Dynatronics' (DYNT) CEO Kelvyn Cullimore on Q3 2014 Results - Earnings Call Transcript

| About: Dynatronics Corporation (DYNT)

Dynatronics Corporation (NASDAQ:DYNT)

Q3 2014 Earnings Conference Call

May 13, 2014, 01:00 PM ET

Executives

Kelvyn Cullimore - Chairman, President and Chief Executive Officer

Analysts

Kelvyn Cullimore

This is Kelvyn Cullimore. I would like to welcome you to the Dynatronics Corporation third quarter conference call. We appreciate you taking the time to be on the call today. The fact that you are on the call, means that you received the press release with the notification.

It's come to our attention that some of our shareholders are not aware that these calls are recorded and posted to our website. So we remind you that these are available, if ever you're unable to make the exact call time. We do post these calls to our website and they can be retrieved there. And we will be keeping those on the website for about 30 days after the conference call.

Also we have made a decision to be in compliance with NASDAQ and SEC rules and to save a little bit of money we will not be mailing press releases in the future. Those will be available on the website and electronically as required by NASDAQ. We appreciate, that was a recommendation from one of our shareholders and we appreciated his recommendation and are following that.

Our conference call today will be to discuss the results of the fiscal year third quarter ending March 31, 2014. And before we begin as a reminder, during the course of this call we may make forward-looking statements regarding future events or the future financial performance of the company. Those statements involve risks and uncertainties that could cause actual results to differ perhaps materially from the results projected in such forward-looking statements.

We caution you that any such statement should be considered in conjunction with the disclosures, including specific risk factors and financial data contained in the company's most recent filings with SEC including its most recent Annual Report on Form 10-K.

So with that, we'll talk a little bit about the third quarter performance and then invite questions, when we are done with that. The operator will allow you to post those questions at the appropriate time.

The news was not as good as we have hoped it would be for the quarter. Obviously, our sales were down 12.5%, despite the introduction of our ThermoStim Probe, and that was not expected obviously.

The sales for the nine-month period is down 8.5%. So when you realize with the nine months we're only down 8.5%, but for the three-month period we're down 12.5%, you can see the difference between the first six months and then this last three months.

We had anticipated with the introduction of the ThermoStim Probe that there would be a significant supporting of sales, but we had not anticipated some of the market conditions that developed, that resulted in core sales being eroded at a greater pace than was anticipated.

Specifically, let me address what we believe is the cause of the underlying sales erosion. Because the ThermoStim Probe that we announced and introduced at the end of last quarter has been extremely well-received and has had some pretty good success, not quite to the level that we had anticipated, but still has been very well-received.

The underlying market conditions related directly to the Affordable Care Act. Under the Affordable Care Act, we have seen a significant amount of uncertainty develop in the healthcare markets. It doesn't just affect our physical therapy. Many markets are experiencing the same thing.

Without the certainty of how reimbursements are going to be conducted under the Affordable Care Act or what role everybody will play in some of the new paradigms, if you're being introduced under the Affordable Care Act, as like many people wondering what the future holds.

Whenever that kind of uncertainty exists, there is even a greater proclivity to button your pockets and batten down the hatches, and as a result we simply are not seeing new clinic openings or expansions, people not replacing equipment that can be out of service and continue to use old equipment instead of replacing it.

All of those kinds of things are artifacts of the uncertainty created by the Affordable Care Act. We expect that that cloud of uncertainty will persist until there is more clarity related to how reimbursements will be handled. There are specific reimbursement factors for physical therapy that are presently being addressed that would limit reimbursement to physical therapist by Medicare, those have been threatened for years, but seem to be coming into fruition.

And so all of those factors have caused our core market of physical therapy to be quite concerned about the future, and wondering how they conducted business affairs. That then has of course the unfortunate effect of them not wanting to buy more supplies and they absolutely need and try to keep their cost down and not purchasing additional equipment.

A lot of the decline in sales that we have seen, particularly in this quarter relate directly to capital equipment. And when I say capital equipment, I am talking about items that have cost over $200, that are durable in nature, things like treatment tables or electrotherapy units, things of that nature. And even distributed capital equipment that we buy from other vendors exercise piece of equipment like treadmills and bikes and things of that nature have seen a significant 20% to 25% decline.

