Summary of SPAN AMERICA MEDICAL SYSTEMS INC

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

OVERVIEW

Span-America's operations are divided into two primary business units or segments: medical and custom products. Our revenues, profits and cash flows are derived from the development, manufacture and sale of products for these two market segments. In the medical segment, we manufacture and market a comprehensive selection of pressure management products, including Geo-Matt®, PressureGuard®, Geo-Mattress®, Span-Aids® and Isch-Dish® products. We manufacture and market medical bed frames including the Maxxum, Rexx, and Advantage series bed frames as well as related case goods, tables and seating products for the long-term care market. We also market the Risk Manager® bedside safety mat, which is manufactured to our specifications by a third-party supplier. We license and market, but do not manufacture, Selan® skin care products. In the custom products segment, we manufacture consumer mattress pads and pillows for the retail bedding market and various engineered foam products for the industrial market. Our consumer mattress pads and pillows are marketed by our exclusive distributor, Louisville Bedding Company. We sell the industrial product line directly to our customers through our own sales force instead of using distributors.

RESULTS OF OPERATIONS FISCAL 2012 VS. 2011

Summary
Fiscal 2012 net sales increased 45% to $76.1 million compared with $52.6 million in fiscal 2011 and benefited from growth in the medical and custom products segments and from the acquisition of M.C. Healthcare. The $23.6 million increase in sales included organic growth of $13.4 million and $10.2 million from the M.C. Healthcare acquisition as further described below. Net income for fiscal 2012 rose to $5.2 million, or $1.77 per diluted share, an increase of 41% from $3.7 million, or $1.30 per diluted share, in fiscal 2011. The earnings increase for fiscal 2012 was the result of higher overall sales volume, the M.C. Healthcare acquisition and a lower rate of increase in SG&A expenses compared with the prior year.

On December 9, 2011, we acquired substantially all the assets of M.C. Healthcare Products Inc. ("M.C. Healthcare" or "MCHP"). MCHP, located in Beamsville, Ontario, Canada, was a privately-owned manufacturer and marketer of medical bed frames and related products for the long-term care market. For their pre-acquisition fiscal year ended July 31, 2011, MCHP reported sales of CDN $12.2 million and operating profit of CDN $170,000, which included non-recurring and owner-related expenses of CDN $1.5 million and CDN $84,000 in depreciation and amortization.

The total purchase price for the MCHP assets was approximately $9.7 million, which included $7.9 million in cash and 100,000 shares of Span-America common stock paid at closing, plus $354,000 paid in January 2012 for the final working capital adjustment. The 100,000 shares of Span-America common stock were valued at $1.44 million based on the average of the high and low sales prices on December 8, 2011. We funded the asset acquisition through a combination of cash on hand, proceeds from the liquidation of our securities available for sale and $6.5 million from our revolving credit facility. The tangible assets purchased consisted primarily of accounts receivable, inventory and manufacturing equipment. Liabilities assumed consisted of accounts payable and accruals incurred in the ordinary course of business. The transaction resulted in goodwill of approximately $2.5 million and other intangible assets of approximately $4.0 million. Span-America is operating MCHP under the registered business name M.C. Healthcare Products, a division of Span Medical Products Canada Inc. (which we refer to as "Span-Canada"), which is a newly-formed British Columbia corporation and wholly-owned subsidiary of Span-America. For reporting and management purposes, financial results for MCHP became part of our existing medical segment as of the acquisition date, December 9, 2011.

Sales
Medical segment sales rose 34% to $46.5 million in fiscal 2012 compared with sales of $34.7 million in fiscal 2011. M.C. Healthcare is included in the medical segment and accounted for 87% of the medical segment sales growth compared with the prior fiscal year. The remaining growth in medical sales was primarily from our lines of therapeutic support surfaces. Therapeutic support surfaces are our largest medical product line, making up 49% of our medical segment sales in fiscal 2012 and 61% in fiscal 2011. We sell these products to long-term care facilities, home care dealers and acute-care hospitals throughout the United States and Canada. Sales of therapeutic support surfaces increased 7% in fiscal 2012 as a result of higher sales of our PressureGuard® Custom Care® support surfaces launched in fiscal 2011 and our broad line of Geomattress® support surfaces.

