PDEX - NASDAQ

Hal Hurwitz - Chief Executive Officer

Greetings, and welcome to the Pro-Dex Fiscal 2014 Third Quarter Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, the conference call is being recorded. I would now like to turn the conference over to Mr. Hal Hurwitz, Chief Executive Officer of Pro-Dex. Please go ahead, Mr. Hurwitz.

Thank you, Brock and thank you all for joining us to review the results for the fiscal 2014 third quarter and nine months ended March 31, 2014. On today’s call, I will provide a synopsis of our operating results as well as some comments. Then as Brock mentioned, we will open up the call for your questions. Before beginning however, I ask our participants and listeners to note that the comments made on this call may include statements that are forward-looking within the meaning of securities laws. These forward-looking statements may include, without limitation, statements related to anticipated industry trends and the company’s plans, products, perspectives and strategies, both preliminary and projected. Actual results or trends could differ materially. We undertake no obligation to revise forward-looking statements in light of new information or future events. For more information, please refer to the risk factors discussed in the company’s Form 10-K for the year ended June 30, 2013, which has been filed with the SEC, the prospectus filed with the SEC on March 24, 2014 in connection with our recently completed rights offering, and Form 10-Q for the quarter ended March 31, 2014 filed with the SEC, as well as the Form 8-K filed with the SEC today, along with the attached press release issued today, all of which can be obtained from the SEC or by visiting our website at www.pro-dex.com. And now, let’s cover the quarter’s results. Net sales for the three months ended March 31, 2014 decreased $656,000 or 21% to $2.4 million from $3.1 million for the three months ended March 31, 2013 due primarily to decreases of $659,000 in medical device development and manufacturing revenues. The decrease in our medical device product line was primarily due to a decrease in product and repair revenues from our largest customer, arising from the revised terms negotiated with the customer in December 2013 following the customer’s suspension of orders from March through November 2013. These revised terms provided for lower monthly shipments in the 2014 period relative to the 2013 period prior to the suspension. Gross profit for the three months ended March 31, 2014 decreased $343,000, or 39%, to $540,000 from $883,000 for the same period in 2013. Contributing to this decrease were the reduction in sales volumes, that I previously discussed, and the related effects of increased under-absorption of manufacturing costs, which reduced gross profit by $67,000. Also contributing to the decrease in gross profit was an accrual of $47,000 for anticipated losses from the development services portion of certain contracts, which did not occur during the corresponding period of the prior fiscal year. These factors were partially offset by an aggregate decrease of $102,000 in inventory and warranty charges. Other than the reduction in sales volume, the factors I just mentioned that affected gross profit also resulted in a decrease of gross margin as a percentage of sales to 22% for the three months ended March 31, 2014 from 29% for the corresponding period in 2013. Operating expenses, which include selling, general and administrative and research and development expenses for the quarter ended March 31, 2014 decreased 41% to $978,000 from $1.7 million in the prior year’s corresponding quarter, reflecting primarily the effects of our cost reduction program. Loss from continuing operations for the quarter ended March 31, 2014 was $358,000, compared to a loss from continuing operations of $765,000 in the corresponding quarter in 2013. Net loss for the quarter ended March 31, 2014 was $385,000 or $0.12 per share compared to a net loss of $747,000 or $0.22 per share for the corresponding quarter in 2013. Turning to the nine months period net sales for the nine months ended March 31, 2014 decreased $1.9 million or 20% to $7.6 million from $9.5 million for the nine months ended March 31, 2013, due primarily to decreases of $1.6 million in medical device development and manufacturing revenues and $315,000 in motion control product revenues, which were partially offset by an increase of $231,000 in dental product revenues. The $1.6 million decrease related to our medical device product line was comprised of $1.2 million decrease in revenues from our current largest customer arising from the effects of the suspension of orders that I previously discussed during the first five months of the nine months period in 2014 and a $278,000 decrease in repair revenues from our former largest customer. We expect sales to this former customer to decline to zero over the balance of fiscal year 2014. Gross profit for the nine months ended March 31, 2014 decreased $1.1 million or 35% to $2 million from $3.2 million for the same period in 2013. Contributing to this decrease were the reduction in sales volume I previously described and the effects of unfavorable production variances which reduced gross profit by $475,000. Also contributing to the decrease in gross profit was an accrual of $278,000 for anticipated losses from the development services portion of certain contracts, which did not occur during the corresponding period of the prior fiscal year. These factors were partially offset by an aggregate decrease of $363,000 in inventory and warranty charges. Other than the reduction in sales volume, the factors I just mentioned that affected gross profit also resulted in a decrease of gross margin as a percentage of sales to 27% for the nine months ended March 31, 2014 from 33% for the corresponding period in 2013. Operating expenses, which include selling, general and administrative, and research and development