So we are obviously concerned about that and taking steps to address that, because $885,000 decline in sales were not expected and not acceptable. So we're going to taking steps to try and correct that.

With the lower sales, we did have obviously less gross profit. The gross profit for the quarter dropped by about $363,000 and that included a slight drop in gross margin percentage from 37.1% to about 36.5%, not a huge drop and most of that was attributable to the drop in revenue from our Stream program. And those who may not be familiar with that, it was a software service that we offered several years ago and had some residual commissions coming in. Those commissions basically went away during this current fiscal year.

And so that did make a difference, because those revenues did not have any expenses associated with them. And in the same quarter last year, we had about $30,000 of STREAM revenue that directly contributed our gross profit and makes up for the majority of that gross margin percentage drop. Same thing we had about $87,000 for the year.

Our gross profit reductions were basically a result of those two factors, the loss of the STREAM revenue and also the lower sales that we reported. In order to try and offset some of the loss margin, we did reduce expenses, unfortunately did not reduce them enough during the quarter, but some of those actions to reduce expenses will carryover into the fourth quarter. And we had about $138,000 less in expenses. SG&A expenses during this quarter compared to the same quarter last year, but obviously not quite enough to offset the $364,000 in less gross profit.

We do for the nine months report almost $0.50 million reduced SG&A expenses compared to the prior year, which puts us on track for about a $600,000 to $700,000 total reduction in SG&A expenses, which is about what we targeted for the fiscal year, and are doing even additional reductions for the future.

We have seen some reduction in our R&D expenses. They declined in the quarter by about $59,000, that's primarily the result of concluding of the ThermoStim Probe R&D project. For the nine-month period, R&D was only down $46,000.

So you can see from those two numbers that through six months, our R&D expense was actually up slightly from prior year, and only in this quarter we had start to realize some of the lower R&D expenses as they return to more normalized level, given the conclusion of some from fairly major R&D projects over the last couple of years, with ThermoStim being the most recently.

As a result of those factors of the lower gross margin, offset by about $138,000 and lower SG&A and $59,000 lower R&D expenses, we generated about $159,000 higher loss this quarter over last quarter, resulting in a reported loss of about $255,000 compared to $95,000 for the same quarter last year.

The medical device tax that was imposed by the Affordable Care Act did began last January, and so this is the first quarter where we have comparable medical device tax obligations quarter-over-quarter. We did pay about $36,500 in medical device tax this quarter.

Of course, that's one of the frustrating things about the healthcare reform is that it does impose things like this, where despite having a $255,000 loss, we're still required to pay $36,500 in medical device taxes. That's something that we continue to support our industry associations and working for repeal of that tax going forward. There seems to be some appetite on the part of both the Senate and the House to do that, if they can ever get on the same page.

With that, about $915,000 less in gross profit for the nine-month period, we were able to offset that with $534,000 in expense reductions. That means that our total pre-tax profit is $381,000 lower than it was last year for the nine-month period.

Last year after nine months, we had about $31,000 profit. This year after our nine-month period, we were at about a $350,000 loss and out of that $350,000, we paid about $118,000 in medical device taxes, so medical device taxes account for about a-third of the losses that we are reporting.

Income tax rates have stayed fairly constant year-over-year for the quarter. For the nine-month period you might notice that there was a significant reduction in our tax obligations last year. We did have a one-time adjustment to our research and development credit, which lowered our tax obligations last year and also because of timing of some of the reported profits, resulting in about a 7.8% effective tax rate last year compared to 35% this year.

Given all these factors, the net loss for the quarter was about $162,000. After-tax benefits were taken into consideration compared to $61,000 last year, and for the nine-month period we declined from a net profit of $29,000 last year to net loss of share of $2.25.

The plans that we have for addressing this because the continued weakness in demand for capital products is going to require an adjustment to our strategic plans, because we don't anticipate seeing a significant change in healthcare reform clarity over the next quarter or two. We think it's going to take a little while for that to settle.

So we are focusing on a couple of things. The new products that we have introduced continue to be a source of strength despite the underlying weakness in the market. And so we will continue to focus on the fact that we have so many new products that carry pretty decent margins and still have good market appeal, including our new ThermoStim Probe, which continues to generate very strong sales for us in a very weak market.