Performance in our other medical product lines included a 7% increase in sales of the Risk Manager bedside safety mat. Selan skin care sales increased 3%, while sales of seating products increased 5% during the same period. Sales of our Span-Aids patient positioners decreased by 2% during fiscal 2012 compared with fiscal 2011, and sales of mattress overlays declined 6% during fiscal 2012. Medical sales accounted for 61% of total net sales in fiscal year 2012 and 66% in fiscal year 2011.

Our custom products segment consists of bedding products for the consumer market and specialty foam products for the industrial market. Sales in the custom products segment increased 66% in fiscal 2012 to $29.7 million compared with $17.8 million in fiscal 2011. Within this segment, consumer sales rose 77% to $26.3 million compared with $14.8 million in fiscal 2011. The majority of sales growth in the custom products segment was due to consumer bedding sales that resulted from several limited-time promotions with our retail customers during fiscal 2012. The remaining portion of the increase came from higher demand from existing customers related to product enhancements as well as the addition of new customers. Our Internet consumer bedding sales also continued to grow, increasing 159% during fiscal 2012 to approximately $740,000 compared with fiscal 2011. All of our consumer products are sold through our marketing and distribution partner, Louisville Bedding Company.

Industrial sales, which make up the other part of the custom products segment, increased 14% to $3.4 million in fiscal 2012 compared with $3.0 million in fiscal 2011. This increase was due to higher demand primarily from customers in the specialty packaging and automotive industries.

Gross Profit
Our gross profit increased by 30% during fiscal 2012 to $23.5 million compared with $18.1 million in fiscal 2011. The increase in gross profit was primarily the result of the asset acquisition of MCHP and two special sales promotions of our consumer products in the retail market. Gross margin decreased to 30.9% for fiscal 2012 from 34.5% in fiscal 2011. The decrease in gross margin was caused by higher foam raw material prices in both the medical and custom products segments, a shift in sales mix toward the lower-margin custom products segment and a less profitable sales mix within the medical segment. Sales in the custom products segment made up 39% of total net sales in fiscal year 2012 compared with 34% in fiscal 2011.

Selling, Research & Development and Administrative Expenses Selling and marketing expenses increased 20%, to $10.4 million (13.7% of net sales) in fiscal 2012 compared with $8.7 million (16.6% of net sales) in fiscal 2011. The increase occurred in the medical segment and was primarily the result of the acquisition of M.C. Healthcare and higher commission and freight expense as a result of the growth in sales volume.

Total research and development expenses increased 71% to $1.1 million in fiscal 2012 compared with $643,000 in fiscal 2011. The increase was the result of new product development efforts for both M.C. Healthcare and Span-America's base medical business. We incur almost all of our research and development expenses in the medical segment for the development of new products, new features of existing products and design improvements. Our R&D expenses will likely fluctuate from quarter to quarter and from year to year, depending on the nature of the development projects being pursued.

General and administrative expenses increased 36% to $4.5 million in fiscal 2012 from $3.3 million in fiscal 2011. The expense increase during fiscal 2012 resulted primarily from the M.C. Healthcare acquisition and higher incentive compensation expenses in fiscal 2012. MCHP acquisition-related expenses included $349,000 of intangibles amortization expense and $319,000 ($.07 per diluted share after taxes) in non-recurring, acquisition transaction costs for the fiscal year 2012. Partially offsetting these increases were income of $183,000 in fiscal 2012 from the cash value of life insurance compared with $33,000 in fiscal 2011.

In spite of the increases in expense levels, total selling, R&D and administrative expenses declined as a percentage of sales to 21.0% in fiscal 2012 compared with 24.1% in fiscal 2011 because total revenues grew at a faster rate than expenses during this period.

