Pro-Dex, Inc. F4Q08 (Qtr End 06/30/08) Earnings Call Transcript

Sep.18.08 | About: Pro-Dex, Inc. (PDEX)

Pro-Dex, Inc. (NASDAQ:PDEX)

F4Q08 Earnings Call

September 18, 2008 4:30 pm ET


Mark P. Murphy - President, Chief Executive Officer, Director

Jeffrey J. Ritchey - Chief Financial Officer, Treasurer, Secretary


Michael Potter - Monarch Capital

[Alex Black - York Capital]

Gary Simon - UVE Partners


Welcome to today’s Pro-Dex call to discuss the company’s fiscal 2008 fourth quarter financial results and a review of current corporate developments. Your speakers today are Mr. Mark Murphy, Chief Executive Officer, and Mr. Jeff Ritchey, Chief Financial Officer. (Operator Instructions)

Before I turn the call over to Mr. Murphy and Mr. Ritchey, I want to read a statement concerning forward-looking statements. Listeners are cautioned that statements made in this presentation are not historical in nature or that state our management’s intentions, hopes, beliefs, expectations or predictions of the future may constitute forward-looking statements within the meaning of Section 21(e) of the Securities and Exchange Act of 1934 as amended. Forward-looking statements involve risks, uncertainties and assumptions. It is important to note that any such performance and actual results, financial condition or business could differ materially from those expressed in such forward-looking statements. Factors that could cause or contribute to such differences include but are not limited to those discussed in this presentation as well as those discussed elsewhere in reports filed with the Securities and Exchange Commission. Other unforeseen factors not identified in this presentation could also have such an effect. We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results, financial condition or business over time.

With that said I’d like to turn the call over to Mr. Murphy.

Mark P. Murphy

Thank you all for joining us to review Pro-Dex’s fourth quarter and year-end results for the fiscal year ended June 30, 2008. We’re going to try a different format this afternoon. Given our current trading level I think it’s best to just cut right to the chase and talk about what’s going on, hopefully providing some missing information about Pro-Dex’s value. As always we want both the comments and the Q&A to be direct, specific and open so as to ensure that we’re all on the same page.

So instead of having Jeff Ritchey, our Chief Financial Officer, provide a thorough recap of all of the numbers in the 10K I have asked him to provide only the basic highlights of the fourth quarter and year. And instead of me commenting on all of the detailed operating functions during the last 90 days I will focus on the specific value of our company. I suspect that upon hearing everything you will agree with me that we hold far greater value than the current market indicates.

So let’s get started with Jeff providing a brief summary of the numbers.

Jeffrey J. Ritchey

Revenue for fiscal year 2008 grew by 17% to $25.1 million from $21.6 million the previous year. As expected we had reduced revenue in the fourth quarter of fiscal 2008 as sales for the quarter were $5.4 million down from $5.8 million in the fourth quarter of fiscal 2007. Sales growth continued to be driven by medical product sales which increased 37% over the prior year. The gross profit for the year increased by 11% to $8.2 million compared to $7.4 million last year. Gross profit in the fourth quarter decreased 21% to $1.5 million compared to the $1.9 million in the same quarter last year primarily due to one-time move costs.

Operating expenses increased to $7,753,000 million in fiscal 2008 from $6,525,000 in the previous year. As a percentage of sales operating expenses were relatively flat at 31% of sales in 2008 and 30% of sales in 2007. For the fourth quarter operating expenses increased to $2.250 million in fiscal 2008 from $1.489 million in fiscal 2007. The increase in operating expense for the prior year and for the quarter was primarily due to higher labor costs and move expenses.

Operating income for fiscal year 2008 was $456,000 or 2% of sales. That’s compared to operating income of $842,000 or 4% of sales in fiscal year 2007. Without the inventory reserve adjustment and the cost associated with the move, operating income would have increased to 5% of sales on a year-to-year basis.

The effective tax rate for fiscal 2008 was 0%. The statutory rate of 34% was reversed by reversal of our FIN 48 estimated tax liability booked last year and the continued use of research and development and investment tax credits.

