Summary of DYNATRONICS CORP

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our consolidated financial statements and notes to those consolidated financial statements, included elsewhere in this Annual Report on Form 10-K. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from our expectations.

Overview

Our principal business is the manufacture, distribution and marketing of physical medicine products and aesthetic products, many of which we design and manufacture. We offer a broad line of medical equipment including therapy devices, medical supplies and soft goods, treatment tables and rehabilitation equipment. Our line of aesthetic equipment includes aesthetic massage and microdermabrasion devices, as well as skin care products. Our products are sold to and used primarily by physical therapists, chiropractors, sports medicine practitioners, podiatrists, plastic surgeons, dermatologists, aestheticians and other aesthetic services providers. Our fiscal year ends on June 30. Reference to fiscal year 2012 refers to the year ended June 30, 2012.

Results of Operations

Fiscal Year 2012 Compared to Fiscal Year 2011

Net Sales

Net sales in fiscal year 2012 were $31,664,181 compared to $32,692,859 in fiscal year 2011. The $1,028,678 decrease in sales is primarily attributable to the following factors: 1) the apparent insolvency of and interruption of purchases by a large, independent distributor that historically purchased between $150,000 to $250,000 per quarter from the Company; and 2) lower sales of capital equipment likely due to continuing weakness of the U.S. economy leading to a postponement of purchases of durable medical equipment. We also believe the uncertainty surrounding healthcare reform in the United States has had the effect of limiting expansion and improvements in our market sector. We expect the introduction of our new SolarisPlus products and Quad 7 devices to stimulate sales in fiscal year 2013.

Sales of manufactured physical medicine products represented approximately 42% and 43% of total physical medicine product sales in fiscal years 2012 and 2011, respectively. Distribution of products manufactured by other suppliers accounted for the balance of our physical medicine product sales in those years. Sales of manufactured aesthetic products in fiscal years 2012 and 2011, represented approximately 73% and 77% of total aesthetic product sales, respectively, with distributed products making up the balance.

The majority of our sales revenues come from the sale of physical medicine products, both manufactured and distributed. In fiscal years 2012 and 2011, sales of physical medicine products accounted for 91% and 92% of total sales, respectively. Chargeable repairs, billable freight revenue, aesthetic product sales and other miscellaneous revenue accounted for approximately 9% and 8% of total revenues in 2012 and 2011, respectively.

Gross Profit

Gross profit totaled $11,943,233, or 37.7% of net sales, in fiscal year 2012, compared to $12,484,824, or 38.2% of net sales, in fiscal year 2011. The decrease in gross profit in absolute dollars and as a percentage of net sales during the year mostly reflects the decrease in total sales attributed to the factors discussed above. The most significant reduction in sales was our higher margin capital equipment which had the effect of lowering the gross margin percentage as lower margin supplies and distributed items became a larger percentage of overall sales in fiscal year 2012. Looking ahead, we expect to generate improved sales of higher margin capital equipment with the introduction of our new SolarisPlus products (released in August 2012) and the Quad 7. In addition, as the effects of healthcare reform become clearer following the presidential and general elections in the United States in November 2012, we expect confidence to increase and demand for our products to begin to strengthen.

Selling, General and Administrative Expenses

SG&A expenses were $10,506,460, or 33.2% of net sales, in fiscal year 2012, compared to $10,431,463, or 31.9% of net sales, in fiscal year 2011. The $74,997 increase in SG&A expenses in fiscal year 2012 as compared to 2011 is a result of the following:

· $24,231 of higher selling expenses;
· $31,735 of higher production labor and depreciation expenses;
· $19,031 of higher general expenses including higher regulatory compliance costs and legal fees

During the fourth quarter of fiscal year 2012 and the first quarter of fiscal year 2013, the Company identified over $750,000 of annual cost reductions which are being implemented to 1) reduce labor costs through a reduction in force; 2) reduce overhead costs; and 3) improve operating efficiencies.