Operating Income
Operating income increased 37% in fiscal 2012 to $7.5 million compared with $5.5 million in fiscal 2011. In the medical segment, operating income for fiscal 2012 increased by 15% to $5.3 million compared with $4.7 million in fiscal 2011. Operating income in the custom products segment increased 84% to $2.8 million in fiscal 2012 compared with $1.5 million in fiscal 2011. The increase in operating income for the year was the result of higher sales volume in both the medical and custom products segments as a result of the MCHP asset acquisition and two special, limited-time consumer products promotions.

Non-Operating Income and Expenses
We incurred net non-operating expense of $44,000 in fiscal 2012 compared with net non-operating income of $19,000 in fiscal 2011. The $63,000 change from income to expense was caused by a $13,000 reduction in investment income, the addition of $21,000 in interest expense and a foreign currency exchange loss of $29,000 related to the December 2011 asset acquisition of M.C. Healthcare. We incurred no interest expense in fiscal 2011. See "Liquidity and Capital Resources" below for further discussion about our revolving credit facility and "Foreign Currency Exchange" below for more information.

Net Income and Dividends
Net income for fiscal 2012 rose to $5.2 million, or $1.77 per diluted share, an increase of 41% from $3.7 million, or $1.30 per diluted share, in fiscal 2011. The earnings increase for fiscal 2012 was the result of higher overall sales volume, the M.C. Healthcare acquisition and a lower rate of increase in SG&A expenses compared with the prior year. The M.C. Healthcare acquisition contributed after-tax income of $734,000, or $0.25 per diluted share, from the closing date of December 9, 2011, through fiscal year-end 2012 and accounted for approximately 48% of the total increase in net income for fiscal 2012 compared with the prior fiscal year. During fiscal 2012, we paid dividends of $1.4 million, or 26% of net income for the year. This amount consisted of two quarterly dividends of $0.11 per share and two quarterly dividends of $0.125 per share.

In November 2012, the Board of Directors declared a special cash dividend of $1.00 per share and a regular quarterly cash dividend of 12.5 cents ($0.125) per share. The special dividend and regular quarterly dividend were paid on December 4, 2012, to shareholders of record on November 21, 2012. This was our 92nd consecutive quarterly dividend and our fourth special cash dividend payment.

RESULTS OF OPERATIONS FISCAL 2011 VS. 2010

Summary
Total sales in fiscal 2011 were $52.6 million compared with $52.4 million in fiscal 2010. Medical sales decreased 2% to $34.7 million due primarily to lower sales of therapeutic support surfaces. Custom products sales for fiscal 2011 increased 6% compared with fiscal year 2010 to $17.8 million due to higher sales of consumer bedding products. Compared with fiscal year 2010, net income for fiscal year 2011 declined 18% to $3.7 million, or $1.30 per diluted share, because of lower sales volume in the medical segment, a less profitable sales mix within our medical segment and our consumer product lines, increased raw material costs and higher administrative expenses.

Sales
Total sales in our core medical business decreased 2% to $34.7 million in fiscal 2011 compared with $35.6 million in fiscal 2010. The decline was due to lower sales of therapeutic support surfaces, which were down by 4% to $21.3 million during fiscal 2011, compared with $22.2 million in fiscal 2010. Therapeutic support surfaces are our largest medical product line, making up 61% of our medical segment sales in fiscal 2011 and 62% in fiscal 2010. Sales of therapeutic support surfaces declined in fiscal 2011 as a result of lower sales of our PressureGuard APM²® powered product line primarily due to weak economic conditions earlier in the fiscal year. We experienced sales growth from PressureGuard Easy Air® products, our non-powered Geo-Mattress product line and the newly launched PressureGuard® Custom Care® support surfaces that partially offset the declines from other support surface product lines.

