenue from sales to government and private institutions increased by approximately $500,000 in fiscal 2011 compared to fiscal 2010. Revenue from sales to the U.S. Department of Veteran Affairs (VA) and other government institutions rose by approximately $114,000 or 91.9% from approximately $124,000 in fiscal 2010 to approximately $238,000 in fiscal 2011. Revenue from sales to private institutions increased by approximately $386,000 or 91.0% from approximately $424,000 in fiscal 2010 to approximately $810,000 in fiscal 2011. The above increases were driven both by increased number of institutions as customers and a higher average total yearly sales amount per institution.
Gross profit increased to $13,778,000, or 72.5% of net revenues, for the fiscal year ended June 30, 2011, from approximately $10,378,000, or 72.6% of net revenues, for the fiscal year ended June 30, 2010. The increase in gross profit dollars resulted from the increase in sales volume.
Selling, general and administrative expenses. Selling, general and administrative expenses for the fiscal year ended June 30, 2011 were approximately $10,874,000, compared to approximately $7,981,000 for the same period in the prior year, an increase of approximately $2,893,000 or 36.2%. SG&A payroll and compensation related expenses increased by approximately $1,391,000 or 36.7% to approximately $5,181,000. SG&A payroll expenses constituted 27.3% of sales in fiscal 2011 compared to approximately $3,790,000 or 26.5% of sales in fiscal 2010. The increase was primarily driven by the increase in size of the sales force and supporting staff as well as higher incentive compensation paid to our sales staff due to higher net revenues. In addition, due to the increase in number of total employees and reporting requirements related to being a public company, we added management personnel. Travel, meals and entertainment, and trade show expenses increased by approximately $467,000 to approximately $1,619,000, or 8.5% of sales, in fiscal 2011 compared to approximately $1,152,000, or 8.1% of sales, in fiscal 2010. This increase was primarily due to the increased size of the sales force.
Legal and professional fees increased by approximately $378,000 to approximately $690,000, or 3.6% of sales, compared to approximately $312,000, or 2.2% of sales, in 2010, due to the need for additional accounting and legal services associated with the reporting and compliance requirements of being a public company in 2011 as compared to being a private company in 2010. Advertising and marketing expenses increased by approximately $275,000 to approximately $823,000, or 4.3% of sales, in fiscal 2011 compared to approximately $548,000, or 3.8% of sales, in fiscal 2010. Management expects to spend approximately 5% of sales on advertising and marketing expenses during fiscal 2012 . Patient training expenses increased by approximately $121,000 to approximately $476,000, or 2.5% of sales, in fiscal 2011 compared to approximately $355,000, or 2.5% of sales, in 2010. The increase in patient training expenses was primarily driven by the increase in number of referrals. Insurance expenses increased by approximately $108,000 to approximately $701,000, or 3.7% of sales, in fiscal 2011 compared to approximately $593,000, or 4.1% of sales, in 2010. General liability insurance expenses are driven by sales volume and workers compensation expenses are driven by payroll levels, both of which increased in fiscal 2011. In addition we had an increase of approximately $59,000 in directors & officers liability expenses due to becoming a public company.
Research and development expenses. Research and development (R&D) expenses were approximately $1,034,000 or 5.4% of sales and $601,000 or 4.2% for the fiscal years ended June 30, 2011 and 2010, respectively, a planned increase of approximately $433,000. As a percentage of sales, management expects to spend at least 5.0% of sales on R&D expenses for the foreseeable future.
Interest expense decreased to approximately $191,000 in fiscal 2011, compared to $263,000 in fiscal 2010, a decrease of approximately $72,000. The decrease was due to a combination of a decrease in average debt outstanding due to payments on term loans and lower average interest rates on outstanding debt.
Income tax expense
Income tax expense was $623,000 in fiscal 2011, compared to $599,000 in the 2010 fiscal year. The effective income tax rate in 2011 was approximately 37.1% compared to approximately 39.5% in 2010. The decrease in the effective rate is due to discrete items recorded in fiscal 2011, which related to higher than originally estimated tax credits and differences between our actual income tax obligation for 2010 as compared to the amount originally estimated.
Net income for the twelve months ended June 30, 2011 was approximately $1,056,000, or 5.6% of revenues, compared to approximately $916,000, or 6.4% of revenues, in the same period in fiscal 2010. The dollar increase in net income was the result of higher sales and gross profit, which was partially offset by increases in expenses. The decrease in net income as a percentage of sales was the result of higher expenses from expansion of our sales force, R&D efforts, and increased reporting and compliance requirements of being a public company.
