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ESMC > SEC Filings for ESMC > Form 10-K on 28-Sep-2011All Recent SEC Filings

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Form 10-K for ESCALON MEDICAL CORP


28-Sep-2011

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read together with the consolidated financial statements and notes thereto and other financial information contained elsewhere in this Form 10-K and the discussion under "Risk Factors" included in Item IA of this Form 10-K.

The Company's continuing operations is primarily in three business segments. Sonomed-Escalon, ECD and Escalon Medical Corp. Certain assets of the Vascular business were sold for $5,750,000 on April 30, 2010 to Vascular Solutions, Inc. (see footnote 12 of the Company's June 30, 2011 annual consolidated financial statements for additional information).

ECD is a diagnostics company specializing in the design, manufacture and distribution of instruments for blood cell counting and blood analysis. ECD is focused on providing instrumentation and consumables for the physician office and veterinary office laboratories. ECD also supplies the reagent and other consumable materials needed to operate the instruments. ECD added to its reagent business with the May 29, 2008 purchase of JAS and the December 31, 2008 acquisition of certain assets of BioCode.

Sonomed-Escalon segment consists of the operations of Sonomed, EMI, and Trek. Sonomed develops, manufactures and markets ultrasound systems used for diagnosis or biometric applications in ophthalmology. Trek develops, manufactures and distributes ophthalmic surgical products under the Trek Medical Products names. EMI manufactures and markets digital camera systems for ophthalmic fundus photography.


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For a more complete description of these businesses and their products, see Item 1-Description of Business.

Certain assets of the Vascular business were sold for $5,750,000 on April 30, 2010 to Vascular Solutions, Inc. (see footnote 12 of the Company's June 30, 2011 annual consolidated financial statements for additional information).

Prior to its sale on April 30, 2010, Vascular developed, manufactured and marketed vascular access products.

Executive Overview-Fiscal Years Ended June 30, 2011 and 2010

The following highlights are discussed in further detail within this Form 10-K. The reader is encouraged to read this Form 10-K in its entirety to gain a more complete understanding of factors impacting Company performance and financial condition.

Product revenue from continuing operations decreased approximately $713,000 or 2.3% during fiscal year ended June 30, 2011 as compared to the prior fiscal year. The decrease is primarily related to decreased sales in the Company's ECD segment which decreased approximately 6.8%, offset by sales increases in the Sonomed-Escalon segment of 5.5%.

Other revenue from continuing operations decreased approximately $985,000 or 100 % during the fiscal year ended June 30, 2011, as compared to the prior fiscal year. The company received royalty income from licensing of certain Biocode technology to TECOM for $888,000 in fiscal year 2010, and the Company did not continue to receive royalties in fiscal year 2011. Biocode has fulfilled all of its responsibilities under the contract and has recognized the remaining contract amount in other revenue during the year ended June 30, 2010.

Cost of goods sold as a percentage of product revenue from continuing operations increased to approximately 59.7% of product revenues during the fiscal year ended June 30, 2011, as compared to approximately 56.9% of product revenue for the prior fiscal year.

Operating expenses decreased approximately 3.7% during the fiscal year ended June 30, 2011 as compared to the prior fiscal year. This was due to decreased marketing, general and administrative expenses of 2.3% and a decrease of 15.4% in research and development related to the completion of research and development projects in the prior year at both ECD and Sonomed-Escalon.

Results of Operations

Fiscal Years Ended June 30, 2011 and 2010

The following table shows consolidated product revenue by business segment, as well as identifying trends in business segment product revenues for the fiscal years ended June 30, 2011 and 2010. Table amounts are in thousands:


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                                        Fiscal Years Ended June 30,
                                     2011            2010        % Change
               Product Revenue:
               ECD                $    18,077      $ 19,403           -6.8 %
               Sonomed Escalon         11,867        11,254            5.5 %

               Total              $    29,944      $ 30,657           -2.3 %

Consolidated product revenue from continuing operations decreased approximately $713,000 or 2.3%, to $29,944,000 during the year ended June 30, 2011 as compared to the last fiscal year.

