Some of the statements in this report may contain forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 that reflect our current view on future events, future business, industry and other conditions, our future performance, and our plans and expectations for future operations and actions. In some cases, you can identify forward-looking statements by the following words: anticipate, believe, continue, could, estimate, expect, intend, may, ongoing, plan, potential, predict, project, should, will, would, or the negative of these terms or other comparable terminology, although not all forward-looking statements contain these words. Our forward-looking statements in this report primarily relate to the following: our ability to gain market share; our expectations regarding the recording of tax credits; our expectations regarding leveraging manufacturing costs and its effect on gross profit percentage; our expected business strategy and the impact of our business strategy on revenues and earnings, including the expected contributions of new members of our sales staff; expected expenditures for research and development; our expectations regarding capital expenditures; and our beliefs regarding the sufficiency of working capital and our ability and intention to renew or obtain financing. These statements involve known and unknown risks, uncertainties and other factors that may cause our results or our industry's actual results, levels of activity, performance or achievements to be materially different from the information expressed or implied by these forward-looking statements. Forward-looking statements are only predictions and are not guarantees of performance. These statements are based on our management's beliefs and assumptions, which in turn are based on currently available information.

You should read this report thoroughly with the understanding that our actual results and actions may differ materially from those set forth in the forward-looking statements for many reasons, including events beyond our control and assumptions that prove to be inaccurate or unfounded. Our actual results or actions could and likely will differ materially from those anticipated in the forward-looking statements for many reasons, including the reasons described in this report. These factors include, but are not limited to: the competitive nature of our market; the risks associated with expansion into international markets; changes to Medicare, Medicaid, or private insurance reimbursement policies; changes to health care laws; changes affecting the medical device industry; our need to maintain regulatory compliance and to gain future regulatory approvals and clearances; our ability to recruit, train and retain an effective sales force, reimbursement staff, and patient services staff; our ability to protect our intellectual property; the effect of pending and potential future litigation, including legal expenses, which may arise, including with respect to our intellectual property or otherwise; the impact of tight credit markets on our ability to continue to obtain financing on reasonable terms; and general economic and business conditions.

Overview

Electromed, Inc. (we, us, our, the Company, or Electromed) was incorporated in 1992. We are engaged in the business of providing innovative airway clearance products applying High Frequency Chest Wall Oscillation (HFCWO) therapy in pulmonary care for patients of all ages.

We manufacture, market and sell products that provide HFCWO, including the Electromed, Inc. SmartVest® Airway Clearance System (SmartVest System) and related products, to patients with compromised mucus clearance function. The products are sold for both the home health care market and the institutional market for use by patients in hospitals, which are referred to as "institutional sales." For approximately ten years, we have marketed the SmartVest System and its predecessor products to patients suffering from cystic fibrosis, bronchiectasis (including chronic bronchitis or chronic obstructive pulmonary disease (COPD) that has resulted in a diagnosis of bronchiectasis), or any one of certain enumerated neuro-muscular diseases, and can demonstrate that another less expensive physical or mechanical treatment did not adequately mobilize retained secretions. Additionally, we offer such products upon physician prescription to a patient population that includes post-surgical and intensive care patients, patients with end-stage neuromuscular disease, and ventilator-dependent patients. Our goal is to be a consistent innovator in providing HFCWO to patients with impaired pulmonary function.

Critical Accounting Policies and Estimates

Our significant accounting policies and estimates are disclosed in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and Note 1 to our Audited Consolidated Financial Statements, included in Part II, Item 8, of our Annual Report on Form 10-K for the fiscal year ended June 30, 2012. The critical accounting policies used in the preparation of the consolidated financial statements as of and for the three and six month periods ended December 31, 2012, have remained unchanged from June 30, 2012.

Some of our accounting policies require us to exercise significant judgment in selecting the appropriate assumptions for calculating financial statements. Such judgments are subject to an inherent degree of uncertainty. These judgments are based upon our historical experience, known trends in our industry, terms of existing contracts and other information from outside sources, as appropriate. We believe the critical accounting policies that require the most significant assumptions and judgments in the preparation of its consolidated financial statements include: revenue recognition and the estimation of selling price adjustments, allowance for doubtful accounts, inventory obsolescence, share-based compensation, income taxes, and warranty liability.