Liquidity and Capital Resources
Cash Flows and Sources of Liquidity
Cash Flows from Operating Activities
For the fiscal year ended June 30, 2011, our net cash used in operating activities was approximately $1,415,000. Our net income of approximately $1,056,000 was adjusted for non-cash expenses of approximately $477,000 and a decrease in current liabilities of approximately $646,000. Net income was also offset by approximately $3,016,000, $385,000 and $193,000 increases in accounts receivable, inventories, prepaid expenses and other current assets, respectively.
For the fiscal year ended June 30, 2010, our net cash provided by operating activities was approximately $608,000. Cash flows provided by operations primarily consisted of net income of $934,000, adjusted for non-cash expenses of approximately $452,000, offset by approximately $229,000, $292,000 and $111,000 increases in accounts receivable, inventories, prepaid expenses and other current assets, respectively and a decrease in current liabilities of approximately $145,000.
Cash Flows from Investing Activities
For the fiscal year ended June 30, 2011, cash used in investing activities was approximately $1,111,000. Cash used in investing activities primarily consisted of approximately $452,000 in net expenditures for property and equipment and $659,000 in payments for patent and trademark costs, the majority of which related to the defense of our SmartVest trademark.
For the fiscal year ended June 30, 2010, cash used in investing activities was approximately $909,000. During the fiscal year ended June 30, 2010, we paid approximately $514,000 in costs related to defending our SmartVest trademark, $270,000 for purchases of property and equipment, and $125,000 for the purchase of the minority interest in Electromed Financial, LLC.
Cash Flows From Financing Activities
For the fiscal year ended June 30, 2011, cash provided by financing activities was approximately $6,007,000, consisting of approximately $6,364,000 net proceeds from the issuance of common stock in our initial public offering, $26,000 from exercise of warrants, and $60,000 in proceeds from subscription notes receivable. This was offset by principal payments on long-term debt of approximately $436,000.
For the fiscal year ended June 30, 2010, cash provided by financing activities was approximately $550,000. Short- and long-term borrowings during the period, which included borrowings under our U.S. Bank credit facility, were approximately $4,288,000. The proceeds from the U.S. Bank credit facility were primarily used to pay off the principal balance of existing debt. Proceeds from the issuance of common stock were approximately $391,000. Offsetting the cash provided by financing activities were principal payments on long-term debt of approximately $3,649,000 and payments of $418,000 of deferred costs associated with our initial public offering.
Adequacy of Capital Resources
We currently have a credit facility with U.S. Bank, National Association (U.S. Bank) that provides for a $3,500,000 revolving line of credit, which is renewable annually at November 30 of each year, and $2,520,000 in term debt. A $1,520,000 Term Loan bears interest at 5.79% (Term Loan A). The remaining $1,000,000 term loan bears interest at 4.28% (Term Loan B). Interest on the operating line of credit accrues at LIBOR plus 2.75% (3.00% at June 30, 2011) and is payable monthly. The amount eligible for borrowing on the line of credit is limited to 60% of eligible accounts receivable less the outstanding balance on our Term Loan B. The line of credit is scheduled to expire on November 30, 2011, if not renewed. Term Loan A requires monthly payments of principal and interest of approximately $10,700 and has a maturity date of December 9, 2014. Term Loan B requires monthly payments of principal and interest of approximately $29,600 and has a maturity date of December 9, 2012. As of June 30, 2011, we had approximately $1,768,000 outstanding on the operating line of credit and approximately $1,940,000 outstanding on the term loan debt for a total outstanding under the U.S. Bank credit facility of $3,708,000. As of June 30, 2011, we had net unused availability of $1,732,000 under the line of credit. We are required to pay a fee of 0.125% per annum on unused portions of the revolving line of credit.
The agreement governing the credit facility contains certain covenants that restrict our ability to, among other things, pay cash dividends, incur indebtedness or liens, change Chief Executive Officer or Chief Financial Officer, merge or consolidate with any person, or sell, lease, assign, transfer or otherwise dispose of any assets other than in the ordinary course of business. The agreement also contains financial covenants that require maintenance of certain fixed charge and cash flow leverage ratios. We were in compliance with all requirements under the credit facility as of June 30, 2011. Subsequent to fiscal year end, we reached an agreement with our Chief Financial Officer pursuant to which he will retire effective on the earlier of October 31, 2011 or the date on which our new Chief Financial Officer commences employment. We expect to obtain consent from U.S. Bank with respect to this event.