In the ECD segment, product revenue decreased $1,326,000 or 6.8%, as compared to last fiscal year. The decrease is related to a decrease in revenue at the Biocode facility related to a change in French law that requires all of the country's labs to consolidate into large regional labs. ECD's instruments are not suitable for large labs so the Company anticipates that instrument revenue in France will continue to significantly decline. In addition, there was a decrease in PDQ instrument sales during the current period as Drew discontinued its manufacturing agreement for this aging instrument and a decrease in DREW3 instruments during the current period as compared to the same period last year.

In the Sonomed-Escalon segment, product revenue increased $613,000, or 5.5%, to $11,867,000 during the year ended June 30, 2011, as compared to the last fiscal year. The increase in revenue is attributed to the increased sales in Sonomed's ultrasound products of $829,000 related to increased demand in both domestic and international markets, an increase in Trek's surgical and gas products of $83,000, offset by a decrease of $299,000 in EMI's digital imaging camera's and AXIS image management systems. While the AXIS system has been well accepted in the market place, it appears to have a much longer selling cycle than originally envisioned. The decrease in the traditional digital imaging system along with the extended sales cycle of the AXIS product caused management to re-evaluate the goodwill recorded on EMI's financial statements during the third quarter of the current fiscal year. This evaluation resulted in the write-off of EMI's goodwill during the year ended June 30, 2011 (see footnote 4 of the consolidated financial statements dated June 30, 2011).

The following table presents consolidated other revenue from continuing operations by reportable business segment for the fiscal years ended June 30, 2011 and 2010. Table amounts are in thousands:

                                       Fiscal Years Ended June 30,
                                   2011          2010         % Change
                 Other Revenue:
                 ECD               $   0       $    985          -100.0 %
                 Sonomed-Escalon       0              0             0.0 %

                 Total             $   0       $    985          -100.0 %

Consolidated other revenue from continuing operations decreased approximately $985,000 or 100% during the fiscal year ended June 30, 2011, as compared to the prior fiscal year. The Company received royalty income from licensing of certain Biocode technology to TECOM for $888,000 in fiscal year 2010, and the Company did not continue to receive royalties in fiscal year 2011. Biocode has fulfilled all of its responsibilities under the contract and has recognized the remaining contract amount in other revenue during the year ended June 30, 2010.


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The following table presents consolidated cost of goods sold by reportable business segment and as a percentage of related segment product revenues for the fiscal years ended June 30, 2011 and 2010. Table amounts are in thousands:

                                           Fiscal Years Ended June 30,
                                     2011         %           2010         %
             Cost of Goods Sold:
             ECD                   $ 11,398       63.1 %    $ 11,137       57.4 %
             Sonomed-Escalon          6,475       54.6 %       6,305       56.0 %

             Total                 $ 17,873       59.7 %    $ 17,442       56.9 %

Consolidated cost of goods sold from continuing operations totaled approximately $17,873,000, or 59.7%, of product revenue from continuing operations, for the fiscal year ended June 30, 2011, as compared to $17,442,000, or 56.9%, of product revenue from continuing operations, for the prior fiscal year.

Cost of goods sold in the ECD segment totaled $11,398,000, or 63.1% of product revenue for the fiscal year ended June 30, 2011 as compared to $11,137,000, or 57.4% of product revenue, for the prior fiscal year. The increase in cost of goods sold as percentage of revenue is related to the write-off of inventories of approximately $620,000, of which approximately $500,000 of the write-off was related to writing down the cost of the Trilogy instrument to its net realizable value. Trilogy sales have continued to decline and prospects for future sales are not good as it was never fully accepted in the marketplace. The remaining $120,000 write down is related to instruments in France that are impaired due to the change in French law that requires labs in France to consolidate into large regional labs. In addition, margins have been compressed due to increased production costs at our Dallas facility. The Company decided in June 2011 that it would close its manufacturing facility in Dallas and outsource certain instruments historically manufactured in Dallas. The Company anticipates ceasing manufacturing activities in Dallas by September 30, 2011 (see footnote 16 of the consolidated financial statements dated June 30, 2011).

Cost of goods sold in the Sonomed-Escalon business segment totaled $6,475,000, or 54.6% of product revenue, for the fiscal year ended June 30, 2011 as compared to $6,305,000, or 56.0% of product revenue, for the prior fiscal year. The modest decrease of 1.4% in cost of goods sold as a percentage of revenue is due mainly to the product mix sold during the current period with increased sales in the higher margin PacScan Plus and an increase in higher margin domestic sales.