Results of Operations

Three Months Ended December 31, 2012 Compared to Three Months Ended December 31, 2011

     Revenues

     Revenue results for the three month periods are summarized in the table
below (dollar amounts in thousands).


                                         Three Months Ended December 31,
                                            2012                 2011             Increase (Decrease)
Total Revenue                         $          3,856     $          4,790    $      (934 )        (19.5 )%
Home Care Revenue                     $          3,328     $          4,298    $      (970 )        (22.6 )%
International Revenue                 $            208     $            192    $        16            8.3 %
Government/Institutional Revenue      $            320     $            300    $        20            6.7 %

Home Care Revenue. Home care revenue was approximately $3,328,000 for the three months ended December 31, 2012, representing a decrease of approximately $970,000, or 22.6%, compared to the same period in 2011. The decrease in revenue was caused by downward pressure on pricing and added administrative procedures implemented by third party payers in the insurance claims process which has lengthened the approval process compared to the prior year.

International Revenue. International revenue was approximately $208,000 for the three months ended December 31, 2012, representing an increase of approximately $16,000, or 8.3%, compared to the same period in 2011. This increase resulted primarily from an increase in sales to the Middle East, which were offset by a decrease in sales to Europe and Asia during the quarter ended December 31, 2012, as compared to the same period in 2011. International sales can be affected by the timing of distributor purchases and cause fluctuation regionally on a quarterly basis. Management continues to explore international opportunities in growth markets while focusing on domestic sales growth. Subsequent to the end of the second quarter, we hired a full-time employee to manage international sales.

Government/Institutional Revenue. Government/institutional revenue was approximately $320,000 for the three months ended December 31, 2012, representing an increase of approximately $20,000, or 6.7%, compared to approximately $300,000 during the same period in 2011. This resulted from an increase in sales to distributors, group purchasing organization (GPO) members, and other institutions of $37,000, from approximately $221,000 in the three months ended December 31, 2011 to approximately $258,000 in the comparable period in the current year. The increase in Institutional sales was offset by a $15,000 decrease in sales to the U.S. Department of Veterans Affairs and other government entities which decreased to approximately $64,000 for the three months ended December 31, 2012, from approximately $79,000 during the same period the prior year. The increase in Institutional and Governmental sales was the result of continued efforts of our sales force.

Gross profit decreased to approximately $2,514,000, or 65.2% of net revenues, for the three months ended December 31, 2012, from approximately $3,481,000, or 72.7% of net revenues, in the same period in 2011. The decrease in gross profit percentage was primarily the result of reduced leverage of manufacturing costs on lower revenue levels. We believe that as we grow sales we will be able to leverage manufacturing costs more effectively and margins will return to more historical levels above 70%.

Operating expenses

Selling, general and administrative expenses. Selling, general and administrative (SG&A) expenses were approximately $3,001,000 for the three months ended December 31, 2012, representing a decrease of approximately $130,000, or 4.2%, compared to SG&A expenses of approximately $3,131,000 for the same period the prior year. Payroll and compensation-related expenses were approximately $1,459,000 for the three months ended December 31, 2012, representing a decrease of approximately $37,000, or 2.5%, compared to approximately $1,496,000 in the same period the prior year.

Travel, meals and entertainment, and trade show expenses were approximately $333,000 in the three months ended December 31, 2012, representing a decrease of approximately $131,000, or 28.2%, compared to approximately $464,000 in the same period in the prior year. This decrease was primarily due to the elimination of industry training that was sponsored by Electromed, eliminating costs related to tradeshows that do not fit our growth strategies and reducing travel expenses among the sales force through improved travel planning.

Advertising and marketing expenses for the three months ended December 31, 2012 were approximately $152,000, a decrease of approximately $156,000, or 50.6%, compared to approximately $308,000 in the same period the prior year. The decrease was related to bringing marketing leadership in-house, thus reducing our external marketing fees, as well as targeting more cost-effective advertising.