On August 13, 2010, we completed the sale of 1,700,000 shares of common stock, par value $0.01 per share, in an IPO, at an offering price of $4.00 per share. On September 28, 2010, Feltl and Company, Inc., the underwriter of the IPO, acquired 200,000 shares of our common stock at a price of $4.00 per share, pursuant to exercise of its over-allotment option. Gross proceeds from the issuance of common stock in connection with the IPO, including the overallotment option, were approximately $7,600,000. After deducting the payment of underwriters discounts and commissions and offering expenses, our net proceeds from the sale of shares in the IPO, including the overallotment option, were approximately $5,946,000.
For fiscal 2011 and 2010, we spent approximately $466,000 and $270,000 on property and equipment, respectively. We currently expect to finance equipment purchases with borrowings under our credit facility and cash flows from operations. We may need to incur additional debt if we have an unforeseen need for additional capital equipment or if our operating performance does not generate adequate cash flows.
In connection with the employment agreements we entered into with our Chief Executive Officer and Chief Financial Officer on January 1, 2010, we may be required to make cash payments to these officers if they resign following a change in control or are terminated at any time without cause. With respect to a resignation upon a change in control, the amount of the severance payment would be equal to two times the annual base salary then in effect. With respect to a termination without cause, the amount of the severance payment would be equal to the base salary of the executive then in effect. In each instance, the executive would also be entitled to a pro rata portion of any earned but unpaid incentive compensation at the time of termination, the severance would be payable in a lump sum within 60 days of the separation event, and the executive would, in order to receive the severance and continued benefits, be required to sign a release of claims against us, return all property owned by Electromed and agree not to disparage us.
On August 19, 2011, we entered into a Transition Agreement with our Chief Financial Officer, pursuant to which he will retire effective on the earlier of October 31, 2011 or the date on which our new Chief Financial Officer commences employment. We expect to enter into a Separation Agreement and Release on the effective date of Mr. Belfords retirement, which will supersede Mr. Belfords January 1, 2010 employment agreement. The Separation Agreement and Release will provide that Mr. Belford will receive approximately $27,600 as payment for accrued but unused vacation time and a payment in the amount of approximately $147,000 representing six months of separation pay and a pro rata portion of the calendar year 2011 bonus payment, which amount will be paid in a lump sum on the first day of the seventh month following the effective date of Mr. Belfords retirement. In exchange, Mr. Belford will execute a general release of claims, will continue to be bound by the terms of his Non-Competition, Non-Solicitation and Confidentiality Agreement dated January 1, 2010, and will provide consulting and transition services as reasonably requested by the Company through December 31, 2011.
Based on our current operational performance, we believe our cash and available borrowings under the existing credit facility will adequately provide our liquidity needs for, at a minimum, the next twelve months. We intend to renew our line of credit with U.S. Bank, National Association upon its maturity date on November 30, 2011. However, we cannot guarantee that we will be able to renew our line of credit or procure additional financing upon favorable terms, if at all.
Certain Information Concerning Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
New Accounting Pronouncements
For recently issued accounting pronouncements, see Note 1 to the Consolidated Financial Statements, included in Part II, Item 8 of this Report.
As a smaller reporting company, we are not required to provide disclosure pursuant to this item.
Index to Financial Statements
To the Board
of Directors and Stockholders
We have audited the accompanying consolidated balance sheets of Electromed, Inc. and Subsidiary as of June 30, 2011 and 2010, and the related consolidated statements of income, equity, and cash flows for the years then ended. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Electromed, Inc. and Subsidiary as of June 30, 2011 and 2010, and the results of their operations and their cash flows for the years then ended in conformity with U.S. generally accepted accounting principles.
/s/ McGladrey & Pullen, LLP
See Notes to Consolidated Financial Statements.
See Notes to Consolidated Financial Statements.
See Notes to Consolidated Financial Statements.
See Notes to Consolidated Financial Statements.
Electromed, Inc. and Subsidiary
Consolidated Statements of Cash Flows (Continued)
See Notes to Consolidated Financial
Note 1. Nature of Business and Summary of Significant Accounting Policies
Nature of business: 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. The Company had international sales of approximately $608,000 and $647,000 for the years ended June 30, 2011 and 2010, respectively. Since its inception, the Company has operated in a single industry segment: developing, manufacturing and marketing medical equipment. As a result, the information disclosed herein materially represents all of the financial information related to the Companys operating segment.