Our net income for fiscal year 2008 was $317,000 or $0.03 per share compared to $506,000 or $0.05 per share for fiscal year 2007. For the fourth quarter fiscal 2008 we showed a net loss of $412,000 or $0.04 per share compared to net income of $187,000 or $0.02 per share for the previous fourth quarter.

We had cash flow from operations of $2,018,000 for fiscal year 2008 compared to $1,480,000 in the prior fiscal year primarily due to increased levels of accounts payable and accruals.

Cash on hand grew slightly. At June 30, 2008 we had $517,000 in cash on hand compared to $403,000 at June 30, 2007. We ended the year with $2 million borrowed from our $4 million total credit line availability, up from $300,000 borrowed at June 30, 2007. Net debt was $3.5 million at June 30, 2008 compared to $2.4 million at June 30, 2007.

As of June 30, 2008 our backlog stood at $10.4 million compared to $10.1 million of backlog at the same time last year.

And with that I’ll turn the call back over to Mark for his review and outlook comments.

Mark P. Murphy

I’ve organized my comments into the following areas. One, some perspective on our historical financials. Two, what we are doing to enhance profitability. Three, growth. Four, remaining unknowns. Five, future opportunities. Six, stock price.

First let me illuminate some perspective on our historical financials.

One. We indicated in our Q3 conference call that we believed we had recurring revenues of approximately $6 million per quarter and that Q4 was going to be less than that due to move-in efficiencies in April and May. It turned out that we had and have sufficient manufacturing capability to recover to a strong top line but the major customer who built their inventory in Q3 last year driving that record $7.6 million quarter is in the process of correcting that inventory build. Accordingly, this $5.4 million quarter was disappointing but not unexpected. These quarter-to-quarter fluctuations in no way reflect a decline in demand for our products or expertise. And in fact, with speaking with our customers, the underlying demand for our products by our customers’ customer continues to expand.

Two. Operating expenses are up $1.2 million year-over-year from $6.5 million to $7.7 million. Nearly $400,000 of this is related to one-time move costs and double rent. Another $125,000 is related to increased SOX and audit compliance work. The balance of $675,000 reflects the investments we have made to restore the company to robust health. Building strength in our business development, engineering and project management functions were all necessary to get us back in the game. Thos investments are now reflected in our P&L but we are still developing the new products and revenues which have resulted from those efforts. We are not hoping that investments will yield results; they already have by increasing the number and the value of projects in our pipeline. We are simply waiting for those results to make it into our top and ultimately our bottom line.

Three. If we adjust the fiscal 2008 results to remove the one-time charges of the move costs, the inventory adjustment related to prior periods, and the catch-up entry from prior periods in our warranty accrual earlier this year the company’s operating engine produced approximately $1.3 million of operating profit or $0.084 per share of after-tax earnings. This would set our current PE ratio at a multiple of 10x and EBITDA multiple of 4x. It is not my intent to create revision as history or to challenge the necessity of these charges to appropriately reflect the financial state of the company. It is only my intent to distinguish the underlying earnings power of our assets from the purely reported numbers.

Lastly, with regard to historical financial performance it is important to note that the company generated $1.5 million in operating cash last year and $2 million this year. Despite all of the challenges we have faced we stand on solid financial footing during this time of uncertainty for many.

Next let me present the specific actions we have taken or are taking to enhance our profitability.

One. We have integrated the leadership of our Carson City operations into Irvine. The business development, engineering, quality and operations leaders in Carson City now report directly to the respective senior leaders in Irvine. This change occurred on July 31 and has already resulted in greater alignment, more effective use of shared resources and compressed timelines. It has also allowed for increased focus on business development and new proposal generation in both the aerospace and medical markets. And lastly it is consistent with our intention to maximize the use of Carson City made motors and Irvine’s design of new products.

Two. We are actively engaged in aligning our business around our core value proposition by providing leveraged engineering and manufacturing expertise to customers with established distribution channels. As part of this process we are taking a closer look at all remaining non-differentiated products which produce small margins on incremental spending. We will convert these to core OEM relationships where possible and simply discontinue such business in most cases where we cannot align it with our core business model.