Performance in our other medical product lines included a 16% increase in sales of the Risk Manager bedside safety mat, which we introduced in fiscal 2009. Sales of our Span-Aids patient positioners increased by 2% during fiscal 2011 compared with fiscal 2010. Selan skin care sales declined 2% as did sales of seating products. Sales of mattress overlays declined 9% during fiscal 2011. Medical sales accounted for 66% of total net sales in fiscal year 2011 and 68% in fiscal year 2010.

Our custom products segment consists of bedding products for the consumer market and specialty foam products for the industrial market. Sales in the custom products segment rose 6% during fiscal 2011 to $17.8 million from $16.8 million in fiscal 2010. The sales growth came from an 8% sales increase in our consumer product lines, where sales were $14.8 million in fiscal 2011 compared with $13.8 million in fiscal 2010. All of our consumer products are sold through our marketing and distribution partner, Louisville Bedding Company.

In the other part of the custom products segment, industrial sales remained level at $3.0 million in fiscal 2011 compared with fiscal 2010 as lower sales in the water sports market were mostly offset by higher sales in the automotive market.

Gross Profit
Our gross profit decreased by 7% during fiscal 2011 to $18.1 million compared with $19.4 million in fiscal 2010. Gross margin decreased to 34.5% for fiscal 2011 from 37.1% in fiscal 2010. The decreases in gross profit and gross margin were caused by the following factors: (1) a decline in sales volume and a less profitable sales mix within the medical segment, (2) various raw material price increases during the last two quarters of fiscal 2011 and (3) a less profitable sales mix for the total company because of the combination of higher sales in the custom products segment and lower sales in the medical segment. The custom products segment made up 34% of total net sales in this fiscal year compared with 32% in fiscal 2010.

Selling, Research & Development and Administrative Expenses Selling and marketing expenses increased less than 1%, remaining at $8.7 million and 17% of net sales in both fiscal 2011 and fiscal 2010. The increase occurred in the medical segment and was primarily the result of higher shipping costs.

Total research and development expenses decreased 31% to $643,000 in fiscal 2011 compared with $938,000 in fiscal 2010. The decrease was caused by the completion in late fiscal 2010 of several new-product development projects that involved contract services.

General and administrative expenses increased 7% to $3.3 million in fiscal 2011 from $3.1 million in fiscal 2010. The expense increase during fiscal 2011 resulted from mostly non-recurring professional fees and other fees related to our acquisition of M.C. Healthcare as previously discussed. These increases were partially offset by lower incentive compensation expenses in fiscal 2011. In addition, we had income of $33,000 in fiscal 2011 from the cash value of life insurance compared with $111,000 in fiscal 2010.

Operating Income
In the medical segment, operating income for fiscal 2011 declined by 19% to $4.7 million compared with $5.7 million in fiscal 2010. The decrease occurred because medical sales declined and raw material costs increased compared with last fiscal year.

Operating income in the custom products segment decreased 7% to $1.5 million in fiscal 2011 compared with $1.6 million in fiscal 2010. In spite of higher sales volume in the custom products segment, an increase in raw material costs and a less profitable sales mix among our consumer product lines caused the decline in operating income for the custom products segment.

Operating income for the total company declined 19% in fiscal 2011 to $5.5 million compared with $6.7 million in fiscal 2010. The decline in operating income was caused primarily by lower sales volume in the medical segment and higher raw material costs.

Non-Operating Income
Investment and other income decreased by 64% to $19,000 in fiscal 2011 compared with $52,000 in fiscal 2010. The decrease was caused by an $18,000 gain on the sale of assets in fiscal year 2010 that was not repeated in fiscal 2011 and lower interest income as a result of lower interest rates in 2011.

Interest Expense
We incurred no interest expense in fiscal 2011. See "Liquidity and Capital Resources" below for further discussion about our revolving credit facility.

Net Income and Dividends
Net income decreased 18% in fiscal 2011 to $3.7 million, or $1.30 per diluted share, compared with $4.5 million, or $1.59 per diluted share, in fiscal 2010. The decline in earnings was caused primarily by lower sales volume in the medical segment, a less profitable sales mix among our consumer products, a less profitable overall sales mix, higher raw material costs in both the medical and custom products segments and higher administrative expenses.