Principles of consolidation and related party transaction: The accompanying consolidated financial statements include the accounts of Electromed, Inc. and its subsidiary, Electromed Financial, LLC. Electromed Financial, LLC was established by the Company to assist in raising capital from outside investors. The Company owned 95 percent of Electromed Financial, LLC through March 2, 2010, at which time the Company acquired the remaining five percent of Electromed Financial, LLC from a director of the Company for $125,000. Income related to the noncontrolling interest in the subsidiary is reflected as noncontrolling interest on the consolidated financial statements. All significant intercompany accounts and transactions have been eliminated in consolidation.
A summary of the Companys 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 estimation of selling price adjustments, allowance for doubtful accounts, inventory obsolescence, share-based compensation, income taxes and the warranty reserve.
Revenue recognition: The Company recognizes revenue when persuasive evidence of a sales arrangement exists, delivery of goods occurs through the transfer of title and risks and rewards of ownership, the selling price is fixed or determinable, and collectability is reasonably assured. Revenues are primarily recognized upon shipment.
Direct patient sales are recorded at amounts to be received from patients under reimbursement arrangements with third-party payers, including private insurers, prepaid health plans, Medicare and Medicaid. In addition, the Company records an estimate for selling price adjustments which often arise from changes in a patients insurance coverage, changes in a patients domicile, insurance company coverage limitations or patient death. Other than the installment sales as discussed below, the Company expects to receive payment on the vast majority of accounts receivables within one year and therefore has classified all accounts receivable as current. However, in some instances, payment for direct patient sales can be delayed or interrupted, resulting in a small portion of collections occurring later than one year.
Certain third-party reimbursement agencies pay the Company on a monthly installment basis, which can span over several years. Due to the length of time over which cash is collected and the inherent uncertainty of collectability with these installment sales, the Company cannot make a reasonable estimate of revenue at the time of sale and does not record accounts receivable or revenue at the time of product shipment. Under the installment method, the Company defers the revenue associated with the sale and, as each installment is received, that amount is recognized as revenue. Deferred costs associated with the sale are amortized to cost of revenue ratably over the estimated period in which collections are scheduled to occur.
A summary of sales made under the installment method are as follows:
Unrecognized installment method sales were as follows:
Shipping and handling expense: Shipping and handling charges incurred by the Company are included in cost of goods sold and were $290,000 and $218,000 for the years ended June 30, 2011 and 2010, respectively.
Cash and cash equivalents: Cash equivalents consist of commercial paper with maturity dates of less than three months. The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in these accounts.
Accounts receivable: The Companys receivable balance is comprised of amounts due from individuals, institutions and distributors. Balances due from individuals are typically remitted to the Company by third-party reimbursement agencies such as Medicare, Medicaid and private insurance companies. Accounts receivable are carried at amounts estimated to be received from patients under reimbursement arrangements with third-party payers. Accounts receivable are also net of an allowance for doubtful accounts. Management determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customers financial condition and credit history. Receivables are written off when deemed uncollectible. Recoveries of receivables previously written off are recorded when received. The allowance for doubtful accounts was approximately $45,000 as of June 30, 2011 and 2010.
Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or market. Work in process and finished goods are carried at standard cost, which approximates actual cost, and includes materials, labor and allocated overhead. Standard costs are reviewed at least quarterly by management, or more often in the event circumstances indicate a change in cost has occurred. The reserve for obsolescence is determined by analyzing the inventory on hand and comparing it to expected production requirements.
Property and equipment: Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Leasehold improvements and assets acquired under capital leases are depreciated over the shorter of their estimated useful lives or the remaining lease term. The Company retains ownership of demonstration equipment in the possession of both inside and outside sales representatives, who use the equipment in the sales process.
Finite-life intangible assets: Finite-life intangible assets include patents and trademarks. These intangible assets are being amortized on a straight-line basis over their estimated useful lives, as described in Note 4.
Long-lived assets: Long-lived assets, primarily property and equipment and finite-life intangible assets are evaluated for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. In evaluating recoverability, the following factors, among others, are considered: a significant change in the circumstances used to determine the amortization period, an adverse change in legal factors or in the business climate, a transition to a new product or service strategy, a significant change in customer base, and a realization of failed marketing efforts. The recoverability of an asset is measured by a comparison of the unamortized balance of the asset to future undiscounted cash flows.
If the Company believes the unamortized balance is unrecoverable, it would recognize an impairment charge necessary to reduce the unamortized balance to the estimated fair value of the asset. The amount of such impairment would be charged to operations in the current period. The Company has not identified any indicators of impairment associated with its long-lived assets.