Professional fees for the three months ended December 31, 2012 were approximately $356,000, an increase of approximately $161,000 compared to approximately $195,000 in the same period in the prior year. These fees are for services related to legal costs, reporting requirements, expenses related to information technology security and backup, one time consulting expenses, and expenses for printing and other shareowner services. The increase in fees over the same period last year was primarily due to a shareholder's proposal at our annual meeting and the resulting litigation brought by the Company, as well as consulting fees related to upgrading our current information technology infrastructure.

Research and development expenses. Research and development expenses were approximately $109,000 for the three months ended December 31, 2012, representing a decrease of approximately $141,000, or 56.4%, compared to approximately $250,000 in the same period the prior year. Approximately $90,000 of the decrease was a result of discontinuing the use of a certain outside vendor based on project needs. Research and development expenses for the three months ended December 31, 2012 were 2.8% of revenue, compared to 5.2% of revenue in the same period the prior year. As a percentage of sales, management expects to spend approximately 5.0% of sales on research and development expenses over the long term.

Interest expense

Interest expense was approximately $37,000 for the three months ended December 31, 2012, representing a decrease of approximately $8,000, or 17.8%, compared to approximately $45,000 for the same period the prior year. The decrease resulted from a decrease in average debt outstanding.

Income tax benefit (expense)

Income tax benefit is estimated at approximately $210,000 for the three months ended December 31, 2012, compared to income tax expense of $32,000 in the same period in the prior year. The effective tax rates for the three months ended December 31, 2012 and 2011 were 33.8% and 56.6%, respectively. On a quarterly basis, management estimates what its effective tax rate will be for the full fiscal year and records a quarterly income tax provision based on the anticipated rate. As the year progresses, the estimate is refined based on the facts and circumstances by each tax jurisdiction. The decrease in effective tax rate is related primarily to permanent differences including certain meals and entertainment expenses that are only 50% deductible for tax purposes as well as the estimate for the Federal Research and Development Tax Credit which was not extended until January 2013 by the U.S. Congress. The effect of the estimated tax credit will be recorded in the quarter ended March 31, 2013.

Net income (loss)

Net loss for the three months ended December 31, 2012 was approximately $411,000 compared to net income of approximately $25,000 for the same period in the prior year. The decrease in net income primarily resulted from a decrease in sales volume partially offset by decreases in expenses. Management continues to believe certain investments currently being made are creating the platform for profitable sales growth. During the quarter ended December 31, 2012, management has completed a realignment of sales territories and instituted a new compensation plan for the sales force designed to drive future sales growth. Management is focused on controlling costs more aggressively short term while implementing key strategies for growth which includes full staffing of our U.S. sales regions, updated branding including a new logo, marketing material, and developing more distributors internationally by hiring an international sales manager.

Six Months Ended December 31, 2012 Compared to Six Months Ended December 31, 2011

     Revenues

     Revenue results for the six month periods are summarized in the table below
(dollar amounts in thousands).


                                        Six Months Ended December 31,
                                         2012                 2011               Increase (Decrease)
Total Revenue                       $         7,888     $          10,169    $    (2,281 )       (22.4 )%
Home Care Revenue                   $         6,902     $           9,430    $    (2,528 )       (26.8 )%
International Revenue               $           317     $             229    $        88          38.4 %
Government/Institutional Revenue    $           669     $             510    $       159          31.2 %

Home Care Revenue. Home care revenue was approximately $6,902,000 for the six months ended December 31, 2012, representing a decrease of approximately $2,528,000, or 26.8%, compared to the same period in 2011. The decrease in revenue was caused by downward pressure on pricing and added administrative procedures implemented by third party payers in the insurance claims process which has lengthened the approval process compared to the prior year. The decrease in revenues also reflects a decrease in the existing sales staff from 26 full time equivalents in the six months ended December 31, 2011, to 24.5 in the same period in the current year as well as turnover in Clinical Area Managers (CAMs) of approximately 30%, or seven CAMs, during the twelve months ended December 31, 2012.