The following table presents consolidated marketing, general and administrative expenses as well as identifying trends in business segment marketing, general and administrative expenses for the fiscal years ended June 30, 2011 and 2010. Table amounts are in thousands:

                                                   Fiscal Years Ended June 30,
                                               2011            2010         % Change
   Marketing, General and Administrative:
   ECD                                      $     9,435      $  10,285            -8.3 %
   Sonomed-Escalon                                2,822          2,531            11.5 %
   Escalon Medical                                3,077          2,877             7.0 %

   Total                                    $    15,334      $  15,693            -2.3 %


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Consolidated marketing, general and administrative expenses from continuing operations decreased $359,000, or 2.3%, to $15,334,000 during the fiscal year ended June 30, 2011 as compared to the prior fiscal year.

Marketing, general and administrative expenses in the ECD business segment decreased $850,000, or 8.3%, to $9,435,000 as compared to the same period last fiscal year. The continued decrease is related to the ongoing implementation of an austerity plan concerning our Dallas facility. Over the past two years the headcount at our Dallas facility has steadily declined due to absorbing certain general and administrative functions at Drew's Miami location. In addition, during June 2011 it was decided that all manufacturing operations at our Dallas facility will be outsourced and the facility in Dallas will be closed on or about September 30, 2011. It is anticipated that this closure will provide significant saving in general and administrative expenses in the coming year.

Marketing, general and administrative expenses in the Sonomed-Escalon business segment increased $291,000, or 11.5%, to $2,822,000 as compared to the same period last fiscal year. The increase is due to an increase in payroll, travel, exhibits, and expenses related to the re-branding of Sonomed, EMI and Trek under the Sonomed-Escalon name.

Marketing, general and administrative expenses in the corporate increased $201,000, or 7%, to $3,077,000 as compared to the same period last fiscal year. The increase is due to an increase in consulting, legal, office rent, medical insurance and payroll expense.

The following table presents consolidated research and development expenses from continuing operations by reportable business segment and as a percentage of related segment product revenues for the fiscal years ended June 30, 2011 and 2010. The Company is including redesignated reporting segments beginning with this Form 10K, this prior period segment information has been reclassified to conform with the current year presentation.

Table amounts are in thousands:

                                                   Fiscal Years Ended June 30,
                                     2011           2010              % Change
        Research and Development:
        ECD                         $   726     $         957               -24.1 %
        Sonomed Escalon                 877               937                -6.4 %

        Total                       $ 1,603     $       1,894               -15.4 %

Consolidated research and development expenses from continuing operations decreased $291,000, or 15.4%, to $1,603,000 during the fiscal year ended June 30, 2011 as compared to the prior fiscal year. Research and development expenses were primarily expenses associated with the planned introduction of new or enhanced products in the ECD and Sonomed-Escalon business units.

Research and development expenses in the ECD business segment decreased $231,000, or 24.1%, to $726,000. The reduction is related to the completion of Drew's new diabetes instrument the DS-360 in January 2011. Under the austerity plan there will no longer be any research and development performed at our Dallas facility. All future research projects will be outsourced on an as needed basis.

Research and development expenses in the Sonomed-Escalon segment decreased $60,000, or 6.4%, to $877,000 as compared to the last fiscal year. The decrease is related to the completion of the PacScan Plus and the Master Vu A products and the decision to suspend further work on the VuMax III, offset by increased research and development expense related to the continued upgrading of our digital imaging product offering.


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For the years ended June 30, 2011 and 2010 the Company had net income from discontinued operations of $168,193 and $3,474,351, respectively. The current year amount was generated from a supply agreement with Vascular Solutions, Inc. The prior year amount included a gain on the sale of certain vascular assets of $3,493,311.

The Company recognized a loss of approximately $70,000 and $75,000 related to its investment in Ocular Telehealth Management ("OTM") during the fiscal years ended June 30, 2011 and 2010 respectively. Commencing July 1, 2005, the Company began recognizing all of the losses of OTM in its consolidated financial statements. OTM is an early stage privately held company. Prior to July 1, 2005, the share of OTM's loss recognized by the Company was in direct proportion to the Company's ownership equity in OTM. OTM began operations during the three-month period ended September 30, 2004. (See note 14 of the notes to June 30, 2011 consolidated financial statements.)