We did talk about that on our last quarter about our excitement about that and as we have discussed already in this call, we have received a significant positive response about the ThermoStim Probe. Sales cycle is turning out to be a little bit longer than we expected, just because budgets are tight. So far, we've shipped almost 300 probes since it was introduced. So through the month of April there has been about 300 probes sold.

We're averaging just over 50 a month. We had hoped to be closer to 100 a month, but the 50 a month is showing consistent strength. And about 80% of the units that we sell also require the sale of an underlying Solaris Plus unit. The average sell price of those Solaris Plus units is about $2,900 and the average sell price of the ThermoStim Probe runs about $1,400.

So these are very good margin generators for us, and we believe it will provide a basis for improving sales as we move forward, and as we stem the erosion of capital equipment sales.

The distribution is going to be the key to doing that. With the new products that we are attracting -- I mean, with the new products we have introduced, we're attracting more new sales reps and dealers. And that's providing better coverage and deeper market penetration. And the reason that's important is because in a market like we are in, the pie is shrinking and the only way to improve sales is to get a bigger piece of the pie.

And the way we're doing that is by emphasizing in the new products, which have the best market appeal of any of our competitive products out there and also by expanding our distribution through the direct sales reps. We have added over 35 new reps that are selling our products and we anticipate adding more. One of our big competitor's just laid off significant number of their sales reps and we have our eye on several of those who we think would be a good fit for us and are in discussions for bringing some of them onboard.

So expansion of distribution channel is a key element to our plan and we are seeing some movement on the international front, as we mentioned before, particularly in China and Southeast Asia, we have had some progress there and believe that before the end of the calendar year, we'll see some sales that will result from those relationships.

We do continue to restructure our overhead, making sure that we're sizing the company to meet the current level of sales and we have continued to find ways of reducing costs and consolidating operations in that regard, everything from closing some satellite operations to consolidating sales functions or overhead functions to operate as lean as possible.

One of the things that we have elected to do is to take the building that houses our corporate headquarters and manufacturing facilities here in Cottonwood Heights, Utah and to sell that building and lease it back, so that we continue to operate from the same location, but in doing so we are unlocking the equity that has been built from this building and using that for several purposes mainly to pay down debt and to create headroom for operations.

We have actually signed an agreement with a party who is interested in purchasing the building and we believe that if that goes as planned, we'll generate $3 million to $4 million of cash flow from the sale of the building and generate a profit from a sale of that building in the next quarter of between $2.5 million to $3 million.

Of course, there is no guarantee everything goes as planned, but at this point, we're just down to due diligence with this particular buyer. And we believe that it has better than a 50-50 chance of going through. We're excited about that, because that extra resources that are being unlocked will enable us to better execute some of our strategic plans to improve sales and profits for the company going forward.

So as we look to the future, the effects of healthcare reform, we think will continue to persist and we need to react to that. The medical device tax maybe will go away in the future, but not in the near future. And so we have to deal with what is this uncertainty created by the healthcare reform.

Our performance in Q4 or about halfway through Q4 is expected to mirror the performance last year and maybe even be a little improved. I don't want to jinx our progress, but I will say that through the first half of this quarter, we're seeing significant improvements.

We hope that those will hold and continue because it's a major turnaround from where we were in the third quarter, where we saw 12.5% drop. At this point in time, we are actually running ahead, instead of behind. And so those are good indicators that hopefully the months of January, February and March were an anomaly and not a pattern.

So by Q4 we hope to see some restoration of the basic demand and hope that the ThermoStim Probe sales will continue to accelerate and help us to generate that kind of margins we need to bring us back into profitability in the coming quarters. Obviously, with the sale of the building, if that occurs in the next quarter, it will show a significant profit that we're talking about operationally, wanting to get closer to profitability as well.

So with that, we will continue to emphasize the new products. We will continue to expand our distribution. We are generating capital through the sale of the building and leasing it back, to be able to take advantage of our strategic plans. And by the way, we do have net operating losses that we have built up such that it will offset a good portion of any tax burden or any taxable income associated with the building sale. And so we are hoping that will be a bit plus for us going forward. And on top of that, we probably will be seeking out other strategic partnerships that will help us to accomplish our strategic objectives.