Warranty liability: The Company provides a lifetime warranty on its products to the prescribed patient for sales within the United States and Canada, a five-year warranty on its products to the prescribed patient for sales within Greece, and a three-year warranty for all institutional sales and sales to individuals outside the United States, Canada and Greece. 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 Companys 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 Companys warranty liability were approximately as follows:
Income taxes: Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
The Company recognizes tax liabilities when the Company believes that certain positions may not be fully sustained upon review by tax authorities. Benefits from tax positions are measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon settlement. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences impact income tax expense in the period in which such determination is made. Interest and penalties, if any, related to accrued liabilities for potential tax assessments are included in income tax expense.
Research and development: Research and development costs include costs of research activities as well as engineering and technical efforts required to develop new products or make improvement to existing products. Research and development costs are expensed as incurred.
Advertising costs: Advertising costs are charged to expense when incurred. Advertising, marketing and trade show costs for the years ended June 30, 2011 and 2010 were approximately $657,000 and $527,000, respectively.
Share-based payments: Share-based payment awards consist of warrants issued to underwriters, to employees for services, and to nonemployees in lieu of payment for products or services. Expense is estimated using the fair value of products or services rendered or the Black-Scholes pricing model at the date of grant and is recognized on a straight-line basis over the requisite service or vesting period of the award.
Fair value of financial instruments: The carrying values of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximate their fair value due to the short-term nature of these instruments. The carrying value of long-term debt is the remaining amount due to debtors under borrowing arrangements. To estimate the fair value of debt, the Company estimates the interest rate necessary to secure financing to replace its debt. At June 30, 2011, the fair value of long-term debt was not significantly different than its carrying value.
Basic and diluted earnings per share: Basic per share amounts are computed by dividing net income attributable to Electromed, Inc. by the weighted-average number of common shares outstanding. Diluted per share amounts assume the conversion, exercise or issuance of all potential common stock instruments unless their effect is anti-dilutive, thereby reducing the loss per share or increasing the income per share (see Note 7 for information on stock warrants).
Recently adopted accounting pronouncements: In June 2009, the FASB issued revised guidance for the consolidation of variable interest entities. This amends the original guidance requiring an enterprise to perform an analysis to determine whether the enterprises variable interest or interests give it a controlling financial interest in a variable interest entity (VIE). This analysis identifies the primary beneficiary of a VIE as the enterprise that has both (a) the power to direct the activities of a VIE that most significantly impact the entitys economic performance, and (b) the obligation to absorb losses of the entity that could potentially be significant to the VIE. Additionally, this new guidance requires an enterprise to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining it has the power to direct the activities of the VIE that most significantly impact the entitys economic performance. This guidance was adopted at the beginning of the Companys 2011 fiscal year, and did not have a material effect on the Companys consolidated financial statements.
Reclassifications: Certain items in the fiscal 2010 financial statements have been reclassified to be consistent with the classifications adopted for fiscal 2011. The fiscal 2010 reclassifications had no impact on previously reported net income and equity.
Note 2. Inventories
The components of inventory at June 30, 2011 and 2010 are approximately as follows:
Note 3. Property and Equipment
Property and equipment, including assets under capital leases, consisted of approximately the following:
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 $228,000 and $114,000 at June 30, 2011 and 2010, respectively.
The activity and balances of finite-life intangible assets were approximately as follows:
Based on the carrying value at June 30, 2011, amortization expense is expected to be approximately $118,000 annually.
Additions consisted primarily of legal defense costs associated with a trademark infringement lawsuit which the Company defended as discussed further in Note 9.
Note 5. Financing Arrangements
The Company entered into a $3,500,000 revolving line of credit on November 30, 2010, which expires on November 30, 2011, if not renewed. Advances are due at the expiration date and are secured by substantially all Company assets. The amount available for borrowing is limited to 60 percent of eligible accounts receivable less the outstanding balance on the Companys 4.28% term note due December 2012. Interest on advances accrues at LIBOR plus 2.75 percent (3.00% at June 30, 2011) and is payable monthly. As of June 30, 2011, there was approximately $1,768,000 outstanding on the line of credit and $1,732,000 available for future borrowing.(a)
Long-term debt consists of approximately the following as of June 30, 2011 and 2010:
Approximate future maturities of long-term debt as of June 30, 2011 are as follows:
Capital leases and related party transaction: The Company has financed certain office equipment through capital leases. The Company also had a building capital lease with a director of the Company through December 2009, at which time the Company purchased the building for approximately $555,000 using the proceeds from a new mortgage note with a bank. The net carrying value of the capital lease obligation exceeded the purchase price by approximately $93,000 which was recognized as a reduction in the net book value of the acquired building, which had been capitalized at the inception of the lease.
