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Pro-Dex, Inc. (NASDAQ:PDEX)

F4Q 2013 Earnings Conference Call

September 25, 2013, 04:30 PM ET

Executives

Harold A. Hurwitz – President and Chief Executive Officer

Analysts

Tim Brady – D.A. Davidson

Operator

Greetings and welcome to the Pro-Dex Fiscal 2013 Fourth Quarter and Full Year Conference Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Hal Hurwitz, Chief Executive Officer. Thank you, Mr. Hurwitz. You may now begin.

Harold A. Hurwitz

Thank you, Manny, and thank you, all for joining us to review the results for the fourth fiscal quarter and full fiscal year of 2013.

On today's call I will provide a synopsis of our operating results as well as some comments. Then as Manny mentioned we will open up the call to your questions.

Before beginning however, I ask our participants and listeners to note that the comments made on this call may include statements that are forward-looking within the meaning of securities laws. These forward-looking statements may include, without limitation, statements related to anticipated industry trends and the company's plans, products, perspectives and strategies, both preliminary and projected.

Actual results or trends could differ materially. We undertake no obligation to revise or publicly revise the results of any revision to the forward-looking statements in light of new information or future events. For more information please refer to the risk factors discussed in the company's Form 10-K, as amended, for the year ended June 30, 2012, and the Form 10-Q related to fiscal 2012, all of which have filed with the SEC over the past year; the Form 10-K for the year-ended June 30, 2013, that we will be filing with the SEC in the next couple of days and the Form 8-K, filed with the SEC today, along with the attached press release issued today, all of which can be obtained from the SEC or by visiting our website at www.pro-dex.com.

My discussion of our results for the fiscal 2013 fourth quarter and the full fiscal year of 2013 will relate to our continuing operations, meaning that the results of our former Astromec motor product line, which was sold in February 2012 will be excluded.

First let's cover fourth quarter results. Sales for the quarter ended June 30, 2013 decreased 26% to $2.7 million from $3.7 million for the corresponding quarter in 2012. This decrease was due primarily to the previously disclosed reductions in purchases by the company's former largest customer and to a deferral in the timing of product orders from the company's current largest powered surgical instrument customer, both of which were partially offset by increases in surgical instrument sales to other customers.

Gross profit for the quarter ended June 30, 2013 decreased to $565,000, compared to gross profit of $858,000 for the year ago period, primarily as a result of the sales volume decrease between periods and the accrual in 2013 of anticipated losses from the development portion of certain contracts. Gross profit as a percentage of sales was 21% for the quarter ended June 30, 2013, as compared to 23% for the corresponding quarter in 2012. This decrease was due primarily to the effects of the accrual for estimated contract losses and to unfavorable variances consistent with the lower sales and manufacturing volume, partially offset by the effects of improved cost performance and lower warranty costs in 2013, relative to 2012.

Operating expenses, which include selling, general and administrative, and research and development expenses for the quarter ended June 30, 2013 decreased 24% to $1.3 million from $1.7 million in the prior year's corresponding quarter. Included in operating expenses for the quarter ended June 30, 2013 were severance costs amounting to $173,000, as compared to $36,000 of such costs in the corresponding 2012 quarter.

Loss from continuing operations for the quarter ended June 30, 2013 was $680,000, compared to a loss from continuing operations of $430,000 in the corresponding quarter of 2012. Net loss for the quarter ended June 30, 2013 was $673,000 or $0.20 per diluted share, compared to a net loss of $544,000, or $0.17 per diluted share for the corresponding quarter in 2012. Of note is that the fiscal 2012 fourth quarter results reflect a $276,000 benefit from the carry back of tax-basis net operating losses that offset taxable income from prior years. Because the 2012 carry back fully offset such prior years' taxable income, a comparable benefit was not available in 2013.

Now I will speak about the fiscal 2013 full year results. Sales for the year-ended June 30, 2013 decreased 29% to $12.2 million from $17.3 million in fiscal year 2012. Excluding product sales and repair services to the company's former largest customer, which represented a reduction of $6 million in fiscal 2013 from fiscal 2012, sales and repair services of surgical instruments increased $1.4 million, or 16%, in fiscal 2013 when compared to fiscal 2012.

For the year ended June 30, 2013, gross profit was $3.7 million, compared to $5.4 million in fiscal 2012. This decrease resulted primarily from the reduced sales and manufacturing volume in fiscal 2013 and from the accrual in fiscal 2013 of anticipated losses from the development portion of certain contracts, partially offset by a decrease in warranty costs from fiscal 2012 to fiscal 2013.

