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ESMC > SEC Filings for ESMC > Form 10-Q on 14-Nov-2012All Recent SEC Filings

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Form 10-Q for ESCALON MEDICAL CORP


14-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Forward Looking Statements

Certain statements contained in, or incorporated by reference in, this report are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, which provide current expectations or forecasts of future events. Such statements can be identified by the use of terminology such as "anticipate," "believe," "could," "estimate," "expect," "forecast," "intend," "may," "plan," "possible," "project," "should," "will," and similar words or expressions. The Company's forward-looking statements include certain information relating to general business strategy, growth strategies, financial results, liquidity, discontinued operations, product development, the introduction of new products, the potential markets and uses for the Company's products, the Company's regulatory filings with the FDA, acquisitions, the development of joint venture opportunities, intellectual property and patent protection and infringement, the loss of revenue due to the expiration on termination of certain agreements, the effect of competition on the structure of the markets in which the Company competes, increased legal, accounting and Sarbanes-Oxley compliance costs, compliance with Nasdaq continued listing qualifications, defending the


Company in litigation matters and the Company's cost saving initiatives. The reader must carefully consider forward-looking statements and understand that such statements involve a variety of risks and uncertainties, known and unknown, and may be affected by assumptions that fail to materialize as anticipated. Consequently, no forward-looking statement can be guaranteed, and actual results may vary materially. It is not possible to foresee or identify all factors affecting the Company's forward-looking statements, and the reader therefore should not consider the list of such factors contained in its periodic report on Form 10-K for the year ended June 30, 2012 and this Form 10-Q quarterly report to be an exhaustive statement of all risks, uncertainties or potentially inaccurate assumptions.

Executive Overview-Three Months Ended September 30, 2012 and 2011.

The following highlights are discussed in further detail within this Form 10-Q. The reader is encouraged to read this
Form 10-Q in its entirety to gain a more complete understanding of factors impacting Company performance and financial condition.
Product revenue from continuing operations decreased approximately $137,000 or 5.7% during the three-month period ended September 30, 2012 as compared to the same period of last fiscal year. The decrease is related to sales decreases in EMI's digital imaging cameras offset by a slight increase in Sonomed's ultrasound products.

Cost of goods sold as a percentage of product revenue from continuing operations increased to approximately 52.7% of product revenues during the three-month period ended September 30, 2012 as compared to approximately 50.9% of product revenue for the same period of last fiscal year.

Total operating expenses increased approximately 4.4% during the three-month period ended September 30, 2012 as compared to the same period of prior fiscal year. This was due to decreased marketing, general and administrative expenses of 1.7% and an increase of 20.0% in research and development expenses.

Company Overview

The following discussion should be read in conjunction with interim condensed consolidated financial statements and
the notes thereto, which are set forth in Item 1 of this report.

The Company operates in the healthcare market specializing in the development, manufacture, marketing and distribution of medical devices and pharmaceuticals in the areas of ophthalmology, diabetes and hematology. The Company and its products are subject to regulation and inspection by the FDA. The FDA requires extensive testing of new products prior to sale and has jurisdiction over the safety, efficacy and manufacture of products, as well as product labeling and marketing. The Company's Internet address is www.escalonmed.com. Critical Accounting Policies
The preparation of financial statements requires management to make estimates and assumptions that impact amounts reported therein. The most significant of those involve the application of FASB-issued authoritative guidance concerning Revenue Recognition, Goodwill and Other Intangible Assets, discussed further in the notes to consolidated financial statements included in the Form 10-K for the year ended June 30, 2012. The financial statements are prepared in conformity with accounting principles generally accepted in the United States of America, and, as such, include amounts based on informed estimates and judgments of management. For example, estimates are used in determining valuation allowances for deferred income taxes, uncollectible receivables, obsolete inventory, sales returns and rebates, warranty liabilities and purchased intangible assets. Actual results achieved in the future could differ from current estimates. The Company used what it believes are reasonable assumptions and, where applicable, established valuation techniques in making its estimates. Revenue Recognition
The Company recognizes revenue from the sale of its products at the time of shipment, when title and risk of loss transfer. The Company provides products to its distributors at agreed wholesale prices and to the balance of its customers at set retail prices. Distributors can receive discounts for accepting high volume shipments. The discounts are reflected immediately in the net invoice price, which is the basis for revenue recognition. No further material discounts are given.