expenses for the nine months ended March 31, 2014 decreased 35% to $2.8 million from $4.4 million in the prior year’s corresponding period, reflecting primarily the effects of our cost reduction program. Loss from continuing operations for the nine months ended March 31, 2014 was $679,000, compared to a loss from continuing operations of $1.2 million for the corresponding period in 2013. Net loss for the nine months ended March 31, 2014 was $512,000 or $0.15 per share, compared to a net loss of $1.1 million or $0.34 per share for the corresponding period in 2013. With all of that now some brief commentary, our results from continuing operations for the quarter and nine months ended March 31, 2014 while improves on a year-over-year basis were adversely impacted by low sales volume, which most directly affects gross margin in the form of under utilized manufacturing capacity. We continue to closely monitor the relationship between manufacturing capacity and anticipated future sales volume in determining whether further cost reductions will be necessary. Also affecting margins were accruals amounting to $47,000 for the quarter ended March 31, 2014 and $278,000 for the nine months then ended, relating to anticipated losses on fixed price engineering services portions of certain large projects currently underway. These projects are complex and require that we meet stringent customer and regulatory specifications. Nonetheless, I am pleased to report that we recently conducted a test of a prototype instrument for one of our customers, and we look forward to conducting a test of another prototype instrument for a second customer this month. We continue to believe that these engineering projects will result in manufacturing revenues in fiscal 2015. Our improved year-over-year results derived primarily from the rightsizing of our cost footprint over the past year. However, as I have previously publicly noted, the nearly singular objective on Pro-Dex’s agenda remains that of rebuilding the revenue base. To that end, I can report that we had a good showing at two important industry conferences in March and April of this year that resulted in promising leads. Of course, converting such leads into customer purchase orders is the goal on which our integrated team of business development, engineering and operations leaders is focused. These challenges notwithstanding, it should be noted that we generated positive cash flow from operating activities during the quarter ended March 31, 2014 of $300,000. This improvement results primarily from the partial liquidation of the inventory build-up undertaken in the first quarter of fiscal year 2014 to reduce lead times and accommodate anticipated customer requirements. As we have previously publicly disclosed, the build-up was exacerbated by our largest customer having suspended its orders from us from March through November 2013, ostensibly due to lagging demand for its product and the inventory liquidation this past quarter results from the resumption of shipments to this customer. In addition, we recently announced the completion of our rights offering of common stock that raised proceeds of $1.65 million before expenses through shareholder subscriptions for 858,732 shares of common stock, represent a 59% participation rate. Of the total amount of shares issued, an aggregate of 473,420 shares were issued to AO Partners I, LP and Farnam Street Partners, LP, our two largest shareholders, who each exercised its full pro-rata allotment of rights in the offering. Nick Swenson, Chairman of our Board of Directors and Ray Cabillot also a member of our board hold positions that allow them to direct the investments of AO Partners I, LP and Farnam Street Partners, LP respectively. The remaining 395,312 shares were issued to 178 other shareholders that participated in the rights offering. We are grateful for the participation of our two major shareholders and we were particularly pleased with the participation of the remaining broad base of shareholders whose subscriptions constituted nearly half of the offering proceeds. The purpose of the rights offering was to raise equity capital in a cost-effective manner that provided all of the company’s shareholders the opportunity to participate on a pro rata basis. We intend to use the net proceeds from the rights offering to pursue strategic opportunities that may present themselves from time-to-time or if not used to pursue strategic opportunities for working capital and general corporate purposes, including to fund ongoing research and development and product initiatives. Also, to the extent net proceeds of the rights offering are not deployed, some of the funds may be invested in accordance with the terms of our previously disclosed Surplus Capital Investment Policy. Under the terms of the rights offering, we have the right to reduce subscriptions in order to preserve certain of the company’s tax attributes, such as the utilization of net operating loss carry-forwards. Similarly, we had the right to reduce shares purchased pursuant to a standby commitment from AO Partners, LLC and Farnam Street Capital, Inc. to whom I will refer collectively as the Standby Purchasers. The Standby Purchasers had agreed to purchase any and all shares of common stock that were not subscribed for by shareholders in connection with the rights offering. On the basis of the company’s analysis of its tax attributes, the company did not reduce the subscriptions of any shareholder in the rights offering, but did reduce to zero the number of shares the Standby Purchasers could have otherwise purchased pursuant to the standby commitment. As a result, no shares will be issued to AO Partners, LLC or Farnam Street Capital, Inc. pursuant to their standby purchase commitment. I am now happy to invite any questions you might have with regard to the quarter or our business operation. And to that end, I will turn the call back over to Brock for questions and answers.