Many in our industry are in the same position that we are and there is a lot of discussions going on about the future of our industry and what it's going to look like and who the players are going to be and how that's all going to shake out. So we're quite confident that there are many opportunities out there for us, if we can be smart enough managers to get through the cloud that is healthcare reform at the moment.

So while the battle does intensify in that regard, we believe that we're up to the task. We do admit that the last three months January, February and March caught us a little off guard with the sales erosion that occurred with capital equipment. That we believe that is bouncing back even in the current quarter. And with our expansion of distribution and exploring opportunities, both domestically and internationally, continuing to reduce our costs and looking for strategic opportunities, that we will have much better news to report in the future.

We do appreciate the loyalty of our shareholders and that is very much appreciated. We know many of you have been with us for a long time. Myself, and my family are also long-time shareholders and we have a great desire to make sure that the stock price is turned around and made something that will benefit all of us who are shareholders in the company. That is our focus. Shareholder value continues to be our top priority.

So we appreciate your support. We appreciate the way that many of you call and make suggestions and want you to know that we do appreciate that. So with that, I will be happy to respond to any questions that you might have. I will ask the operator to open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from [ph] Sam Birdmen.

Unidentified Analyst

Couple of questions. In terms of giving us a little color on the fourth quarter where you said business is somewhat better, has there been any shipments internationally in this quarter?

Kelvyn Cullimore

We do have some shipments in this quarter internationally, yes. And we still have some pending, so international sales will be a percentage of the sales for this quarter. Yes.

Unidentified Analyst

Besides the Affordable Act, is there anything else going on that caused that drop in revenue, because that's a substantial drop in revenue for a quarter, especially the size that Dynatronics has. Is there anything else going on, because I know you've added, you've tried to add some sales people, and I would have thought, with the new catalogue that came out maybe eight, nine months ago and the new products, that somewhere along the line the sales decline would be mitigated and it would be very, very small and things would turn. So was there anything else going on in the third quarter that caused that?

Kelvyn Cullimore

Sam, our opinion was the same as yours. I mean it caught us totally off-guard, because we figured that we were on a course. When you look at the first quarter and second quarter, if could have maintained that and added ThermoStim Probe we would have had a very good quarter in the third quarter.

And so it was that loss of underlying sales that really was surprising. And when we tracked it, it all went back to primarily capital equipment sales, which through last fiscal year were flat. I mean we hadn't seen much of a decline. And even through the first quarter of this year, we haven't seen much of a decline.

At the very end of the second quarter, we mentioned at the end of December, which is usually a very big month for us, we didn't see that develop. We were concerned about whether that was an anomaly or trend and then we saw that keep going February and March. Although, we saw a flattening of that decline every month as we went along. And now that we're into May, it seems to have reversed. But in answer to your question, specifically, we can't find anything specifically other than that.

And the only thing we can attribute it to are three factors: first, was the Affordable Care Act, just creating tremendous uncertainty; second, was some of the Medicare reimbursement issues that came more to the forefront, more prominently in December and January, they're still hanging fire, but because it looks like they're going to try and address that, that may have caused some uncertainty; and then we did have some horrible weather during the quarter and that always has a temporary impact. We didn't think it would have that big of an impact, but maybe it had a bigger impact than we thought.

Unidentified Analyst

In terms of selling the building or leasing it back to you, where does that will leave the covenants and the banking arrangements. I thought that banking arrangements was termed out until May of '14, which is this month. And how was that going to be left assuming that's sold. Are you going to be with the same bank? Are they going to give you a couple of years on the line or are there any other changes that you can talk about?

Kelvyn Cullimore

Yes. The bank has been working with us very well. They extended our line of credit till the end of October. And so we are working with them on that. We did fail to meet covenant in the quarter ending in March. They were concerned about that, but they're not taking any action because of it. They are very pleased with our plan to sell the building, because by unlocking all of the equity we have in the building and applying that to our debt, we basically take the bank out of a risk position.

And so our line of credit we believe will enroll, and all of a sudden down our line of credit will be under $1 million and our borrowing base would be 4.5. So it will give us significant amount of room. And the bank is acting very pleased with what we're doing. So I believe we will be with the same bank. And I think they are being very supportive.

Unidentified Analyst

And the last question R&D is starting to go down, when do you feel there will be a next bump up in R&D for new products?

