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

Overview

Aetrium designs, manufactures and markets a variety of electromechanical equipment used in the handling and testing of integrated circuits, or ICs, which constitute the highest revenue component of the semiconductor industry. Our primary focus is on high volume ICs, the latest IC package designs, and ICs using advanced geometry designs. Our test handler products are purchased primarily by semiconductor manufacturers and their assembly and test subcontractors and are used in the test, assembly and packaging, or TAP, segment of semiconductor manufacturing. Our reliability test products are used to validate IC designs and evaluate and improve semiconductor wafer fabrication processes, and are used in advanced reliability test labs at wafer manufacturing sites. Our products automate critical functions to improve manufacturing yield, raise quality levels, increase product reliability and reduce manufacturing costs.

Demand for Aetrium's test handler products is driven primarily by worldwide demand for ICs, which in turn depends on end-user demand for electronic products. Demand for Aetrium's reliability test products is less sensitive to fluctuations in IC demand and is driven more by technological change in IC design and manufacturing processes. The demand for our products can fluctuate significantly from period to period due to the direct or indirect impact of numerous factors, including but not limited to changes in the supply and demand for ICs, changes in IC manufacturing capacity, advancements in industry technologies, changes in U.S. and worldwide economic conditions and competitive factors.

The worldwide financial crisis and economic recession that began to unfold in 2008 led to a significant decrease in the sales of electronic products and one of the most severe downturns ever in our industry. In mid-2009, general economic conditions began to improve and the semiconductor industry began a slow and uneven recovery. Demand for ICs improved in 2010 and many IC manufacturers expanded their production capacity. However, by the end of the year, IC demand had weakened and IC production decreased significantly late in the year. Aetrium's results generally followed the trend of our industry. In the first nine months of 2010, our net sales increased substantially over the prior year before declining significantly in the fourth quarter as business conditions weakened. Despite the sharp drop-off in sales in the fourth quarter, our net sales for fiscal year 2010 totaled $16.3 million compared with $8.6 million in 2009.

In 2011, worldwide economic uncertainty contributed to relatively flat and inconsistent business conditions in the semiconductor industry. IC production growth resumed in the first half of the year but leveled off in the third quarter and then decreased significantly in the fourth quarter, having never reached the previous peak production levels of 2010. As a result, many manufacturers operated at less than full capacity throughout the year and many semiconductor equipment manufacturers experienced reduced sales in 2011 compared with 2010. Sales of our test handler products decreased dramatically in 2011 as many of our customers operated with excess production capacity throughout the year and required new equipment for only their fastest growing products. Sales of our reliability test equipment and change kits/spare parts increased slightly in 2011 despite the generally weak industry conditions. Our total sales declined to $9.0 million in 2011 as a result of a 75% decrease in test handler sales.

Generally weak semiconductor industry conditions characterized by high inventories and excess production capacity continued into early 2012. Our net sales in the first quarter of 2012 were $1.9 million, approximately flat with sales for the same period in 2011.

Some industry analysts have recently indicated that IC demand and production are increasing and predict that IC unit growth will continue in 2012. However, we believe excess production capacity in the industry needs to be absorbed before meaningful increases in the purchases of production-based equipment occur. We believe business conditions will improve for Aetrium in the second half of 2012. However, a worsening or prolonged continuation of the slowdown in our industry would likely adversely impact the demand for and prices of our products, and in particular our test handler products, and adversely affect our future operating results and cash flows.

Critical Accounting Policies

Aetrium's critical accounting policies are disclosed in our most recent Annual Report on Form 10-K for the year ended December 31, 2011. There were no changes in such policies during the three months ended March 31, 2012.

Results of Operations

Net Sales. Net sales for the three months ended March 31, 2012 were $1.9 million, approximately flat with sales for the same period in 2011. Sales of test handlers were $0.5 million in the three months ended March 31, 2012 compared with $0.1 million for the same period in 2011. Sales of change kits and spare parts were $0.3 million in the three months ended March 31, 2012 compared with $0.8 million for the same period in 2011. Sales of test handlers, although higher than the prior year, and sales of change kits continued to be impacted by semiconductor industry conditions characterized by relatively flat IC demand and excess production capacity that existed during fiscal year 2011 and continued into 2012. Sales of reliability test equipment products, which are driven more by technology factors and less by IC demand and production capacity, were $1.1 million in the three months ended March 31, 2012 compared with $1.0 million for the same period in 2011.

Gross Profit. Aetrium's gross profit as a percentage of net sales can fluctuate based on a number of factors, including but not limited to the mix of products sold, distribution channel mix, price discounting, product maturity, inventory writedowns, and the utilization of our manufacturing capacity based upon varying production levels. Gross profit was 48.7% of net sales in the three months ended March 31, 2012 compared with 55.9% for the same period in 2011. Our gross margin decreased in 2012 primarily due to a less favorable product mix and a $48,000 charge recorded for severance costs related to a workforce reduction implemented in January 2012. Test handlers, which are generally lower margin sales than reliability test equipment and spare parts/change kits, represented 26% of total net sales in the first three months of 2012 compared with 7% for the same period in 2011. Reliability test equipment sales represented 57% of total net sales in the first three months of 2012 compared with 53% for the same period in 2011 and spares/change kit sales represented 17% of total net sales in the first three months of 2012 compared with 40% for the same period in 2011.