As a percentage of sales, gross margin was 30% for the year ended June 30, 2013, as compared to 31% in fiscal 2012. This decrease was due primarily to the accrual in fiscal 2013 of the anticipated contract losses, partially offset by favorable changes in warranty costs.

Operating expenses for the year ended June 30, 2013 decreased 17% to $5.6 million, from $6.8 million in fiscal 2012. Comprising this decrease were planned company-wide expense reductions, and the deployment of engineering resources, normally charged to research and development expense, to support revenue-producing development contracts with customers, the costs of which will be recorded as costs of sales when the development projects are completed.

Partially offsetting these expense decreases were costs of $190,000 incurred in fiscal 2013 that were associated with the contested election of Directors at our January annual meeting of shareholders.

For the year ended June 30, 2013 loss from continuing operations was $1.9 million compared to a loss from continuing operations of $960,000 in fiscal 2012. Net loss for the year ended June 30, 2013 was $1.8 million or $0.54 per diluted share as compared to a net loss of $876,000 or $0.27 per diluted share for fiscal 2012. As I previously described the fiscal 2012 results reflected $276,000 tax benefit not available in fiscal 2013.

During the year ended June 30, 2013 the company used $1.3 million of cash in operating activities. This use of cash reflects primarily an increase in inventory amounting to $1 million resulting largely from the buildup of the company’s backup component with the objectives of shortening lead times with respect to certain of the company’s products.

In the fourth quarter of fiscal 2013 the company’s largest customer began deferring the timing of its product orders, thus prolonging the effect of his inventory buildup with respect to inventory that is unique to that customer's product.

In addition as announced previously in September 2012 the company repaid the entire outstanding balance on its term loan from Union Bank amounting to $685,000 and in June 2013 the company made its first investment amounting to $365,000 as part of its program to direct excess capital into opportunities identified by a capital allocation committee established by the company’s Board of Directors. As a result of the foregoing, cash on hand at June 30, 2013 was $1.7 million compared to $4.1 million at June 30, 2012.

So having covered the numbers at the surface let’s better understand them. As I stated in today’s press release Pro-Dex’s plan for fiscal year 2013 had a clear and challenging agenda to rebuild our revenue base and right size our cost footprints. A look beneath the surface of our reported results allows for an understanding about backdrop in both areas.

In fiscal 2013 we commenced engineering work on project in which we are developing a next generation platform for power surgical instruments, which if our work is successful are expected to begin generating manufacturing revenues from our customers in fiscal 2014 or 2015.

In addition we started development efforts on contract manufacturing projects related to a device to be used in a potentially disruptive new surgical system being developed by one of our customers, also with the expectations of manufacturing revenues commencing in fiscal 2014 or 2015.

Each project arose from business development efforts through which we initiated contact with these customers two years ago, and we currently are in either discussion or in the proposal phase for additional next generation or contract manufacturing projects as a result of our continuing business development efforts. Our hard work to rebuild our revenue base is starting to show results.

And one significant note regarding our reported revenue, the close of fiscal 2013 marks the end of the year-over-year comparison that had been affected by the loss of our former largest customer. This disclosure has cast a shadow over our results in fiscal 2010. We are happy to close this chapter, and I look forward to focusing our comments on the revenue rebuilding efforts, which we believe is the true measure of our revenue performance.

With respect to rightsizing our cost footprint, as pleased as we are with the 17% year-over-year reduction in operating expenses, this comparison does not fully reflect our progress. Here are three examples.

First, during fiscal 2013, we reduced the composition of our senior management team from six to four members and our headcount from 74 to 67. As a result, our annualized base compensation was reduced from $4.6 million at June 30, 2012 to $3.7 million at June 30, 2013, a 20% decrease. Certain of these reductions, however, including those affecting our senior team, are not effective until the end of fiscal year 2013 as evidenced by the severance cost reported in the fiscal fourth quarter.

The second example has to do with the rental rate we renegotiated for the remainder of our lease term for our facility in Irvine, California that will result in a reduction of annualized expense of approximately $51,000. This new lease rate did not go into effect until this past July 1, thus not yielding benefit to us until the current fiscal year 2014.

And the final example relates to non-employee Director compensation; as we have previously disclosed, as approved by the new Board of Directors, who were elected this past January, annualized compensation for non-employee members of our Board of Directors has been reduced by approximately $140,000. However, we have derived the benefit of this reduced Director compensation for only the second half of fiscal year 2013.