Thank you, sir. (Operator Instructions) Our first question today comes from Matthew (indiscernible) of Valor Capital. Please go ahead.

(indiscernible). Thanks for taking my questions.

Hi, Matt. How are you?

Good. How are you?

Good.

Well, I have actually a couple of questions. The first one relates to the rights offering, I would imagine that the standby purchase commitment wasn’t taken up, because of the tax implication, does that possibly moving too far (indiscernible) percentage basis, but I am just wondering if there was no reason for them to oversubscribe, why weren’t oversubscription rights given to other shareholders?

Well, first of all, your assumption with respect to why we have reduced to zero the standby purchase commitment ability to (generalize) purchase shares is correct. The – another subscription process was never contemplated frankly in the original offering. And I think that’s somewhat worn out by the results, which we are pleased with. I don’t want that misunderstood, but after participation rates, it didn’t seem reasonable to complicate the transaction anymore and have to endure that much more review of it before it could go effective by putting in the oversubscription feature.

Alright. And then do you have any information about what the net proceeds will be after any sort of expenses related to the rights offering?

I would anticipate the net proceeds to be around – I would say, we raised 1.65. So, I would say, 1.625 to 1.63, somewhere around that.

Okay, alright. Thank you. And then just could you possibly provide some additional commentary about these prototype tests and maybe some of the leads that you hear from the industry conferences you are at, I mean, we keep carrying about these, but I am just wondering what the process is after these prototypes are tested, how many more stages were involved, when and potentially how much could come from these as far as revenue down the road, just any further additional color would be beneficial?

I will give you as much color as I can. As we previously discussed and this is rather typical for particularly for medical device contract manufacturers, nearly all of our agreements with our customers were governed by pretty stringent confidentiality arrangements. So, we have governed most, if not all of the terms of the contract. But with that as a backdrop, I will address what I can. The prototype testing for the customer was rather significant, because it involves technological aspects of each of these instruments that frankly the marketplace hasn’t seen a whole lot of, and in these particular applications maybe even not at all. So, these were significant milestones for us. And as far as what lies between the prototype testing and eventual manufacturing revenues would be quality assurance testing that we have to undertake. I believe that the instruments likely will be put into the hands of each of our customers, key opinion leaders, one last time before they give their final buy-out as to design and maybe even functionality aspects. I frankly would hope that if that does occur that they are not yet continuing changes, but we do need to pay attention to the end user. And so there is every reason that they would want to place that in the hands of the physicians one more time just to get their final buy-out. And then we start gearing up for production.

Okay, alright. I appreciate that. And then on the leads at the industry conferences, are those more rights manufacturing or is that a situation where you will need to also go through the development process like these larger contracts?

I would say, Matthew, the culture is – of the meetings we had, some were very general in nature, but from some – for major names in the medical device OEM communities, but because they are general in nature and these meetings are not yet covered by non-disclosure agreements, they remain general in nature, but I will say that even in that context, the conversations more often than not were through development and manufacturing as opposed to just one or just the other. We did have conversations with some smaller entities that might have been in one pace just for development, just for engineering. And we as a company will be more open to those types of agreements than we have in the past. In the past, we have been far more receptive to arrangements that included both development and manufacturing or just contract manufacturing, but we do want to leverage more off of the engineering resources we have. And so we are more amenable to just quickly engineering agreements as well.

Alright, thank you. And then just one final question about current situation with the customer is that now, I mean, even planned, can we expect this to kind of moderate or is there going to be flip through more ups and downs like last year?

Well, that’s a good question. We certainly hope that it’s on an even claim, but we are in I’d say more frequent communication with that customer than we ever have been, but their practice as I discussed I believe in the last conference call, their practice is to not want to engage in a lot of forward-looking conversation until maybe six months before their existing agreement expires. So, I would anticipate that we will have more definitive discussions starting in the summer time.

Okay, alright. I appreciate the responses and I hope things continue to move forward.

Thank you.

(Operator Instructions) Mr. Hurwitz, there are no further questions at this time. Would you like to make any closing remarks?

Okay, thank you Brock and thank you everyone for joining us today. All of us at Pro-Dex appreciate your interest, your time, and your support of the company and we look forward to speaking with you in September when we report our fiscal year 2014 fourth quarter and full year months financial results. Thank you.