International Revenue. International revenue was approximately $317,000 for the six months ended December 31, 2012, representing an increase of approximately $88,000, or 38.4%, compared to the same period in 2011. This increase resulted primarily from an increase in sales to the Middle East. Management continues to explore international opportunities in growth markets while focusing on domestic sales growth.

Government/Institutional Revenue. Government/institutional revenue was approximately $669,000 for the six months ended December 31, 2012, representing an increase of approximately $159,000, or 31.2%, compared to approximately $510,000 during the same period in 2011. This resulted from a $145,000 increase in sales to distributors, group purchasing organization (GPO) members, and other institutions which increased to approximately $544,000 for the six months ended December 31, 2012, from approximately $399,000 during the same period the prior year. Sales to the U.S. Department of Veterans Affairs and other government entities also increased by approximately $14,000, to $125,000 for the six months ended December 31, 2012, compared to $111,000 for the same period in 2011. The increase in government/institutional sales is due to the efforts of our sales force continuing to produce higher sales in these categories.

Gross profit decreased to approximately $5,335,000, or 67.6% of net revenues, for the six months ended December 31, 2012, from approximately $7,551,000, or 74.2% of net revenues, in the same period in 2011. The decrease in gross profit percentage was primarily the result of reduced leverage of manufacturing costs on lower revenue levels. We believe that as we grow sales we will be able to leverage manufacturing costs more effectively and margins will return to more historical levels above 70%.

Operating expenses

Selling, general and administrative expenses. Selling, general and administrative expenses were approximately $5,817,000 for the six months ended December 31, 2012, representing a decrease of approximately $714,000, or 10.9%, compared to SG&A expenses of approximately $6,531,000 for the same period the prior year. Payroll and compensation-related expenses were approximately $2,794,000 for the six months ended December 31, 2012, representing a decrease of approximately $327,000, or 10.5%, compared to approximately $3,121,000 in the same period the prior year. This decrease was primarily a result of lower incentive compensation for the CAMs which is correlated with revenue levels, as well as a reduction of overall management compensation as compared to the same period in the prior year.

Travel, meals and entertainment and trade show expenses were approximately $724,000 in the six months ended December 31, 2012, representing a decrease of approximately $214,000, or 22.8%, compared to approximately $938,000 in the same period in the prior year. This decrease was primarily due to the elimination of industry training that was sponsored by Electromed, eliminating costs related to tradeshows that do not fit our growth strategies and reducing travel expenses among the sales force through improved travel planning.

Advertising and marketing expenses for the six months ended December 31, 2012 were approximately $334,000, a decrease of approximately $327,000, or 49.5%, compared to approximately $661,000 in the same period the prior year. These decreased expenditures related to bringing marketing leadership in-house, thus reducing our external marketing fees, as well as targeting more cost-effective advertising.

Professional fees for the six months ended December 31, 2012 were approximately $561,000, an increase of approximately $53,000 compared to approximately $508,000 in the same period in the prior year. These fees are for services related to legal costs, reporting requirements, expenses related to information technology security and backup, one time consulting expenses, and expenses for printing and other shareowner services. The increase in fees over the same period last year was primarily due to a shareholder's proposal at our annual meeting and the resulting litigation brought by the Company, as well as consulting fees related to upgrading our current information technology infrastructure.

Research and development expenses. Research and development expenses were approximately $210,000 for the six months ended December 31, 2012, representing a decrease of approximately $257,000, or 55.0%, compared to approximately $467,000 in the same period the prior year. Approximately $180,000 of the decrease was a result of discontinuing the use of a certain outside vendor based on project needs. Research and development expenses for the six months ended December 31, 2012 were 2.7% of revenue, compared to 4.6% of revenue in the same period the prior year. As a percentage of sales, management expects to spend approximately 5.0% of sales on research and development expenses over the long term.