Three. Given our expanded capacity of our new facility and equipment set, we are currently in-sourcing approximately $0.5 million annually that we had previously purchased from outside machine shops better leveraging our overhead investment.

Four. Our investments in both engineering and quality are paying dividends as we continue to see increased reliability in our key products. Recent trends suggest as much as a 3x increase in the reliability of today’s key products over those we shipped two years ago.

Five. During Q1 we reviewed every aspect of the business for efficiency and cost savings resulting in the reduction of our labor force by 8% over the last 60 days. Such reductions were not sheer volume related but took into account creative ways to use our labor more efficiently.

While these are the specific areas regarding profitability enhancement I can point to in the last quarter, rest assured that your leadership team is on full alert with regard to bottom line results. We must protect the value of the engine we have built while simultaneously getting as much out of it as possible. Aligning operations, eliminating unprofitable customers, in-sourcing more machining, improving product reliability and recent labor reductions are all relatively new initiatives that will not fully impact our financials until later this fiscal year.

Next let’s talk about our growth.

One. Pro-Dex’s cumulative annual growth rate for the last three years is 22%. Throughout this growth our backlog has remained very stable between $9 million and $12 million. As Jeff mentioned our backlog at June 30, 2008 was $10.4 million indicating that future shipments are sustainable.

Two. The 17% growth in total sales we saw during fiscal year 2008 was primarily driven by a 37% or $4.4 million increase in medical device sales generated by our Irvine operation. Our two largest customers fall into this category and we saw robust sales to both of them during the year. We believe this growth is indicative of the strong market drivers in the orthopedic segment of the medical device industry where the aging population, higher incidences of obesity and increasingly hazardous recreational activities are all resulting in the growth of joint damage and disease. We’ve seen no indication that these trends are slowing and therefore believe this market has continued potential for strong growth.

Three. A comparison of our development fees charged in the last three fiscal years also gives us strong indication of the market’s demand for new products and our positioning to respond to such opportunities. Increasing from virtually no engineering fees in the previous two years, the $470,000 of development fees this year confirms that our revitalized business development, engineering and project management functions have begun to once again create new recurring revenue streams for the future of the company. We expect that these efforts will reach our order backlog this fiscal year continuing the top line growth we have seen in recent years from this product category.

Four. We finished last year with three major development projects in process. With regard to these projects, let me give you a brief update on each.

The first one has just completed verification and validation testing indicating that it is ready for market launch. An exclusive long-term supply agreement for this product is currently circulating inside our customer’s organization for final approval and upon execution we will book approximately $1.7 million in new product sales. It is important to note that the shipment of these sales are contingent on the customer receiving final approval of their surgical procedure from the FDA, an approval that will likely result in large shipments in the fourth quarter of this fiscal year. The customer is however requesting small shipments of the product ahead of FDA approval so that they have inventory on hand as soon as the product is approved.

The second project is progressing well towards its targeted launch in March of 09. The customer for this product has recently approved the proof of concept noting its impressive performance that will make the product very competitive in the market place. This product represents approximately $1.5 million in incremental revenue to us in the first 12 months after its release and could hit $4 million to $5 million annually when fully mature. Pro-Dex has applied for patent protection on several features of this product, patents that we believe we can build on in the future new products. Given the customer’s strategic commitment to taking this product to market, they have already signed an exclusive supply agreement that includes minimum first-year purchases of approximately $1.5 million upon final approval of the product. This purchase commitment is not yet reflected in our current backlog numbers and will not be until the product receives final customer approval. We expect this approval to come in December and shipments of the product to begin in the third quarter of this fiscal year.

The third project is currently in proof of concept phase and we have already received the customer’s approval of the fundamental performance characteristics. We are projecting to complete proof of concept approval in mid-to-late October. Given the complexity of this project and the expected duration of the development, we have not forecasted any product revenue from this product in this fiscal year but do expect to earn substantial development fees.