Interest expense was $324,000 and $427,000 for the fiscal years ended June 30, 2011 and 2010, respectively. The decrease is related to payment and restructuring of debt.

Goodwill Impairment-EMI

At March 31, 2011 management became concerned about EMI's performance year to date as compared to our projected budget. The projected budget included sales related to EMI's new image management system, Axis, as well as traditional legacy digital imaging systems. A significant portion of the Axis product target market represents institutions requiring large-scale, multi-instrument solutions, which has resulted in a much longer sales cycle than we had originally envisioned. While the feedback from initial and potential customers of the Axis product has been positive, converting this interest into sales has not materialized to date at the levels we had originally projected.

EMI has also encountered unexpected lagging demand for its legacy digital imaging systems primarily due to institutions allocating a disproportionate level of their capital budgets toward purchasing Optical Coherence Tomography ("OCT") devices. It was anticipated that the emerging OCT technology would erode legacy digital imaging product sales due to competition for budgetary resources; however, the level has been greater than originally expected and not reflected in our original projections. OCT and digital imaging technologies are complementary and it is not known whether or for how long the lower available capital budgets for digital imaging will continue. These events will negatively affect the evaluation of the future operating results and cash flows of EMI.

The Company typically tests goodwill for possible impairment on an annual basis at June 30, and at any other time events occur or circumstances indicate that the carrying amount of goodwill may be impaired. Management determined that the events discussed above warranted performing an interim test of goodwill for possible impairment during the quarter ended March 31, 2011.

The first step of the FASB ASC 350 impairment analysis consists of a comparison of the fair value of the reporting segment with its carrying amount, including the goodwill. The fair value was determined based on the income approach, which estimates the fair value based on the future discounted cash flows. Under the income approach, the Company assumed, with respect to EMI, a forecasted cash flow period of five years, long-term annual growth rates of 3% and a discount rate of 19%.

Based on the interim income approach analysis that was performed for EMI it was determined that the carrying amount of the goodwill was in excess of its respective fair value. As such, the Company was required to perform the second step analysis in order to determine the amount of the goodwill impairment. The second step analysis consisted of comparing the implied fair value of the goodwill with the carrying amount of the goodwill, with an impairment charge resulting from any excess of the carrying value of the goodwill over the implied fair value of the goodwill. Based on the second step analysis, the Company concluded that all $905,810 of the goodwill recorded at EMI was impaired. As a result, the Company recorded a non-cash goodwill impairment charge to continuing operations totaling $905,810 during the year ended June 30, 2011.


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The determination as to whether a write-down of goodwill is necessary involves significant judgment based on short-term and long-term projections of the Company. The assumptions supporting the estimated future cash flows of the reporting segment, including profit margins, long-term forecasts, discount rates and terminal growth rates, reflect the Company's best estimates.

Liquidity and Capital Resources

The following table presents overall liquidity and capital resources as of June 30, 2011 and 2010. Table amounts are in thousands:

                                                           June 30,
                                                     2011            2010
         Current Ratio:
         Current assets                           $   13,262      $   16,748
         Less: Current liabilities                     5,573           5,998

         Working capital                          $    7,689      $   10,750

         Current ratio                              2.4 to 1        2.8 to 1

         Debt to Total Capital Ratio:
         Notes payable and current maturities     $      278      $    1,254
         Long-term debt, net of current portion        4,506           2,916

         Total debt                                    4,784           4,170

         Total equity                                  6,190          12,065

         Total capital                            $   10,974      $   16,235

         Total debt to total capital                    43.6 %          25.7 %

Working Capital Position

Working capital decreased $3,061,000 as of June 30, 2011, and the current ratio decreased to 2.4 to 1 from 2.8 to 1 when compared to June 30, 2010. The decrease in working capital was caused primarily by a decrease in cash of $1,427,000 to $1,915,000 in 2011 from $3,342,000 in 2010. Accounts receivable increased by $284,000 to $4,765,000 in 2011 from $4,481,000 in 2010. Net inventory decreased $718,000 to $6,261,000 in 2011 from $6,979,000 in 2010. Overall total current assets decreased $3,486,000 to $13,262,000 in 2011 from $16,748,000 in 2011. Total current liabilities, which consist of current portion of long-term debt, accounts payable and accrued expenses, decreased $425,000, to $5,573,000 in 2011 from $5,998,000 in 2010. The decrease in current liabilities was due to a decrease in current portion of long term debt of $976,000 to $278,000 in 2011 from $1,254,000 in 2010 offset by an increase in accounts payable of $579,000 and in accrued expenses of $678,000 compared to fiscal year 2010 and a decrease of liabilities from discontinued operations of $706,000.