The Company's considerations for recognizing revenue upon shipment of product to a distributor are based on the following:


Persuasive evidence that an arrangement (purchase order and sales invoice) exists between a willing buyer (distributor) and the Company that outlines the terms of the sale (company information, quantity of goods, purchase price and payment terms). The buyer (distributor) does not have a right of return.

Shipping terms are ex-factory shipping point. At this point the buyer (distributor) takes title to the goods and is responsible for all risks and rewards of ownership, including insuring the goods as necessary.

The Company's price to the buyer (distributor) is fixed and determinable as specifically outlined on the sales invoice. The sales arrangement does not have customer cancellation or termination clauses.

The buyer (distributor) places a purchase order with the Company; the terms of the sale are cash, COD or credit. Customer credit is determined based on the Company's policies and procedures related to the buyer's (distributor's) creditworthiness. Based on this determination, the Company believes that collectibility is reasonably assured.

The Company assesses collectibility based on creditworthiness of the customer and past transaction history. The Company performs ongoing credit evaluations of its customers and does not require collateral from its customers. For many of the Company's international customers, the Company requires an irrevocable letter of credit to be issued by the customer before the purchase order is accepted.
Valuation of Intangible Assets
The Company annually evaluates for impairment its intangible assets and goodwill in accordance with SFAS 142, "Goodwill and Other Intangible Assets," or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. These intangible assets include goodwill, trademarks and trade names. Recoverability of these assets is measured by comparison of their carrying amounts to future discounted cash flows the assets are expected to generate. If identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the assets exceeds its fair market value. The Company does not amortize intangible assets with indefinite useful lives, rather such assets are required to be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. The Company performs its intangible asset impairment tests on or about June 30, of each year. Any such impairment charge could be significant and could have a material adverse impact on the Company's financial statements if and when an impairment charge is recorded.
Income/(Loss) Per Share
The Company computes net income/(loss) per share under the provisions of FASB issued authoritative guidance.
Under the provisions of FASB issued authoritative guidance, basic and diluted net income/(loss) per share is computed by dividing the net income/(loss) for the period by the weighted average number of shares of common stock outstanding during the period. The calculation of diluted net income/(loss) per share excludes potential common shares if the impact is anti-dilutive. Basic earnings per share are computed by dividing net income/(loss) by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share are determined in the same manner as basic earnings per share, except that the number of shares is increased by assuming exercise of dilutive stock options and warrants using the treasury stock method.

Taxes
Estimates of taxable income of the various legal entities and jurisdictions are used in the tax rate calculation. Management uses judgment in estimating what the Company's income tax will be for the year. Since judgment is involved, there is a risk that the tax rate may significantly increase or decrease in any period.
In determining income/(loss) for financial statement purposes, management must make certain estimates and judgments. These estimates and judgments occur in the calculation of certain tax liabilities and in the determination of the recoverability of certain deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenue and expense. FASB issued authoritative guidance concerning accounting for income taxes also requires that the deferred tax assets be reduced by a valuation allowance, if based on the available evidence, it is more likely that not that all or some portion of the recorded deferred tax assets will not be realized in future periods.