Selling, General and Administrative. Selling, general and administrative (S, G &
A) expenses for the three months ended March 31, 2012 were $1.1 million compared with $1.2 million for the comparable period in 2011, a decrease of 5%. The decrease in S, G & A expenses from the prior year was primarily attributable to lower wages and share-based compensation expense resulting from reductions in personnel and lower travel costs, partially offset by higher commission expense and a $39,000 charge for severance costs related to a workforce reduction we implemented in January 2012.

Research and Development. Research and development expenses for the three months ended March 31, 2012 were $0.4 million compared with $0.6 million for the comparable period in 2011, a 29% decrease. The decrease from the prior year was primarily attributable to lower wages resulting from reductions in personnel, and lower contract services, travel, and materials expense, partially offset by a $72,000 charge for severance costs related to a workforce reduction we implemented in January 2012. Research and development expenses represented 22.7% of total net sales for the three month period ended March 31, 2012 compared with 32.4% of total net sales for the comparable period in 2011. New product development is an essential part of our strategy to gain market share. Over time, we expect to invest approximately 12% to 15% of our net sales in research and development, although we may exceed this range in periods of relatively low net sales, as was the case during the three months ended March 31, 2012 and 2011.

Interest Income, net. Interest income, net amounted to approximately $2,000 and $13,000 for the three months ended March 31, 2012 and 2011, respectively. These amounts consisted primarily of interest income from the investment of excess funds. The decrease in interest income in 2012 resulted primarily from lower average invested cash balances.

Income Taxes. We recorded no income tax benefit or expense for the three month periods ended March 31, 2012 and 2011. Since 2009, we have maintained a valuation allowance to fully reserve our deferred tax assets. We expect to continue to maintain a full valuation allowance until we determine that we can sustain a level of profitability that demonstrates our ability to realize these assets. To the extent we determine that the realization of some or all of these benefits is more likely than not based upon expected future taxable income, a portion or all of the valuation allowance will be reversed. Such a reversal would be recorded as an income tax benefit and, for some portion related to deductions for stock option exercises, an increase in shareholders' equity.

Financial Condition, Liquidity and Capital Resources

Cash and cash equivalents decreased by approximately $0.4 million in the three months ended March 31, 2012. We used $0.4 million of cash to fund operating activities during this period, including our net loss of $0.6 million, partially offset by non-cash depreciation and share-based compensation expense of $0.1 million and $0.2 million in working capital changes. Working capital changes generating cash consisted primarily of a $0.5 million decrease in accounts receivable and a $0.2 million decrease in inventories, partially offset by decreases of $0.1 million in each of accounts payable, accrued compensation and accrued severance costs. Accounts receivable decreased due to a decrease in net sales in the first quarter of 2012 compared with the fourth quarter of 2011 and the timing of collections. Inventories and accounts payable decreased due to reduced inventory purchases in the first quarter of 2012 compared with the fourth quarter of 2011. Net cash flows used in investing and financing activities in the three months ended March 31, 2012 were not significant.

Cash and cash equivalents decreased by approximately $2.2 million in the three months ended March 31, 2011. We used $2.3 million of cash to fund operating activities during this period, including our net loss of $0.7 million and $1.7 million in working capital changes, partially offset by $0.1 million in non-cash depreciation and share-based compensation expense. Working capital changes using cash consisted primarily of a $0.4 million increase in accounts receivable and a $1.5 million increase in inventories, partially offset by a $0.3 million increase in accounts payable. The increase in inventories reflected an increase in inventories related to our new VMAXeight-site test handler to meet anticipated sales demand and demo/evaluation unit requirements for potential new accounts. Net cash flows from investing and financing activities in the three months ended March 31, 2011 were not significant.

Historically we have supported our capital expenditure and working capital needs with cash generated from operations and our existing cash and cash equivalents. We believe our cash balance of $4.6 million at March 31, 2012 will be sufficient to meet capital expenditure and working capital requirements for at least the next twelve months. Our revolving credit line agreement with a bank expired on March 31, 2012. We have had discussions with the bank regarding a potential new agreement and are exploring other potential sources of working capital financing as well. There can be no assurance that we will obtain a credit line with terms favorable to us or at all or that funds will be available to us under any financing agreement. As discussed above, semiconductor industry conditions weakened in the second half of 2011 and the slowdown has continued into 2012. A worsening or prolonged continuation of the slowdown would likely adversely impact the demand for and prices of our products and adversely affect our future operating results and cash flows. Also, as we continue to monitor the industry and customer needs, we may acquire other companies, product lines or technologies that are complementary to our business, and our working capital needs may change as a result of such acquisitions.