In sum, we enjoyed at best only a portion of the benefits of these, among many other cost saving measures in fiscal 2013, and we are looking forward to realizing the full-year effect of our efforts in the current fiscal year 2014.

Obviously, we are not satisfied with the direction and magnitude of our fiscal 2013 loss from continuing operations and cash used in operations. While proxy contests and severance costs, aggregating $560,000 constituted 30% of the loss and 44% of the cash usage, the point remains that our goal is to restore Pro-Dex to profitability and positive cash flow from operations. Accomplishing this goal is neither easy nor assured. Nonetheless, the examples of rebuilding the revenue base and right-sizing our cost footprint discussed today are evidence of our best efforts to accomplish this goal in the context of our new operating structure.

Turning to the balance sheet, during fiscal 2013, we invested $1 million in inventory growth, principally to accommodate delivery commitments to our largest customer based on its anticipated delivery requirements. In the fiscal 2013 fourth quarter, we learned from this customer of its need to schedule deliveries for later dates than the customer originally anticipated. As a result, conversion to cash of the inventory related to this customer likely will be weighted toward the second half of the current fiscal year 2014 and possibly the first half of fiscal 2015.

Even with this unanticipated prolonged investment in inventory, we continue to maintain liquidity in excess of our anticipated short-term requirements. As a result, as of June 30, 2013, we had invested $365,000 in marketable equity securities under the investment framework approved by our Board, as we have previously described. And as we disclosed in today’s press release, our Board has approved the share repurchase program authorizing us to repurchase up to 750,000 shares of our common stock.

The final note regarding the balance sheet is with respect to the previously announced completion this past July of the sale of the land and building we owned in Carson City, Nevada that formally housed our Astromec fractional horsepower motor business. We were very pleased not only to have completed the sale but to have done so for net sales proceeds in excess of the real estate carrying value on the June 30, 2013 balance sheet.

I’m now happy to invite any questions you might have with regard to the quarter, to the full fiscal year, or our business operations. With that I’ll turn the call back over to Manny for Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Thank you. The first question is from Paul Andrews, a private investor. Please go ahead.

Unidentified Analyst

Hey guys. First let me just say congrats, the turnaround's looking pretty nice.

Harold A. Hurwitz

Thank you.

Unidentified Analyst

I’ve got a couple of questions. I’m guessing there aren’t too many people in the queue. First, the big build-up of inventory, so it’s contracted sales already, I mean it’s pretty clear that these sales are going to happen and you’re not going to be left holding the bag with all this inventory?

Harold A. Hurwitz

That’s correct.

Unidentified Analyst

Okay, great. And obviously you haven’t booked any of the inventory costs or any of the revenue yet, but it’s just kind of sitting on the balance sheet and we will see the results towards the end of this year?

Harold A. Hurwitz

Towards the end of this year, and I think there is a possibility in the beginning of next year also. I think it will be weighted toward the end of this year and into next year.

Unidentified Analyst

Perfect, perfect, okay. So then digging a little deeper, I remember Q2 of this year kind of the old management team said the breakeven point for the business was around $13 million to $14 million in run rate sales.

Given the kind of -- you guys have obviously done a great job of bringing operating expenses down even further. I mean would you think breakeven is even lower than that now. Like, I would guess it's probably somewhere around where today’s level of sales is or maybe even a bit lower than that with all the cost cutting, but what do you think?

Harold A. Hurwitz

Yeah, I think that’s a reasonable conclusion to draw. Obviously, I can’t get too specific at this moment and frankly our cost cutting efforts continue to be dynamic. But…

Unidentified Analyst

Yeah, yeah. I mean you’ve only been in place for six months, so I am sure there is still a little bit of fat left to trim.

Harold A. Hurwitz

Well, yeah I certainly I don’t know at this stage of the game, if I’d call it fat, but there are certainly some cost cutting opportunities that we can still do without stunting our growth. I think that in Nick Swenson's quote, he used the term prudent frugality and that's really the name of the game. We are frugal by culture now, but that's prudent nonetheless .

Unidentified Analyst

And Nick's not on the call, is he?

Harold A. Hurwitz

No.

Unidentified Analyst

Okay, all right. So then, I guess my next question would be Nick obviously, he’s got a hedge fund, the other member of the surplus capital committee has a hedge fund. Nick's the Chairman of another Board where he is also on the capital allocation committee. So, how is he going to work with the allocation of ideas between you guys investing in security, the hedge funds investing in securities all that sort of stuff?