In evaluating the Company's ability to recover the Company's deferred tax assets, management considers all available positive and negative evidence including the Company's past operating results, the existence of cumulative losses and near-term forecasts of future taxable income that is consistent with the plans and estimates management is using to manage the underlying businesses. Through September 30, 2012, the Company has recorded a valuation allowance against the Company's net operating losses for all of the deferred tax asset due to uncertainty of their realization as a result of the Company's earnings history, the number of years the Company's net operating losses and tax credits can be carried forward, the existence of taxable temporary differences and near-term earnings expectations. The amount of the valuation allowance could decrease if facts and circumstances change that materially increase taxable income prior to the expiration of the loss carryforwards. Any reduction would reduce (increase) the income tax expense (benefit) in the period such determination is made by the Company.
The Company has adopted FASB issued guidance related to accounting for uncertainty in income taxes, which provides a comprehensive model for the recognition, measurement, and disclosure in financial statements of uncertain income tax positions that a company has taken or expects to take on a tax return. Under the FASB guidance a company can recognize the benefit of an income tax position only if it is more likely than not (greater than 50%) that the tax position will be sustained upon tax examination, based solely on the technical merits of the tax position. Otherwise, no benefit can be recognized. The tax benefits recognized are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Additionally, companies are required to accrue interest and related penalties, if applicable, on all tax exposures for which reserves have been established consistent with jurisdictional tax laws. The Company has elected to recognize interest expense and penalties related to uncertain tax positions as a component of its provision for income taxes.
Stock-Based Compensation
Stock-based compensation expense for all stock-based compensation awards granted after July 1, 2006 is based on the grant-date fair value estimate in accordance with the provisions of the FASB issued guidance. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award.
Valuations are based on highly subjective assumptions about the future, including stock price volatility and exercise patterns. The fair value of share-based payment awards was estimated using the Black-Scholes option pricing model. Expected volatilities are based on the historical volatility of the Company's stock. The Company uses historical data to estimate option exercise and employee terminations. The expected term of options granted represents the period of time that options granted are expected to be outstanding. The risk-free rate for periods within the expected life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.

Results of Operations
Three Months Ended September 30, 2012 and 2011
The following table shows consolidated product revenue by business segment, as
well as identifying trends in business segment product revenues for the three
months ended September 30, 2012 and 2011.
Table amounts are in thousands:
                        Three Months Ended September 30,
                           2012               2011     % Change
Product Revenue:
Sonomed-Escalon  $     2,270                $ 2,407      (5.7 )%
Total            $     2,270                $ 2,407      (5.7 )%

Consolidated product revenue from continuing operations decreased approximately $137,000 or 5.7%, to $2,270,000 during the three months ended September 30, 2012 as compared to same period of the last fiscal year. The decrease in revenue is attributed to a decrease in EMI's digital imaging cameras and AXIS image management systems offset by slight increase in Sonomed's ultrasound products.

The following table presents consolidated cost of goods sold by reportable business segment and as a percentage of related segment product revenues for the three months ended September 30, 2012 and 2011. Table amounts are in thousands:


                          Three Months Ended June 30,
                       2012        %        2011       %
Cost of Goods Sold:
Sonomed-Escalon     $   1,196    52.7 %   $ 1,224    50.9 %
Total               $   1,196    52.7 %   $ 1,224    50.9 %

Consolidated cost of goods sold from continuing operations totaled approximately $1,196,000, or 52.7%, of product revenue from continuing operations, for the three months ended September 30, 2012, as compared to $1,224,000, or 50.9%, of product revenue from continuing operations, for the same period of the prior fiscal year. The increase of 1.8% in cost of goods sold as a percentage of revenue is due mainly to the product mix sold during the current period. 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 three months ended September 30, 2012 and 2011. Table amounts are in thousands:

                                               Three Months Ended September 30,
                                                 2012               2011     % Change
Marketing, General and Administrative:
Sonomed-Escalon                        $       753                $   684      10.0  %
Escalon Medical                                653                    698      (6.5 )%
Total                                  $     1,406                $ 1,382       1.7  %

Consolidated marketing, general and administrative expenses from continuing operations increased $24,000, or 1.7%, to $1,406,000 during the three months ended September 30, 2012, as compared to the same period of the prior fiscal year.
Marketing, general and administrative expenses in the Sonomed-Escalon business segment increased $69,000, or 10%, to $753,000, as compared to the same period last fiscal year. The increase is due to an increase in sales people and related sales and marketing expenses and also an increase in business taxes. Marketing, general and administrative expenses in the corporate decreased $45,000, or 6.5% to $653,000, as compared to the same period last fiscal year. The decrease is due to decreased expense in payroll, legal and accounting, investor relations and compensation expense related to stock options. 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 three months ended September 30, 2012 and 2011. Table amounts are in thousands:

                                   Three Months Ended September 30,
                                      2012                 2011    % Change
Research and Development:
Sonomed Escalon           $       264                     $ 220        20.0 %
Total                     $       264                     $ 220        20.0 %

Consolidated research and development expenses from continuing operations increased $44,000, or 20.0% of product revenue, to $264,000 during the three-month period ended September 30, 2012, as compared to the same period of the prior fiscal year. Research and development expenses were primarily expenses associated with the planned introduction of new or enhanced products in the Sonomed-Escalon business units. The increase is related to increased engineering staff and related expenses necessary as Sonomed-Escalon researches and develops its next generation of diagnostic ultra-sound instruments.

For the three-month period ended September 30, 2012 and 2011 the Company had net income and net loss from discontinued operations of $191,000 and $289,000, respectively. The current year amount for income from discontinued operations is related to the discontinued operations of the ECD segment. The prior year amount for loss from discontinued operations includes a loss from discontinued operations of BHH of $300,000 offset by income from discontinued operations of the ECD segment of $11,000.
The Company recognized a gain of $1,000 related to its investment in Ocular Telehealth Management ("OTM") during both of the three-month periods ended September 30, 2012 and 2011. OTM is an early stage privately held company. OTM began


operations during the three-month period ended September 30, 2004. (See note 6 of the notes to the September 30, 2012 condensed consolidated financial statements.)
Interest expense was $93,000 and $82,000 for the three-month periods ended September 30, 2012 and 2011, respectively. The increase is related to the accrued interest related to related-party note payable. Interest accrued on the related party note payable at September 30, 2012 was $32,216 (see Note 6 of the notes to the September 30, 2012 condensed consolidated financial statements).

Liquidity and Capital Resources
The following table presents overall liquidity and capital resources as of
September 30, 2012 and June 30, 2012. Table amounts are in thousands:

                                      September 30, 2012      June 30, 2012
Current Ratio:
Current assets                       $           7,176       $       7,881
Less: Current liabilities                        7,724               8,063
Working capital                      $            (548 )     $        (182 )
Current ratio                                 0.9 to 1            1.0 to 1
Debt to Total Capital Ratio:
Notes payable and current maturities $           4,450       $       4,450
Total debt                                       4,450               4,450
Total equity                                       166                 645
Total capital                        $           4,616       $       5,095
Total debt to total capital                       96.4 %              87.3 %

Working Capital Position
Working capital decreased $366,000 as of September 30, 2012, and the current ratio decreased to 0.9 to 1 from 1.0 to 1 when compared to June 30, 2012. Debt to Total Capital Ratio increased to 96.4% as of September 30, 2012 from 87.3% when compared to June 30, 2012 as a result of the reduction of the total equity of $479,000 to $166,000 at September 30, 2012 from $645,000 at June 30, 2012 due mainly to the net loss of $433,000. Subsequent Events

On October 3, 2012 the Company sold its Clinical Diagnostics Business to ERBA Diagnostics, Inc. The ECD consisted of Drew Scientific, Inc., and its wholly owned subsidiaries JAS and Drew Scientific Limited Co. The sales price was $6,500,000 in cash and the transaction generated a gain on sale of approximately $2,300,000.


Table of Contents
Escalon Medical Corp.
Form 10-Q Quarterly Report

On October 18, 2012, the Company and its debt holder reached an agreement whereby the Company paid the balance of the seller-provided financing plus accrued interest related to the purchase of certain assets of Biocode of $4,367,604 with a one-time payment of $2,487,480 resulting in a gain on extinguishment of debt of $1,880,124. The repayment of the debt has reduced the Company's debt related to Biocode to zero.

