The following discussion and analysis provides information that management believes is relevant to an assessment and understanding of the Company's results of operations and financial condition for the years ended June 30, 2012 and 2011. Unless otherwise indicated, this discussion excludes the results of our fractional horsepower motor product line, operating under the name Pro-Dex Astromec, which we sold in February 2012 and which has been classified as a discontinued operation. This discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included elsewhere in this report. This report contains certain forward-looking statements and information. The cautionary statements included below and elsewhere in this report should be read as being applicable to all related forward-looking statements wherever they may appear. Our actual future results could differ materially from those discussed herein.

Critical Accounting Estimates and Judgments

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of our financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

Revenue Recognition

Revenue on product sales is recognized upon shipment to the customer when risk of loss and title transfer to the customer and all other conditions required by GAAP, as promulgated by the Financial Accounting Standards Board ("FASB") in Accounting Standards Codification ("ASC") Section 605 (formerly Staff Accounting Bulletin No. 104, Revenue Recognition), have been satisfied.

Returns of our product for credit are minimal; accordingly, we do not establish a reserve for product returns at the time of sale.

Warranties

Certain of our products are sold with a warranty that provides for repairs or replacement of any defective parts for a period, generally one year, after the sale. At the time of the sale, we accrue an estimate of the cost of providing the warranty based on prior experience with such factors as return rates and repair costs, which factors are reviewed quarterly.

Warranty expenses, including changes of estimates, are included in cost of sales in our consolidated statements of operations.

Inventories

Inventories are stated at the lower of cost (first-in, first-out method) or market value. Reductions to estimated market value are recorded, and charged to cost of sales, when indicated based on a formula that compares on-hand quantities to estimated demand over the ensuing 12 months from the measurement date.

Accounts Receivable

Trade receivables are stated at their original invoice amounts, less an allowance for doubtful portions of such accounts. Management determines the allowance for doubtful accounts based on facts and circumstances related to specific accounts, and on historical experience related to the age of accounts. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously reserved are offset against the allowance when received.

Long-lived Assets and Real Estate Held for Sale

We review the recoverability of long-lived assets, consisting of equipment and leasehold improvements, and of real estate held for sale, when events or changes in circumstances occur that indicate carrying values may not be recoverable.

Stock-Based Compensation

We recognize compensation expense for all share-based awards made to employees and directors. The fair value of share-based awards is estimated at the grant date using the Black-Scholes option-pricing model. The portion that is ultimately expected to vest is recognized as compensation cost over the requisite service period using the straight-line single option method.

The determination of fair value using the Black-Scholes model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables, including expected stock price volatility, risk-free interest rate, expected dividends and projected employee stock option exercise behavior. We estimate stock price volatility based on two factors: (a) the measurement date (typically the grant date) and (b) the expected life of the option, which we calculate using the Staff Accounting Bulletin No. 107 simplified method.

Income Taxes

We recognize deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities along with net operating loss and tax credit carryovers. Deferred tax assets at June 30, 2012 and 2011 consisted primarily of basis differences related to research and development tax credit utilization, net operating loss carryovers, intangible assets, accrued expenses and inventories.

Significant management judgment is required in determining our provision for income taxes and the recoverability of our deferred tax assets. Such determination is based on our historical taxable income, with consideration given to our estimates of future taxable income and the periods over which deferred tax assets will be recoverable. We record a valuation allowance against deferred tax assets to reduce the net carrying value to an amount that we believe is more likely than not to be realized. When we establish or reduce the valuation allowance against deferred tax assets, the provision for income taxes will increase or decrease, respectively, in the period such determination is made. At June 30, 2012 and 2011, we maintained a valuation allowance against the entire balance of our deferred tax assets, net of deferred tax liabilities.

RESULTS OF OPERATIONS

Results of Operations for the Fiscal Year Ended June 30, 2012, Compared to the
Fiscal Year Ended June 30, 2011

The following table sets forth financial data and the percentage of net sales
regarding our financial position and operating results:



                                                               Fiscal Year ended June 30,
                                                             2012                       2011
                                                                  Dollars in thousands
Net sales                                            $ 17,257         100 %     $ 24,060         100 %
Cost of sales                                          11,841          69 %       13,919          58 %


Gross profit                                            5,416          31 %       10,141          42 %
Selling expenses                                        1,531           9 %        1,600           7 %
General and administrative expenses                     3,182          18 %        3,174          13 %
Research and development costs                          2,068          12 %        1,889           8 %


Income (loss) from continuing operations before
items below                                            (1,365 )        -8 %        3,478          14 %
Interest expense                                           36           0 %          148           0 %
Provision (benefit) for income taxes                     (441 )         3 %          530           2 %


Income (loss) from continuing operations                 (960 )        -5 %        2,800          12 %
Income (loss) from discontinued operations                 84           0 %         (160 )        -1 %

Net income (loss)                                    $   (876 )        -5 %     $  2,640          11 %

Net sales in 2012 decreased 28%, or $6.8 million, to $17.3 million from $24.1 million in 2011, due primarily to a reduction of $5.6 million in sales of our medical device products to our largest customer.