Debt to Total Capital Ratio increased to 43.6% in 2011 from 25.7% in 2010 as a result of the debt restructuring plan and also the reduction of the total equity of $5,875,000 to $6,190,000 in 2011 from $12,065,000 in 2010 due to the Company's net loss of $5,758,000.


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Cash Used In or Provided By Operating Activities

During fiscal 2011, the Company used approximately $1,167,000 of cash for operating activities as compared to using approximately $468,000 for operating activities during the year ended June 30, 2010.

Net revenue for 2011 decreased $1,698,000 to $29,944,000 from $31,642,000 in 2010 and also goodwill impairment of $906,000 was recognized in 2011, which has resulted in loss from operations of $5,772,000 in operating activities during 2011 as compared to $3,386,000 for the year ended June 30, 2010.

Cash used in operating activities during 2011 was primarily the result of the net loss of $5,758,000 partially offset by non cash items of depreciation and amortization of $1,036,000, goodwill impairment of $906,000 and compensation expense related to stock options of $111,000 and also were offset by the increase in accounts payable, accrued and other liabilities of $1,256,000, a decrease in inventory of $718,000 offset by increases in accounts receivable of $283,000. Cash flow from operations also included $870,000 and $290,000 related to discontinued operations for the years ended June 30, 2011 and 2010, respectively. These cash inflows will not recur in future periods.

Cash used in operating activities during 2010 was primarily the result of net loss of $414,000 partially offset by non cash items of depreciation and amortization of $1,147,000, compensation expense related to stock options of $125,000, and decrease in inventory of $2,395,000. An increase in accounts payable, accrued and other liabilities of $1,296,000 also contributed to cash outflows in operating activities during 2010.

Net cash provided by operating activities from discontinued operations was approximately $870,000 in 2011, mainly related to net income from discontinued operations of $169,000, a decrease in accounts receivable and accounts payable and inventory of $1,075,000, $721,000, and $342,000 respectively.

Cash Flows Used In Investing and Financing Activities

Cash flows used in investing activities for 2011 were approximately $402,000. This amount is made up of purchases of fixed assets of $357,000 and investment in OTM of $45,000. Cash flows provided by investing activities for 2010 were approximately $4,108,000, mainly due to proceeds from sales of Vascular assets of $4,108,000 and reduced by cash outflows to purchase of fixed assets of $190,000 and investment in OTM of $39,000.

Any necessary capital expenditures have generally been funded out of cash from operations, and the Company is not aware of any factors that would cause historical capital expenditure levels to not be indicative of capital expenditures in the future and, accordingly, does not believe that the Company will have to commit material resources to capital investment for the foreseeable future.

Cash flows used in financing activities in the amount of $123,000 during 2011 relate to repayment of debt. Cash flows used in financing activities for 2010 were approximately $1,177,000. The cash used in financing activities decreased as the Company amended its seller-financed debt in connection with the Biocode transaction in April 2011.

The Company continues to operate under an austerity plan to stem the recurring losses at Drew (see footnote 16 of the statements to the consolidated financial statements for June 30, 2011). If the Company is unable to achieve improvement in this area in the near term, it is not likely that our existing cash and cash flow from operations will be sufficient to fund activities throughout the next 6 to 12 months without curtailing certain business activities. The Company's forecast of the period of time through which h its financial resources will be adequate to support its operations is a forward-looking statement and involves risks and uncertainties, and actual results could vary as a result of a number of factors, including the factors discussed in "Risk Factors".


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If the Company raises funds in the future, the Company may be required to raise those funds through public or private financings, strategic relationships or other arrangements at prices and other terms that may not be as favorable as they would be absent such qualification. The sale of additional equity and debt securities may result in additional dilution to the Company's shareholders. Additional financing may not be available in amounts or on terms acceptable to us or at all.

Debt History

On December 31, 2008, Drew acquired certain assets of Biocode for $5,900,000 (4,200,000 Euros) plus acquisition costs of approximately $300,000. The sales price was payable in cash of approximately $324,000 (approximately 231,000 . . .

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