Research and Development

Over the last two years, we have undertaken the most extensive research and development efforts in our history. More new products will be introduced in fiscal 2013 than any year since the Company began. As a result, research and development ("R&D") expense increased 2%, or $26,694, to $1,410,406 in fiscal year 2012, from $1,383,712 in 2011. R&D expense increased as a percentage of net sales in fiscal year 2012 to 4.5% from 4.2% of net sales in fiscal year 2011. In March 2012, we introduced the Dynatron Quad7, the first of several new planned product introductions. The Company has been heavily involved with developing five new SolarisPlus units, four of which were introduced to the market in August 2012. These development efforts are directly responsible for the significant R&D expenses for the past two years. By contrast, the average annual R&D expenditures in the three years ended June 30, 2010 were $1,087,671. R&D expenses are expected to normalize closer to historic levels in fiscal year 2013, as a result of the completion of development of the new SolarisPlus products. R&D costs are expensed as incurred.

Interest Expense

Interest expense decreased by $32,411, to $261,993 in fiscal year 2012 compared to $294,404 in fiscal year 2011 due to lower negotiated borrowing rates on our bank line of credit compared to fiscal year 2011, and the first mortgage on our Salt Lake City facility entering the final two years of its term.

Income/Loss Before Income Tax Provision

Pre-tax loss in fiscal year 2012 was $190,241, compared to pre-tax income of $418,864 in fiscal year 2011. The reduction in income before income tax provision for 2012 resulted from lower sales and gross profits generated during the year as explained above, along with higher selling, labor, depreciation and R&D expenses. The reduction of gross margin accounted for $542,000 of the $609,000 difference in pre-tax results, or about 90%. The balance of the difference is accounted for by higher SG&A expenses as well as higher R&D expenses. The increase in selling expense was associated with our pursuit of GPO and national account business, while increased depreciation expense was related to increased investments in information systems. We offset some of these higher expenses with lower interest expense for the year ended June 30, 2012. As noted above, steps have been taken to reduce expenses at an annualized amount of approximately $750,000, the effect of which only began to be realized in the last two months of the fiscal year.

Income Tax Provision/Benefit

Income tax benefit was $166,706 in fiscal year 2012, compared to income tax provision of $147,976 in fiscal year 2011. Due to tax benefits associated with R&D tax credits and other credits, the income tax benefit reduced the pre-tax loss in fiscal year 2012 by 87.6% compared to an effective tax rate of 35.3% in 2011. The difference in the effective tax rates is attributable to higher R&D tax credits in fiscal year 2012, as well as certain permanent book to tax differences.

Net Income/Loss

Net loss was $23,535 ($.00 per share) in fiscal year 2012, compared to net income of $270,888 ($.02 per share) in fiscal year 2011. The reduction in net income in 2012 was caused primarily by decreased sales and margins generated during the year compared to fiscal year 2011. However, the net loss was mitigated by the recognition of significant tax benefits associated with R&D tax credit as explained above. We expect that R&D expense will decrease in fiscal year 2013 as a result of the completion of development of the new SolarisPlus products in August 2012. We expect improved profitability in fiscal year 2013, due to a reduction in R&D expense and with other reductions implemented or anticipated to be made as well as sales of new products that we recently introduced.

Liquidity and Capital Resources

We have financed operations through available cash reserves and borrowings under a line of credit with a bank. Working capital was $3,565,858 as of June 30, 2012, inclusive of the current portion of long-term obligations and credit facilities, compared to working capital of $4,552,731 as of June 30, 2011. During fiscal year 2012, we generated $35,812 in cash from operating activities, used $401,408 to repurchase and retire common stock, paid $328,707 for capital expenditures primarily related to improving our e-commerce and IT infrastructure, and paid $371,339 in principal on long-term debt. In addition, we purchased $450,782 of inventory primarily for the introduction of the new Dynatron Quad7 product. During fiscal year 2012, the outstanding balance on our line of credit increased by $913,660.

Accounts Receivable

Trade accounts receivable, net of allowance for doubtful accounts, decreased $5,042, or 0.1%, to $3,667,086 as of June 30, 2012, compared to $3,672,128 as of June 30, 2011. Trade accounts receivable represent amounts due from our dealer network as well as from medical practitioners and clinics. We believe that our estimate of the allowance for doubtful accounts is adequate based on our historical knowledge and relationship with these customers. Accounts receivable are generally collected within 30 days of the agreed terms.

Inventories

Inventories, net of reserves, increased $450,782, or 8.0%, to $6,098,597 as of June 30, 2012, compared to $5,647,815 as of June 30, 2011. The amount of inventory we carry fluctuates each period based on the timing of large inventory purchases from overseas suppliers. Inventory levels increased in fiscal year 2012 in conjunction with the introduction of the Dynatron Quad7 unit.