Although selective price increases and decreases were implemented in response to market conditions, the majority of the sales growth and declines for each product line is due primarily to changes in sales volume, not the effect of price changes.

At June 30, 2012, we had a backlog of $5.3 million compared with a backlog of $13.4 million at June 30, 2011. The decrease in orders from our largest customer contributed $5.1 to the backlog decrease, and $1.9 million of the backlog decrease was due to a delay in the timing of orders from our second largest customer, which orders were placed with us in July 2012.

Gross profit in 2012 decreased $4.7 million, or 47%, to $5.4 million from $10.1 million in 2011, resulting primarily from (a) $3.1 million attributable to the sales volume decreases discussed above, (b) $875,000 related to product mix changes and (c) $602,000 attributable to manufacturing inefficiencies caused by the lower sales volume. Gross profit as a percentage of sales was 31% for the year ended June 30, 2012, compared to 42% for the year ended June 30, 2011. Of this eleven percentage point decrease, the aforementioned product mix changes and manufacturing inefficiencies were the primary causes, each contributing five percentage points.

Selling expenses decreased $69,000, or 4%, to $1.5 million in 2012 from $1.6 million in 2011, due primarily to reduced website enhancement costs and departmental compensation expense of $130,000 and $95,000, respectively, offset by increased advertising and trade show participation, the costs of which grew $92,000 and $65,000, respectively, from 2011 to 2012.

General and administrative expenses were relatively unchanged, amounting to $3.2 million in both 2012 and 2011. Underlying the absence of a year-over-year change were decreases in employee compensation, primarily attributable to a decrease from 2011 to 2012 in performance-based bonuses, and legal expense of $247,000 and $128,000, respectively, offset by an increase of $339,000, related to costs incurred in connection with the resignation of our former Chief Executive Officer (see Note 8 of Notes to Consolidated Financial Statements).

Research and development costs, which include costs related to development of new products and enhancements to existing products, increased $179,000, or 9%, to $2,068,000 in 2012 from $1,889,000 in 2011 due primarily to increases of $83,000 and $84,000 in small motor development costs and employee related expenses, respectively, from 2011 to 2012.

Interest expense in 2012 was $36,000, compared to $148,000 in 2011. This decrease was due to the effects of (a) the refinancing of our bank term loan in February 2011, and (b) the repayment and retirement in September 2010, prior to its maturity, of the mortgage collateralized by the land and building then owned in Carson City, Nevada (see Note 5 of Notes to Consolidated Financial Statements).

Our effective combined federal and state tax benefit rate in 2012 was 31%, as compared to a 16% tax provision rate in 2011. The benefit generated in 2012 is attributable to the net operating losses incurred. The effective tax rates in both 2012 and 2011 were lower than the federal statutory rate primarily due to changes in net deferred tax credits not resulting in a deferred tax provision in 2011, such changes being fully offset by corresponding changes in the valuation allowance against such net deferred tax debits (see Note 7 of Notes to Consolidated Financial Statements).

As a result of the foregoing, loss from continuing operations for the year ended June 30, 2012 was $960,000 as compared to income from continuing operations of $2.8 million for the year ended June 30, 2011.

Discontinued operations reflect (a) the results of Astromec's operations, which in 2012 include the period of our ownership of the Astromec business from July 1, 2011 through the date of its sale on February 27, 2012, and, for 2012,
(b) costs directly related to the Astromec sale. For both 2012 and 2011, discontinued operations also include the income tax effects related to Astromec's operations and sale, as appropriate in each period (see Note 3 of Notes to Consolidated Financial Statements).

As a result of the foregoing, net loss for the year ended June 30, 2012 was $876,000 as compared to net income of $2.6 million for the year ended June 30, 2011.

Liquidity and Capital Resources

The following table presents selected financial information as of June 30, 2012 and 2011:

                                              June 30, 2012       June 30, 2011
      Cash                                   $     4,112,000     $     4,689,000
      Working capital                        $     6,618,000     $     7,819,000
      Cash, net of bank debt                 $     3,338,000     $     3,558,000
      Tangible book value per common share   $          2.92     $          3.15

Net cash provided by operating activities during the year ended June 30, 2012, amounted to $45,000. Our operations, excluding the balance sheet changes discussed below, required cash amounting to $112,000 after adjustment for non-cash items. Sources of cash arose from a reduction of accounts receivable amounting to $1.4 million, due primarily to the lower sales volume experienced during the 2012 period relative to the corresponding period in 2011, and a decrease in inventories of $912,000, the majority of which was due to the sale of our Astromec business as more fully described in Note 3 of Notes to Consolidated Financial Statements. Partially offsetting these cash sources were uses of cash in increasing income taxes receivable by $641,000 due to the ability to carry back tax-basis net operating losses to generate refunds of taxes from prior years, and in reducing accounts payable and accrued liabilities by $1.5 million, due primarily to reduced inventory purchasing activities in 2012, consistent with the reduced sales volume in 2012, and the payment in the first quarter of fiscal 2012 of employee bonuses based on the attainment of pre-determined goals related to fiscal 2011.