As a result of these transactions the Company expects to realize total gains of approximately $4,200,000 during the three month period ending December 31, 2012. The Company expects that the total gain will bring the Company back into compliance with the minimum $2,500,000 stockholders' equity requirement for continued listing on the NASDAQ Capital Market as set forth in Listing Rule 5550(b).

The Company expects that these transactions will provide the Company with sufficient cash to fund its operations over the next 12 months.

Cash Used In or Provided By Operating Activities During the three-month periods ended September 30, 2012 and 2011, the Company generated cash outflows and inflows from operating activities of $271,000 and $41,000 respectively. The net decrease in cash used in operating activities of approximately $312,000 for the three-month period ended September 30, 2012, as compared to the same period in the prior fiscal year is due primarily to the following factors:
For the three-month period ended September 30, 2012, the Company had a net loss of $433,000, which includes net income from discontinued operations of $191,000, and experienced net cash in flows from a decrease in accounts receivable of $413,000, a decrease in current and long-term assets of $29,000, and non-cash expenditures on depreciation and amortization and compensation expense related to stock options of approximately $4,000 and $16,000, respectively. These cash in-flows were partially offset by a decrease in accounts payable, accrued expenses and other liabilities of $204,000 and an increase in inventory of $360,000.
For the three-month period ended September 30, 2011, the Company had a net loss of $790,000, which includes a net loss from discontinued operations of $289,000, and experienced net cash in flows from a decrease in accounts receivable of $973,000, increase in accounts payable, accrued expenses and other liabilities of $194,000, and non-cash expenditures on depreciation and amortization and compensation expense related to stock options of approximately $4,000 and $24,000, respectively. These cash in-flows were partially offset by an increase in current and long-term assets and inventory of $56,000 and $385,000, respectively.
Cash flow from operations also included $456,000 provided by operating activities from discontinued operations and $212,000 used in operating activities from discontinued operations for the three months ended September 30, 2012 and 2011, respectively. These cash inflows and outflows are not expected to recur in future periods.
Cash Flows Used In Investing and Financing Activities Cash flows used in investing activities of $9,000 is related to purchase of fixed assets in discontinued operations during the three-month period ended September 30, 2012.
Cash flows used in investing activities of $7,000 is related to purchase of fixed assets during the three-month period ended September 30, 2011, among which $4,000 is related to the purchase of fixed assets in continuing operations. There was no cash provided by or used in financing activities during the three-month period ended September 30, 2012.
Cash flows provided by financing activities of $46,000 were related to proceeds of $134,000 from a related party note payable offset by the scheduled long-term debt payment of $89,000 during the three-month period ended September 30, 2011.

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 Euros) and $5,865,000 in debt from Drew. The seller-provided financing is collateralized by certain assets of Biocode. Biocode assets were vertically integrated into the Company's clinical diagnostics business that includes Drew and JAS.
On April 29, 2011 the Company amended its seller financed debt in connection with the Biocode transaction. Under the terms of the debt refinancing, the Company agreed to pay the balance of the seller provided financing of 3,375,000 Euros by


the sum per month in euros having an exchange value of $50,000 United States Dollars as of the date of payment. Interest remained unchanged and will accrue on the outstanding amount of the purchase price at an interest rate of 7% per year on the basis of the actual days elapsed and a 365 day year. The first payment under the amended agreement was paid on May 31, 2011. Upon the 60th month after this Amendment, the Company agreed to pay the balance of the outstanding amount in euros in full in one payment. At the time of the refinancing, the current portion of our long-term debt was reduced from approximately $2,600,000 to $252,000.
On January 12, 2012 BH Holdings, S.A.S. ("BHH") a wholly owned subsidiary of Drew, initiated the filing of an insolvency declaration with the Tribunal de Commerce de Rennes, France ("Commercial Court"). The Commercial Court on January 18, 2012 opened the liquidation proceedings with continuation of BHH's activity for three months and named an administrator to manage BHH. Because BHH is no longer controlled by Drew it was deconsolidated in the December 31, 2011 quarterly consolidated financial statements and prior period amounts are presented as discontinued operations (see footnote 10 to the Notes to Condensed . . .

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