During fiscal 2011, we paid dividends of $1.2 million, or 32% of net income for the year. This amount consisted of two quarterly dividends of $0.10 per share and two quarterly dividends of $0.11 per share.

LIQUIDITY AND CAPITAL RESOURCES

We generated cash flow from operations of $6.9 million during fiscal 2012, which represented an increase of 129% compared with cash flow of $3.0 million in fiscal 2011. The primary reasons for the increase in cash flow during fiscal 2012 were higher net income, as previously described, and a decrease in inventory levels during the year. Inventory levels at fiscal year-end 2012, excluding inventory purchased in the MCHP acquisition, declined by $521,000 compared with fiscal year end 2011. During the comparable period of fiscal year 2011, inventory levels increased by $3.5 million, primarily due to preparation for a large consumer products order that shipped in November 2011. This swing from a $3.5 million increase in inventory in fiscal 2011 to a $521,000 inventory decrease in fiscal 2012 was the main reason for the large increase in cash flow from operations during fiscal 2012. See below for additional information about inventory levels.

Major uses of cash provided by operations during fiscal 2012 included the purchase of the assets of MCHP for cash at closing of $8.3 million (including the final working capital adjustment), payment of dividends of $1.4 million and the purchase of other property and equipment of $684,000.

Working capital decreased by $781,000, or 5%, to $14.5 million at fiscal year-end 2012 compared with fiscal year-end 2011. The decrease in working capital resulted from the liquidation of securities available for sale to fund the asset acquisition of MCHP and increases in accrued income tax and incentive compensation during fiscal 2012. In addition, our current ratio decreased to 3.2 at fiscal year-end 2012 from 3.7 at fiscal year-end 2011.

Accounts receivable, net of allowances, increased 30%, or $1.9 million, to $8.2 million at the end of fiscal 2012 compared with $6.4 million at the end of fiscal 2011. The days sales outstanding (or average collection time), calculated using a 12-month average for trade accounts receivable balances, decreased to 42.6 days in 2012 compared with 43.9 days in 2011. Approximately $1.2 million included in accounts receivable at September 29, 2012 were for sales made by Span-Canada. All of our accounts receivable are unsecured. Certain receivables of Span-Canada are insured under the terms of an insurance policy.

Inventory, net of reserves, increased by $1.7 million, or 23%, to $9.4 million at fiscal year-end 2012 compared with $7.7 million at fiscal year-end 2011. Excluding the inventory acquired as part of the MCHP acquisition, inventory levels decreased by $521,000 during fiscal year 2012. At September 29, 2012 our inventory included approximately $2.0 million of inventory belonging to MCHP. The work-in-process inventory shown in Note 4 in the Notes to Consolidated Financial Statements is associated entirely with MCHP. At year-end in both fiscal 2012 and 2011 we were holding larger than normal amounts of consumer finished goods related to an order in each respective year that shipped the subsequent November. Inventory turns increased to 6.2 times in fiscal 2012 compared with 5.8 times in fiscal 2011. We experienced an increase in the reserve for obsolete inventory as a result of the MCHP asset acquisition.

Our deferred income tax asset increased by 31%, or $145,000, during fiscal 2012 to $613,000 from $468,000 due mostly to incentive compensation accrued during fiscal 2012 that is not deductible for tax purposes until fiscal year 2013.

Net property and equipment increased by $235,000, or 5%, during fiscal 2012. The increase was made up of $757,000 in depreciation expense, approximately $300,000 in equipment purchased as part of the MCHP asset acquisition and $684,000 in other equipment purchases not related to the acquisition.

On December 9, 2011, we acquired substantially all of the assets of MCHP, a privately-owned manufacturer and marketer of medical bed frames and related products. The purchase price was approximately $9.8 million. The transaction resulted in additional goodwill of approximately $2.5 million and other intangible assets of $4.0 million. The acquisition-related intangible assets included in other assets were made up of trade names, non-compete agreements and customer relationships.