Accounts Payable

Accounts payable increased $286,038, to $2,413,201 as of June 30, 2012, from $2,127,163 as of June 30, 2011. The increase in accounts payable is a result of the timing of our weekly payments to suppliers and the timing of purchases of product components. Accounts payable are generally not aged beyond the terms of our suppliers. We take advantage of available early payment discounts when offered by our vendors.

Cash and Cash Equivalents

Our cash position as of June 30, 2012 was $278,263, compared to cash of $384,904 as of June 30, 2011. We expect that cash flows from operating activities, together with amounts available through an existing line-of-credit facility, will be sufficient to cover operating needs in the ordinary course of business for the next twelve months. If we experience an adverse operating environment, including a further worsening of the general economy in the United States, or unusual capital expenditure requirements, additional financing may be required. However, no assurance can be given that additional financing, if required, would be available on terms favorable to us, or at all.

Line of Credit

During fiscal year 2012, the outstanding balance on our line of credit increased by $913,660, leaving a balance outstanding of $3,497,597 as of June 30, 2012, compared to $2,583,937 as of June 30, 2011. The increase in the line of credit was primarily the result of $401,408 used to repurchase and retire common stock, $328,707 for capital expenditures primarily related to improving our e-commerce and IT infrastructure and $371,339 in principal payments on long-term debt. We also purchased an additional $450,782 of inventory primarily related to the introduction of the new Dynatron Quad7 product.

Interest on the line of credit is based on the 90-day LIBOR rate (0.46% as of June 30, 2012) plus 3%. The line of credit is collateralized by accounts receivable and inventories. Borrowing limitations are based on approximately 45% of eligible inventory and up to 80% of eligible accounts receivable, up to a maximum credit facility of $7,000,000. Interest payments on the line are due monthly. As of June 30, 2012, the borrowing base was approximately $5,115,000, resulting in approximately $1,617,000 available on the line. The line of credit is renewable on December 15, 2012 and includes covenants requiring us to maintain certain financial ratios. As of June 30, 2012, we were in compliance with the loan covenants.

The current ratio was 1.5 to 1 as of June 30, 2012 compared to 1.8 to 1 as of June 30, 2011. Current assets represented 70% of total assets as of June 30, 2012 and June 30, 2011. The lower current ratio reflects the use of short term borrowings to finance stock repurchases, capital equipment investments and repayment of long-term debt.

Debt

Long-term debt (excluding current installments) totaled $1,916,315 as of June 30, 2012, compared to $2,238,417 as of June 30, 2011. Long-term debt is comprised primarily of the mortgage loans on our office and manufacturing facilities in Utah and Tennessee. The principal balance on the mortgage loans is approximately $2,118,000 with monthly principal and interest payments of $37,503. For a more complete explanation of the long-term debt, see Note 7 to the financial statements.

Critical Accounting Policies

Management's discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires estimates and judgments that affect the reported amounts of our assets, liabilities, net sales and expenses. Management bases estimates on historical experience and other assumptions it believes to be reasonable given the circumstances and evaluates these estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.

We believe that the following critical accounting policies involve a high degree of judgment and complexity. See Note 1 to our consolidated financial statements for fiscal year 2012, for a complete discussion of our significant accounting policies. The following summary sets forth information regarding significant estimates and judgments used in the preparation of our consolidated financial statements.

Inventory Reserves

The nature of our business requires that we maintain sufficient inventory on hand at all times to meet the requirements of our customers. We record finished goods inventory at the lower of standard cost, which approximates actual costs (first-in, first-out) or market. Raw materials are recorded at the lower of cost (first-in, first-out) or market. Inventory valuation reserves are maintained for the estimated impairment of the inventory. Impairment may be a result of slow-moving or excess inventory, product obsolescence or changes in the valuation of the inventory. In determining the adequacy of reserves, we analyze the following, among other things:

· Current inventory quantities on hand;
· Product acceptance in the marketplace;
· Customer demand;
· Historical sales;
· Forecast sales;
· Product obsolescence;
· Technological innovations; and
· Character of the inventory as a distributed item, finished manufactured item or raw material.

Any modifications to estimates of inventory valuation reserves are reflected in cost of goods sold within the statements of operations during the period in which such modifications are determined necessary by management. As of June 30, 2012 and 2011, our inventory valuation reserve balance, which established a new cost basis, was $292,999 and $337,748, respectively, and our inventory balance was $6,098,597 and $5,647,815, net of reserves, respectively.