During the year ended June 30, 2011, net cash provided by operating activities amounted to $2.9 million. Our operations, after adjustment for non-cash items and excluding balance sheet changes discussed below, provided cash amounting to $3.4 million. Additional sources of cash arose from increases in accounts payable and accrued liabilities, amounting to $383,000 and due primarily to high ordering activity relative to sales volumes and accruals for employee bonuses related to fiscal 2011 results. Uses of cash arose from increases in accounts receivable of $418,000 and inventories of $475,000, both increases due primarily to the high sales volumes during the 2011 period.

Net cash used in investing activities during the year ended June 30, 2012 consisted of purchases of equipment amounting to $341,000, net of proceeds received, amounting to $82,000, from the sale of equipment in connection with the sale of the Astromec business (see Note 3 of Notes to Consolidated Financial Statements). Net cash used in investing activities during the corresponding period in 2011 consisted of purchases of equipment, amounting to $265,000.

Net cash used in financing activities during the year ended June 30, 2012 was $362,000, and consisted primarily of reductions in the principal balance of our bank term loan, amounting to $357,000. For the year ended June 30, 2011, net cash used in financing activities amounted to $1.7 million. Comprising this amount were principal reductions, amounting to $236,000, to our term loan with Wells Fargo Bank (until February 2011) and with Union Bank (commencing February 2011), and the payment, in September 2010, of the remaining $1.5 million balance due on a mortgage loan, held by Union Bank and collateralized by our Carson City, Nevada property, fully retiring such indebtedness. (See Note 5 of Notes to Consolidated Financial Statements.)

Our bank credit facility agreements contain various covenants, including certain covenants measured annually based on fiscal year results, concerning our financial performance. At June 30, 2012, we were in violation of profitability-based covenants, for which the bank had the right to declare us in default of the bank credit facility agreements and the entire amount owing under the facility, consisting of a term loan, to become immediately due and payable. We have historically not made any borrowings against our bank lines of credit, and believe that existing cash balances and cash flows from operations will be sufficient to fund operations for the next twelve months and to fully repay the term loan. Accordingly, on August 30, 2012, we notified the bank of our intent to terminate the credit facility agreements and repay the term loan in full on or before September 30, 2012. By letter to us dated September 4, 2012, the bank waived, through October 1, 2012, the rights it otherwise would have had pursuant to the covenant violations described above. Accordingly, we have classified all amounts owing under the term loan as current liabilities as of June 30, 2012 in the Consolidated Financial Statements appearing elsewhere in this report.

Reduction in Large Customer Orders

In December 2009 our largest customer informed us that it was in the process of developing, and planned to eventually manufacture, its own surgical devices which were functionally comparable to the products the Company provided to the customer at that time. Pro-Dex had been the exclusive manufacturer of these products since they were developed. The resulting reduction in orders from our largest customer and its expected future impact on our business is more fully described in "Description of Business" under Item 1.

Changes in Bank Debt and Credit Facilities

Union Bank Credit Facility

As more fully described in Note 5 of Notes to Consolidated Financial Statements, during the fiscal year ended June 30, 2011, we effected the following changes in our bank debt and credit facility arrangements:

• On February 4, 2011, we entered into a credit facility agreement with Union Bank that provides for (a) a revolving credit line of up to $1.5 million, (b) a non-revolving credit line of up to $350,000 for the purchase of equipment, and (c) a term loan of $1.25 million. The proceeds of the term loan were used to pay off in full the Wells Fargo term loan previously outstanding.

• On September 16, 2010, we paid the remaining $1.5 million balance due on a mortgage previously outstanding with Union Bank, fully retiring such indebtedness.

As discussed above in "Liquidity and Capital Resources" under this Item 7, on August 30, 2012 we informed the bank of our intent to repay the term loan in full and terminate the credit facility agreements. By letter to us dated September 4, 2012, the bank waived, through October 1, 2012, the rights it otherwise would have had pursuant to the covenant violations described above.

Impact of Inflation and Changing Prices

The industries in which we compete are labor intensive, often involving personnel with high-level technical or sales skills. Wages and other expenses increase during periods of inflation and when shortages in the marketplace occur. In addition, suppliers pass along rising costs to us in the form of higher prices. We have been able to partially offset increases in operating costs by increasing charges, expanding services and implementing cost control measures. However, our ability to increase prices is limited by competitive market conditions, including international competition in many of our markets.

Recent Accounting Pronouncements

We evaluate authoritative accounting pronouncements upon their issuance and estimate the effect, if any, of such pronouncements on our financial statements. In our evaluation, we have concluded that there are no such pronouncements that have been issued with effective dates subsequent to June 30, 2012 that would have an effect on our financial statements or accounting policies had such pronouncements been currently in effect.