Harold A. Hurwitz

Well, suffice it to say that the Board has approved the structure with appropriate control, and since we haven’t probably disclosed those controls, I don't know if it's appropriate for me to get into it here. So, I guess so – (inaudible) controls surrounding the other mechanism.

Unidentified Analyst

It’s not even the controls, I guess I am wondering, but he comes up -- the two of them have a great idea, how do they decide which funds buy it first ? If the fund buys it first, if you guys buy it first, how is it kind of allocated in terms of that?

Harold A. Hurwitz

Yeah, that boils down to their decision making, and my involvement is solely with respect to Pro-Dex.

Unidentified Analyst

Okay that’s completely fine. And just my last question, I remember a long, long time back, there was a discussion around you guys used to get contracted for products, the customers with kind of own all of the IP. And there was a switch and you guys started earning all of the IP, obviously the customers could use it all within their products.

But you guys actually own the IP and could go out and market it to other customers if you wanted to and all that sort of stuff. Is there any value in kind of licensing that IP out or is there anything that can come of that or is it all just kind of -- is it just not much?

Harold A. Hurwitz

Well, I’ll answer the last part specifically, the not much part; in certain of our projects, it certainly would not be not much. In other words, it would be much, we think it would be of value. But how much that value is and who owns the IP is really on a deal-by-deal basis, depends on a product-by-product basis. Because as you might have gleaned from the press release and from my comments here, we have certain projects that involve new technologies and we have other projects that involve contract manufacturing. And so, you can appreciate I hope that the value of IP would be different in the former than it would be in a later.

Unidentified Analyst

Yeah, great. Well, I am going to hop back in the queue. I just want to let you know I think you are doing a great job, keep up the great work.

Harold A. Hurwitz

Thank you Paul.

Operator

(Operator Instructions). Our next question is from Paul Andrews, a private investor. Please go ahead.

Unidentified Analyst

Hey, I have one follow up since apparently no one else is hopping on. The 365k in marketable securities, I don’t know if you can or will disclose this. Is that all one or two individual stocks that’s what I’m guessing, but...?

Harold A. Hurwitz

No, I’m not in liberty to disclose that unfortunately, Paul.

Unidentified Analyst

Okay. That’s fine.

Operator

Thank you. The next question is from Tim Brady of D.A. Davidson. Please go ahead. Hello Tim?

Harold A. Hurwitz

Tim, are you there?

Tim Brady – D.A. Davidson

Hey, sorry guys, I was on mute. Just wondering if you could expand on Paul’s question with the investment purchases sector, any strategy, obviously kind of a black box at this point for investors.

Harold A. Hurwitz

I’m sorry Tim, I got a little bit (inaudible) . I’m going to have to ask you to repeat that question.

Tim Brady – D.A. Davidson

Okay. Just in regards to the investments as a follow up to Paul’s question, any insights on sector, strategies, obviously it’s kind of a black box for investors right now, any insights at all you can provide?

Harold A. Hurwitz

Not at present, Tim, and I apologize for not being able to do that, but we really can’t. What I can share is what I already shared in the interchange with Paul and that is that when the structure was set up, it was set up with appropriate controls at the Board and management level. But to test that, we haven’t really gone into the details of the structure itself. So, I really am not at liberty to talk a lot about it in detail right now.

Tim Brady – D.A. Davidson

Okay. And then just as I guess also related to surplus capital investment policy, that’s not public, but does that encompass more than just purchase of marketable investments or does that include share buybacks, dividend policies, or is it just the purchase of marketable investments?

Harold A. Hurwitz

Well, again I can’t get into to those specifics regarding the plan, because as you just noted, it’s not a public document. With the exception of share buyback, you might have noted that in the release and in my comments today, our Board has approved a share repurchase plan. That would be an alternate vehicle or a vehicle I should say that is available to the allocation committee.

Tim Brady – D.A. Davidson

Okay. That’s all I've got. I appreciate it.

Harold A. Hurwitz

Sure.

Operator

Thank you. Mr. Hurwitz, we have no further questions in the queue at this time. So, I will turn it back to you.

Harold A. Hurwitz

Okay. Well, thank you Manny and my thanks to all of you for joining us today. All of us at Pro-Dex appreciate your interest, your time and your support to the company, and we look forward to speaking with you in November when we report our first fiscal 2014 quarter financial results. Thank you very much.

Operator

Thank you. Ladies and gentlemen, this concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.

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