Revenue Recognition

Our sales force and distributors sell our products to end users, including physical therapists, professional trainers, athletic trainers, chiropractors, medical doctors and aestheticians. Sales revenues are recorded when products are shipped FOB shipping point under an agreement with a customer, risk of loss and title have passed to the customer, and collection of any resulting receivable is reasonably assured. Amounts billed for shipping and handling of products are recorded as sales revenue. Costs for shipping and handling of products to customers are recorded as cost of sales.

Allowance for Doubtful Accounts

We must make estimates of the collectability of accounts receivable. In doing so, we analyze historical bad debt trends, customer credit worthiness, current economic trends and changes in customer payment patterns when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivable balance was $3,667,086 and $3,672,128, net of allowance for doubtful accounts of $201,349 and $293,436, as of June 30, 2012 and 2011, respectively.

Deferred Income Tax Assets

In August 2012 and August 2011, our management performed an analysis of the deferred income tax assets and their recoverability. Based on several factors, including our strong earnings history of pre-tax profit averaging over $500,000 per year in 18 of the last 22 fiscal years and the fact that the principal causes of the loss in fiscal 2008 (goodwill impairment and expenses resulting from six acquisitions) are considered to be unusual and are not expected to recur in the near future, we believe that it is more likely than not that all of the net deferred income tax assets will be realized.

Business Plan and Outlook

During the past two years, we have focused much of our resources and energy on developing new and innovative products. The scope of that R&D effort has been more significant than at any time in our history. As a result, more new products will be introduced during fiscal year 2013 than we have introduced in any other year.

In March 2012, we introduced the new Dynatron Quad7 therapy device to the market. The innovative Quad7 utilizes thermoelectric technology to deliver thermal therapy (either cold or hot therapy) combined with compression treatments through a variety of wraps and innovative ThermoStim Probes. The ThermoStim Probes are unique in their design as they allow for delivery of electrotherapy treatments concurrent with thermal therapy. The Quad7 has the flexibility to offer seven different treatments including intermittent compression, cold with compression, heat with compression, cold with stim, heat with stim, cold therapy alone, and heat therapy alone. This capability dramatically expands both the variety and location of conditions that can be treated. The Quad7 employs state-of-the-art technology providing precise temperature control moving beyond the current technology by eliminating the need for ice. Thermal therapy in our Quad7 is achieved by using a thermoelectric computer chip technology.

In August 2012, we introduced to the market our new Dynatron SolarisPlus line of electrotherapy/ultrasound/ light therapy units. This new product line consists of four new units: the Dynatron SolarisPlus 709, 708, 706, and 705. These attractive new units provide our most advanced technology in combination therapy devices by adding tri-wave light therapy capabilities to enhanced electrotherapy and ultrasound combination devices. Tri-wave light therapy features infrared, red and blue wavelength light. The new Dynatron Solaris light pad is capable of treating large areas of the body via unattended infrared, red and blue wavelength light therapy. As part of the SolarisPlus product line introduction, we also introduced a new display cart specifically designed for these units. This new cart is expected to begin shipping in October 2012. The SolarisPlus line is expected to quickly become popular for its power and versatility. The new units are capable of simultaneously powering five electrotherapy channels, ultrasound therapy, a light probe and light pad.

The commitment to innovation of high-quality products has been a hallmark of Dynatronics and will continue to be part of our future strategic objectives. This emphasis on R&D contributed in large part to the lower profitability we experienced over the past two years. R&D costs for us have been cyclical in nature. The higher costs in fiscal year 2012 reflect the fact that we have been in a more intense part of the development cycle. With the new products introduced to the market in August 2012, we expect that R&D costs will cycle back to a lower level more in line with historical amounts. However, we have several additional products that are targeted for introduction in the coming fiscal year that will build on the technology developed over the past two years. Management is confident the higher costs associated with the more intense part of the development cycle in the short term will yield long-term benefits and are important to assuring that we maintain our reputation in the industry for being an innovator and leader in product development.