At June 30, 2011 and 2010, carrying value of assets under these capital leases are approximately as follows:
Depreciation expense for these assets was approximately $28,000 and $26,000 for the years ended June 30, 2011 and 2010, respectively.
Approximate future minimum payments under capital leases as of June 30, 2011 are as follows:
Note 6. Common Stock
Common stock issued for property and services: During fiscal year 2010, the Company issued 5,000 shares for services valued at $22,500. No shares were issued for services during fiscal year 2011.
Common stock subscriptions receivable: In years prior to 2010, the Company issued 30,000 shares of common stock to unrelated third parties upon the exercise of outstanding warrants. The Company agreed to accept subscription notes receivable from these individuals for a total of approximately $60,000. During the year ended June 30, 2011, these notes were paid in full.
During fiscal 2009, the Company issued 31,000 shares of common stock to an employee upon exercise of outstanding warrants. The Company agreed to accept a subscription note receivable from this individual for $46,500. For the years ended June 30, 2011 and 2010, cash collected on this note was approximately zero and $9,000, respectively. The outstanding balance of this subscription note receivable was $22,500 at June 30, 2011.
Initial public offering: On August 13, 2010, The Company completed an initial public stock offering (IPO) of 1,700,000 shares of common stock, at an offering price of $4.00 per share. In addition, on September 28, 2010, the underwriter in the IPO acquired an additional 200,000 shares at $4.00 per share pursuant to exercise of a portion of its over-allotment option. After deducting the payment of underwriter discounts, commissions and offering costs, the net proceeds from the sale of shares in the IPO was approximately $5,946,000. See Note 7 for warrants issued in conjunction with the IPO.
Authorized Shares: At the annual meeting of shareholders held on November 5, 2010, the shareholders of the Company voted to amend the Companys Articles of Incorporation to increase the number of authorized shares of capital stock from 10,000,000 to 15,000,000, consisting of 13,000,000 shares of common stock par value $0.01 per share, and 2,000,000 shares of undesignated stock.
Note 7. Share-Based Payments
Employee warrants: The Company has historically granted stock warrants to employees as long-term incentive compensation. Warrants generally expire four to ten years from the grant date and vest over a period of up to five years. Warrants have not been granted under a formal plan; however, the number of warrants eligible for issuance is limited to the number of authorized shares of the Companys common stock.
The Company recognizes compensation expense related to share-based payment transactions in the consolidated financial statements based on the estimated fair value of the award issued. The fair value of each warrant is estimated using the Black-Scholes pricing model at the time of award grant. The Company estimates the expected life of warrants based on the expected holding period by the warrant holder. The risk-free interest rate is based upon observed U.S. Treasury interest rates for the expected term of the warrants. The Company makes assumptions with respect to expected stock price volatility based upon the volatility of similar companies. 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.
Share-based compensation expense for the years ended June 30, 2011 and 2010 was approximately $156,000 and $169,000, respectively.
The following weighted-average assumptions were used to estimate the fair value of warrants granted:
The following table presents employee warrant activity for the years ended June 30, 2011 and 2010:
For the years ended June 30, 2011 and 2010 net cash proceeds from the exercise of employee warrants was approximately $24,000 and $339,000 respectively. The Company received no income tax benefit in 2011 and approximately $23,000 income tax benefit in 2010 from the exercise of employee warrants.
At June 30, 2011, the Company had approximately $297,000 of unrecognized compensation expense, which is expected to be recognized over a weighted-average period of 2.4 years. The aggregate intrinsic value of warrants outstanding was approximately $368,000, and the intrinsic value of warrants exercisable was approximately $224,000 at June 30, 2011.
Warrants issued in conjunction with the IPO: In connection with the IPO and the exercise of the over-allotment option, the Company issued to the underwriter warrants to purchase up to 190,000 additional shares of the Companys common stock at a price of $4.80 per share. These warrants became exercisable in August 2011 and expire in August 2015.