Other assets increased 5% to $2.4 million at fiscal year-end 2012 compared with $2.3 million at fiscal year-end 2011 mainly as a result of an increase in the cash value of corporate-owned life insurance policies.

Our accounts payable increased by 4% to $3.4 million at fiscal year-end 2012 compared with $3.2 million at fiscal year-end 2011. The balance at fiscal year-end 2012 included approximately $474,000 in accounts payable of MCHP. Excluding the MCHP accounts payable at fiscal year-end 2012, accounts payable would have decreased by approximately $346,000 due to normal fluctuations in accounts payable levels. Accrued and sundry liabilities, including obligations for Span-Canada, increased by 42% during the year to $3.4 million compared with $2.4 million last year due mainly to higher levels of accrued income taxes payable and incentive compensation.

In connection with our acquisition of the assets of MCHP, we borrowed $6.5 million under our revolving credit agreement in early December 2011. During the remainder of fiscal 2012, we borrowed additional funds primarily for working capital needs related to the two consumer sales promotions that took place in the first and second quarters of fiscal 2012 and the unusually high sales of MCHP products during the second quarter of fiscal 2012. As of September 29, 2012, we had no borrowings under our existing revolving line of credit.

On December 9, 2011 we amended and restated our revolving credit agreement in connection with the acquisition of the assets of MCHP. The maximum principal amount we can borrow at any one time under the loan agreement is $10 million. The maturity date was extended to April 30, 2015. The agreement is unsecured and accrues interest at a variable rate equal to 30-day LIBOR plus a margin ranging from 85 to 165 basis points depending on our leverage ratio (as defined in the agreement). The current margin is 85 basis points. The interest rate, including the margin, in November 2012, was 1.062%. Interest-only payments are required monthly. There is a 25 basis point annual fee on any unused availability above $5 million payable quarterly. We have pledged to grant the bank a security interest in our accounts, instruments, and chattel paper upon its request in the event of a default as defined in the credit agreement. Our obligations under the credit agreement are guaranteed by our new subsidiary Span Medical Products Canada Inc.

The credit facility includes financial covenants relating to tangible net worth and leverage ratios, and restricts mergers and acquisitions, assets sales, indebtedness, liens and capital expenditures. The credit facility also restricts dividends and stock repurchases during any fiscal year to an aggregate amount of no more than 50% of the sum of (i) our income from continuing operations for that fiscal year plus (ii) the absolute value of any aggregate after-tax, non-cash and extraordinary losses for that fiscal year. As an exception to the restriction above, we may pay a regular quarterly dividend in an amount no greater than the previous quarter's regular dividend so long as we remain in compliance with the financial covenants after giving effect to the payment of the dividend. Also, our wholly-owned subsidiary, Span-Canada, is not restricted in its ability to pay dividends or make distributions to the parent company. Violation of loan covenants could result in acceleration of the term of the agreement. We believe that we were in compliance with the loan covenants as of September 29, 2012.

In November 2007, we announced a program to repurchase up to 138,772 shares of our outstanding common stock. In February 2009, the Board expanded the repurchase program by 100,000 shares, bringing the total number of authorized shares to 238,772. As of September 29, 2012, we had repurchased a total of 142,869 shares under the expanded program at an average price of $11.94 per share, representing a total investment of $1.7 million. Considering these prior purchases, we are authorized to repurchase an additional 95,903 shares under the current program. We may continue to repurchase our stock from time to time in the open market or in private transactions, depending on market and company conditions. The stock repurchase program, however, may be suspended or discontinued at any time.

In November 2012, the Board of Directors declared a special cash dividend of $1.00 per share and a regular quarterly cash dividend of 12.5 cents ($0.125) per share. The special dividend and the regular quarterly dividend were paid on December 4, 2012, to shareholders of record on November 21, 2012.

We believe that funds on hand, funds generated from operations and funds available under our revolving credit facility are adequate to finance our . . .