In calendar 2011, we announced the signing of contracts with four Group Purchasing Organizations (GPOs): Premier, Inc., Amerinet, Inc., FirstChoice Cooperative and Champs Group Purchasing. These GPOs represent tens of thousands of clinics and hospitals around the nation. With the broader offering of products now available through our catalog and e-commerce website, we are better able to compete for this high volume business. Over the past two years, we have also been successful in becoming a preferred vendor to many national and regional accounts.

The contracts with the GPOs represent a license to solicit business directly from the members of the respective GPOs. The GPOs do not order any product directly. They serve the function of negotiating favorable pricing terms on behalf of their members. We believe it will require years of effort to develop relationships with the individual GPO and national account clinics and hospitals and convert this business to our brand. This has been manifest by the lack of significant progress under the limited contracts with Premier and Amerinet and the decision by other GPO's like MedAssets and Novation to not put Dynatronics on contract. While we will continue to seek effective ways of accessing business with GPO members outside of a GPO contract, the pattern of the GPO's has not been conducive to putting new vendors, like Dynatronics, on contract. Therefore, while we will continue to petition for fairer treatment by the GPO's we also realize that the resources that may be required to secure contracts with the GPO's could be more productively deployed in other ways to improve sales of our products. While we are not abandoning the GPO effort, we recognize that the GPO bar is set very high and we would be better served initiating other strategies to increase sales.

In late 2012 or early 2013 we plan to introduce a new, updated version of our product catalog. This new catalog will expand our product offering in order to better service the broader needs of our customers. It will also provide an excellent new sales tool for all of our sales representatives in the field as well as provide a foundation for expanding our e-commerce platform.

Over the past few years, consolidations in our market have changed the landscape of our industry's distribution channels. At the present time, we believe that there remain only two companies with a national direct sales force selling proprietary and distributed products: Dynatronics and Patterson Medical. All other distribution in our market is directed through catalog companies with no direct sales force, or through independent local dealers that have limited geographical reach. In the past year, we have reinforced our direct sales team to include 53 direct sales employees and independent sales representatives. In addition to these direct sales representatives, we continue to enjoy a strong relationship with scores of independent dealers. We believe we have the best trained and most knowledgeable sales force in the industry. The changes taking place within our market provide a unique opportunity for us to grow market share in the coming years through recruitment of high-quality sales representatives and dealers.

To further our efforts to recruit high-quality direct sales representatives and dealers, we intend to continue to improve efficiencies of our operations and the sales support for the industry. Chief among the steps we are taking to make these improvements was the introduction of our first true e-commerce solution on July 6, 2010 and the enhancements to that portal in the two years since its introduction. With the availability of this e-commerce solution, customers are able to more easily place orders and obtain information about their accounts. Sales representatives are increasing their effectiveness with the abundance of information available to them electronically through our e-quote system, which is a companion to the e-commerce solution introduced. Not only is our e-commerce solution easy and efficient to use, it should also facilitate reducing transactional costs thus enabling us to accommodate higher sales without significantly increasing overhead.

The passage in 2010 of the Patient Protection and Affordable Care Act and with the Health Care and Educational Reconciliation Act will affect our future operations. The addition of millions to the rolls of the insured is expected to increase demand for services. That increased demand could lead to increased sales of our products. The magnitude of those increases is difficult to assess at this time. A negative impact of this legislation as enacted is its imposition of an excise tax on all manufacturers and importers of medical devices. An excise tax is assessed against sales, not profits. Therefore, even in a year when we may have no profits, we will still owe the excise tax to the federal government. Barring a change in the statute, we estimate that this tax would be approximately $300,000 to $400,000 annually based on current sales levels. Because of the phase-in of various provisions in the legislation, the impact of the 2012 elections, and possible legislative actions, we cannot predict what the full effects of this legislation on our business and industry will be. The first impact is expected in the early part of calendar year 2013. In addition, rule-making under the law is not yet complete which could mean a temporary postponement in implementing the tax. In the meantime, we are taking full advantage of every opportunity presented by this legislation to increase sales and to offset any negative effects that may accompany those opportunities. Should the tax become effective January 1, 2013 as anticipated, we will likely be compelled to raise prices as a reflection of that new tax.

Economic pressures from the recent recession in the United States have affected available credit that would facilitate large capital purchases, and have also reduced demand for discretionary services such as those provided by the purchasers of our aesthetic products. As a result, we reduced our expenses in the Synergie department. We believe that our aesthetic devices remain the best value on the market and we are seeking innovative ways to market these products, . . .