Interest expense

Interest expense was approximately $78,000 for the six months ended December 31, 2012, representing a decrease of approximately $13,000, or 14.3%, compared to approximately $91,000 for the same period the prior year. The decrease resulted from a decrease in average debt outstanding.

Income tax benefit (expense)

Income tax benefit is estimated at approximately $272,000 for the six months ended December 31, 2012 compared to income tax expense of approximately $195,000 in the same period in the prior year. The effective tax rates for the six months ended December 31, 2012 and December 31, 2011 were 36.1% and 41.9%, respectively. On a quarterly basis, management estimates what its effective tax rate will be for the full fiscal year and records a quarterly income tax provision based on the anticipated rate. As the year progresses, the estimate is refined based on the facts and circumstances by each tax jurisdiction. The decrease in effective tax rate is related primarily to permanent differences including certain meals and entertainment expenses that are only 50% deductible for tax purposes as well as the estimate for the Federal Research and Development Tax Credit which was not extended until January 2013, by the U.S. Congress. The effect of the estimated tax credit will be recorded in the quarter ended March 31, 2013.

Net income (loss)

Net loss for the six months ended December 31, 2012 was approximately $482,000 compared to net income of approximately $270,000 for the same period the prior year. The decrease in net income primarily resulted from a decrease in sales volume partially offset by decreases in expenses. Management continues to believe certain investments currently being made are creating the platform for profitable sales growth. During the quarter ended December 31, 2012, management completed a realignment of sales regions. Management is focused on controlling costs more aggressively short term while implementing key strategies for growth which includes full staffing of our U.S. sales regions, updated branding including a new logo, marketing material, and developing more distributors internationally by hiring an international sales manager.

Liquidity and Capital Resources

Cash Flows and Sources of Liquidity

For the six months ended December 31, 2012, net cash provided by operating activities was approximately $1,202,000. Cash flows provided by operations consisted of approximately $482,000 in net loss, adjusted for non-cash expenses of approximately $413,000, offset by decreases in accounts receivable and inventory of $1,126,000 and $493,000, respectively, and increases in prepaid expenses and other assets of $272,000. In addition, accounts payable and accrued liabilities decreased approximately $75,000.

For the six months ended December 31, 2011, net cash used in operating activities was approximately $1,533,000. Cash flows used by operations consisted of approximately $270,000 in net income, adjusted for non-cash expenses of approximately $332,000, offset by increases in accounts receivable, inventory, and prepaid expenses and other assets of $1,112,000, $542,000, and $139,000, respectively. In addition, accounts payable and accrued liabilities decreased approximately $343,000.

For the six months ended December 31, 2012, cash used in investing activities was approximately $510,000. During this period we paid approximately $482,000 for purchases of property and equipment. We also paid approximately $28,000 for patent related costs.

For the six months ended December 31, 2011, cash used in investing activities was approximately $642,000. During this period we paid approximately $619,000 for purchases of property and equipment, including $414,000 for converting approximately 10,000 square feet of a newly leased building to office space. We also paid approximately $23,000 for patent related costs.

For the six months ended December 31, 2012, cash used in financing activities was approximately $1,389,000, which consisted of principal payments on long-term debt of $221,000, and payments on our revolving line of credit of $1,168,000.

For the six months ended December 31, 2011, cash used in financing activities was approximately $172,000. We received approximately $28,000 from warrant exercises and receipts on subscription notes receivable, offset by principal payments on long-term debt of approximately $189,000 and payments of deferred financing fees of approximately $11,000.

Adequacy of Capital Resources

Based on our current operational performance, we believe our cash and available borrowings under the existing credit facility will provide adequate liquidity for the next year. However, we cannot guarantee that we will be able to procure additional financing upon favorable terms, if at all.

Our primary capital requirements relate to adding employees in our sales force and supporting functions; continuing research and development efforts; and for general corporate purposes, including to finance equipment purchases and other capital expenditures in the ordinary course of business and to satisfy working capital needs.

For the first six months of fiscal years 2013 and 2012, we spent approximately $482,000 and $619,000 on property and equipment, respectively. We currently expect to finance equipment purchases with borrowings under our credit . . .