Warrants issued to non-employees for services: In years prior to fiscal 2010, the Company issued warrants to non-employees for services in lieu of cash payments. During the year ended June 30, 2010, a warrant to purchase 5,000 shares was exercised at an exercise price of $3.50 per share. There were no warrants forfeited during the year ended June 30, 2010. At June 30, 2010, the Company had warrants outstanding and exercisable to purchase 20,000 shares of common stock at a weighted-average exercise price of $3.00 per share. These warrants expired during the fiscal year ending June 30, 2011, leaving no remaining non-employee service warrants at June 30, 2011.
Warrants issued with convertible debt: In years prior to fiscal 2010, the Company issued convertible notes payable to certain individual creditors. In conjunction with the issuance of these convertible notes, creditors also received warrants to purchase common stock for an exercise price of $3.00 per share. At June 30, 2011, the Company had approximately 82,000 warrants outstanding and exercisable at a weighted-average exercise price of $3.00 per share. Approximately 37,000 warrants expire in September 2012 and approximately 45,000 expire in September 2015. During the years ended June 30, 2011 and 2010, warrant holders exercised 600 and 13,733 warrants at a weighted-average exercise price of $3.00 and $2.50, respectively. There were no warrants forfeited and cancelled during the years ended June 30, 2011 and 2010.
Components of the provision for income taxes for the years ended June 30, 2011 and 2010, are as follows:
The total income tax expense differs from the expected tax expense, computed by applying the federal statutory rate to the Companys income before income taxes, as follows:
The significant components of deferred income taxes are as follows:
The components giving rise to the net deferred tax assets described above have been included in the accompanying consolidated balance sheets as follows:
The company applies the accounting standard for uncertain tax position pursuant to which a more-likely-than-not threshold is utilized to determine the recognition and derecognition of uncertain tax positions. Once the more-likely-than-not threshold is met, the amount of benefit to be recognized is the largest amount of tax benefit that is greater than fifty percent likely of being ultimately realized upon settlement. It further requires that a change in judgment related to the expected ultimate resolution of uncertain tax positions be recognized in earnings in the period of such a change. We have unrecognized tax benefits in the amount of $20,000 and zero as of June 30, 2011 and 2010, respectively, for estimated exposures associated with uncertain tax positions. However, due to the complexity of some of these uncertainties, the ultimate settlement may result in payments that are different from our current estimate of tax liabilities, resulting in the recognition of additional charges or benefits to income tax expense.
The Company is subject to U.S. federal income tax as well as income tax of multiple state jurisdictions. With limited exceptions, tax years prior to fiscal 2008 are no longer open to federal, state and local examination by taxing authorities.
Operating Leases: During fiscal year 2011, the Company entered into a financing arrangement to lease certain vehicles under 36 month operating leases. During fiscal year 2011, the Company also entered into two leases for office and warehouse space which require monthly payments that include base rent and the Companys share of common expenses including property taxes. These leases have escalating payments ranging from approximately $2,700 to $5,200 and expire in July 2013 and July 2016. Rent expense for the year end June 30, 2011 was approximately $124,000.
Approximate future minimum operating lease payments as of June 30, 2011 are as follows:
Litigation: Subsidiaries of Hill-Rom Holdings, Inc., (collectively, Hill-Rom) brought an action on August 21, 2009, against the Company alleging that the Companys use of the term SmartVest infringes on its alleged trademark The Vest. For years ended June 30, 2011 and 2010, the Company incurred and capitalized costs of approximately $283,000 and $880,000, respectively, in defending this trademark. On September 30, 2010, the parties reached a settlement to the lawsuit without a material impact to the Company. The terms of the Settlement Agreement are confidential, but will not prohibit the Companys continued use of its SmartVest® trademark.
In addition to the trademark matter discussed above, 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.
401(k) profit sharing plan: The Company has an employee benefit plan under Section 401(k) of the Internal Revenue Code covering all employees who are 21 years of age or older and have 1,000 hours of service with the Company. The Company matches each employees salary reduction contribution, not to exceed 4 percent of annual compensation. Total employer contributions to this plan for the years ended June 30, 2011 and 2010 were approximately $157,000 and $125,000, respectively.
Employment Agreements: Effective January 1, 2010, the Company entered into new employment agreements with its chief executive officer and chief financial officer. These agreements provide the officers, with among other things, one years salary upon a separation of service without cause for termination. Also, in the event the employee resigns within six months of a change in control, the chief executive officer and chief financial officer are entitled to receive a severance equal to two years base salary.