Kelvyn Cullimore

If you look at our pattern, we go through about three to four year cycles. And what we did in the last two to three years was the most significant R&D investment in our history. So with the introduction of ThermoStim Probe that brought that cycle to a close. And what we'll be doing over the next couple of years, at least for the next 12 months, is some refinements off of the platform that we have built. For instance, we have our ThermoStim product and with the introduction of that ThermoStim product, we may come out with a version two of that in the next year.

We with our Solaris Plus units were able to focus on how we can tweak those in a way that maybe is more internal to save costs than it is to change the appearance. And so we go through what's call the refinement period now that we've got the new products introduced and what you'll see for the next year or so are those kinds of refinements that will help bring our cost of manufacturing down and will refine the products appeal to the market, but will not require significant investment of R&D dollars to accomplish that. So it's kind of a stabilization period. And then as we move forward, over the next year to 18 months, we'll identify the next new round of products and then start into that probably 18 months from now.

Unidentified Analyst

And I have two remaining questions, you want me get offline and come back or do you want me to?

Kelvyn Cullimore

You've got the floor, Sam, take it.

Unidentified Analyst

So in terms of adding new employees, when do you think the majority of that will happen and how many you're planning to add, part a. And, part b, is when do you think we can see some increase in revenue from these hires.

Kelvyn Cullimore

Well, we're starting to see that increase now. I think part of the reason things were up in the fourth quarter is the bringing on these new reps and dealers. So that's already starting to happen. I think we'll see that in the fourth quarter. I am a little snake-bit, because at the end of the second quarter we really thought the third quarter was going to be good. It turned out not to be, I'm looking at fourth quarter and thinking, gosh, it should be, if we had 12.5% drop in sales in third quarter, we should be well under that in the fourth quarter, given what we're seeing right now.

And so I'm cautiously optimistic that we're already starting to see the benefit from that. But to answer your first part of your question, I think over the next six months, we will bring on most of those new reps and dealers that we intend to bring on. And keep in mind, when we talk about that they are really employees as much as they are commission sales people, right. So they only cost us if they produce.

So I think we will see -- I really believe we will see an improvement over the third quarter and in the fourth quarter, mainly because we are seeing the effect of bringing out some of these sales reps and dealers. And I believe we'll see that continue into the first and second quarter of next year.

Unidentified Analyst

And last question is, who is the competitor that that you're getting some of these people from and you said they're having a layoff.

Kelvyn Cullimore

We have two big competitors, one is Patterson Companies, they are medical division and they just laid-off about 35 reps. Some of those was probably recently got laid-off and for that reason we probably wouldn't be interested in, but some of them we have known for a long time, we're already in discussions with, because they have a great client base and we think that on a commission basis with us, they can perform well. And so we're pursuing that.

And then we know from reading the -- and part of the reason we know this is an industry-wide thing is we've read our competitors numbers and we know that they are having the same effect we are, both Patterson and DJO have reported declines in sales in the 7% to 8% range for this period. So it's not just us, it's industry-wide.

Maybe Sam cleared the decks here, but if anyone else has a question, we're happy to hang on the line here and take it.

Operator

I am sorry there are no additional audio questions.

Kelvyn Cullimore

Well, if there are no additional questions, of course, we always welcome your calls to us directly, and to the extent we can respond to those appropriately, we will. You're welcome to call myself or Bob Cardon.

Again, let me just express my appreciation to you as shareholders and those of you who have been very loyal to us and have believed in us, as we have tried to work through these very difficult circumstances. We feel the weight of that trust and are working hard to merit that trust.

And we do appreciate it and would welcome your questions. And I guess we'll give you one last chance, so if there is anyone who has any additional questions, we'll be happy to take them at this time. Operator, if you'll just watch for a second, so if anybody else registers, remind them one more time, how they register for a question.

Operator

(Operator Instructions)

Kelvyn Cullimore

Sounds like there are no other questions. Again, we thank you again for being on the call. I appreciate your support, your loyalty. And we will work hard in this fourth quarter to make some things happen to merit that loyalty. Thank you again for being on the call today. And again, I'll remind you that the call is going to be posted to our website and you can revisit that if you would like to it any time in the next 30 days. Thanks for being on the call today.

Operator

Ladies and gentlemen, thank you for your participation in today's conference call. You many now disconnect your line.

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