On August 19, 2011, the Company entered into a Transition Agreement with Terry Belford, its Chief Financial Officer, pursuant to which he will retire effective on the earlier of October 31, 2011 or the date on which a new Chief Financial Officer commences employment. The Company expects to enter into a Separation Agreement and Release on the effective date of Mr. Belfords retirement, which will supersede Mr. Belfords January 1, 2010 employment agreement. The Separation Agreement and Release will provide that Mr. Belford will receive approximately $175,000 as payment for accrued but unused vacation, separation and bonus pay which will be paid during fiscal year 2012. In exchange, Mr. Belford will execute a general release of claims, will continue to be bound by the terms of his Non-Competition, Non-Solicitation and Confidentiality Agreement, and will provide consulting and transition through December 31, 2011.
The Company uses a related-party service provider, a director and minority shareholder of which was the original inventor of the Companys product, to perform certain outsourced research and development functions. The Companys chief executive officer is also the president, chief executive officer and chairman of the board of directors of the service provider and owns approximately 11% of that entitys outstanding common stock. In addition, two members of the Companys board of directors are directors and minority shareholders of the service provider. The Company has an agreement with the service provider which provides that the service provider will perform 80 hours per week of research and development work in exchange for a monthly fee, in the amount of $30,000 through December 2012. The Company does not have exposure or commitments with this service provider beyond this agreement. For the years ended June 30, 2011 and 2010, expenses for these services totaled approximately $369,000 and $280,000, respectively, and such expenses are included in research and development expense in the income statement.
The Company uses a parts supplier whose founder and president became a director of the Company during fiscal year 2011. The Company has made payments to the supplier of approximately $611,000 and $409,000 during 2011 and 2010 fiscal years, respectively. Also see Notes 1 and 5 for additional related party transactions with Company directors.
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 Rule 13a-15(e) or Rule 15d-15(e), 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 to provide reasonable assurance that information required to be disclosed by us in the periodic and current reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the periods specified by the Securities and Exchange Commissions rules and forms and that our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Managements Report on Internal Control over Financial Reporting and Auditor Attestation
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and includes those policies and procedures that:
(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorization of our management and directors; and
(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting cannot provide absolute assurance of preventing and detecting misstatements on a timely basis. It is possible to design into the process safeguards to reduce, though not eliminate, the risk that misstatements are not prevented or detected on a timely basis. Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company.
Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework set forth in the report entitled Internal Control-Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission, known as COSO. Based on this assessment, management has concluded that, as of June 30, 2011 our internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation and presentation of financial statements for external purposes in accordance with generally accepted accounting principles.
This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Managements report was not subject to attestation by the Companys independent registered public accounting firm pursuant to Section 989G of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which exempts smaller reporting companies from the auditor attestation requirement.
Changes to Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the fourth quarter of fiscal 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Other than the information included in this Annual Report on Form 10-K under the caption Executive Officers of the Registrant, which is set forth at the end of Part I, the information required by Item 10 is incorporated herein by reference to the sections labeled Election of Directors, Corporate Governance, Compliance With Section 16(a) of the Exchange Act, and Security Ownership of Principal Shareholders, Directors and Management in our definitive proxy statement for our Fiscal 2012 Annual Meeting of Shareholders.
The information required by Item 11 is incorporated herein by reference to the sections labeled Executive Compensation, Director Compensation, and Corporate GovernancePersonnel and Compensation Committee in our definitive proxy statement for our Fiscal 2012 Annual Meeting of Shareholders.
The information required by Item 12 is incorporated herein by reference to the sections labeled Security Ownership of Principal Shareholders, Directors and Management and Equity Compensation Plan Information in our definitive proxy statement for our Fiscal 2012 Annual Meeting of Shareholders.
The information required by Item 13 is incorporated herein by reference to the sections labeled Corporate GovernanceIndependence and Certain Transactions and Business Relationships in our definitive proxy statement for our Fiscal 2012 Annual Meeting of Shareholders.
The information required by Item 14 is incorporated herein by reference to the sections labeled Ratification of the Appointment of McGladrey & Pullen, LLP as the Companys Independent Registered Public Accounting FirmAudit Fees in our definitive proxy statement for our Fiscal 2012 Annual Meeting of Shareholders.
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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Each person whose signature appears below constitutes and appoints Robert D. Hansen as the undersigneds true and lawful attorney-in fact and agent, with full power of substitution and resubstitution, for the undersigned and in the undersigneds name, place and stead, in any and all amendments to this Annual Report on Form 10-K and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granted unto said attorney-in-fact and agent, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as the undersigned might or could do in person, hereby ratifying and confirming all said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue thereof.