Two of the three projects just mentioned involve the sale of disposable components creating recurring revenues that are specifically more stable than capital equipment. In addition, all three products are planned to contain motors manufactured in our Carson City operation.

Moving back to the overall growth conversation.

Five. Upstream in the business development process we have recently provided proposal on several significant projects in both the medical device and aerospace markets totaling approximately $8 million in potential future development and sales revenue. I am most pleased to announce that the most significant among them is a proposal to an existing aerospace Carson City customer who exclusively supplies a custom motor for actuating flight critical control services on a very light jet project. This proposal includes development fees and potential sales revenue of over $5 million during the multi-year life of the project.

We also recently made several product proposals to existing and new medical device customers for both system and component level projects as we continue our efforts to both increase overall revenue and diversify our customer base. As with all business development activities we do not expect a 100% close ratio but we have received a favorable initial response in all cases to our capabilities and our business model. The professionalism of our new facility has not hurt us either in communicating to these prospects a sense of confidence in our ability to support their requirements.

Six. Last quarter’s staffing addition of our first regional business development director has already resulted in the identification of a number of viable business opportunities particularly in the neuro and cranial segments of the medical device market. We are actively making proposals to multiple customers in these segments and have already provided beta test products based on existing product platforms. Given this initial success and in conjunction with our Carson City reorganization, we have reallocated existing resources to fill a second regional business development director position to bolster our business development activities in both the medical and aerospace markets. We believe that all of these activities will serve to grow our top line sales over time, reduce our current field concentrations and provide a more predictable recurring revenue stream for the company.

Seven and lastly to comment on the discussion regarding growth. We tested our manufacturing group during fiscal 2008 as we surged our capacity to address the high demand placed by our customers in Q3. The team responded remarkably well demonstrating our ability to manufacture at a much higher capacity than we were currently running. Our new facility and equipment solidified that capability. Unlike some companies who may be looking to generate new revenues and not sure where they’ll find it and then have to build the infrastructure to make it, we have already identified the new revenue sources and have a proven track record of achieving higher shipments. We are simply marching through the engineering and regulatory processes necessary to realize our growth.

Let’s shift momentarily to a couple of remaining unknowns at this time. These are areas we are working diligently on to bring clarity. I’ve mentioned them in the spirit of addressing all aspects of the company. There are two

First, we have identified multiple strategic partners who have expressed an interest in our intraflow product line. We are still in the exploration mode as they conduct testing of the product. As such we have not yet reached any conclusions as to a specific structure for leveraging our technology across their dental distribution channels. We hope to reach clarity regarding this product line during the next three to six months.

Two. As will be indicated in our 10K the Orange County Water District has filed a lawsuit against 17 companies including Pro-Dex alleging groundwater contamination of our previous Santa Ana facility as long as 30 years ago. We have almost no facts yet regarding the case except that Pro-Dex is in the plaintiff’s smallest sphere of potential contributors to the issue and that our geology and test reports on the site appear to be extremely favorable for Pro-Dex. For these reasons we cannot determine a final cost but it is obviously our hope to exit the suit as early and as inexpensively as possible.

In terms of the future, there are a couple more subtle but important changes we have made to our business model that will dramatically enhance the future value of our company.

One. Pro-Dex now specifically retain the rights to certain intellectual property of base technology that is developed. This represents a change from prior agreements we have entered. While our customers own the technology as it relates to their product’s appearance and distinct position in the market, Pro-Dex owns the underlying technology that is applied in a particular device. This has two important implications. A, we have the ability to continue to develop new products without ever designing ourselves into a corner. And B, we accumulate an increasing level of IP within the company enhancing our value.

The second change in our business model is a shift from being almost exclusively a capital equipment supplier to constantly looking for consumable revenue streams that are associated with the main capital device we are being asked to develop. While consumables may not be available to us on every project, when they are available they also enhance the value of our company in two ways: A, the simple recurring revenues and gross margins associated with such annuity, and B, the demonstration that Pro-Dex’s business model provides access to desirable revenue streams early in the customer’s development process. This could have substantial value in the right circumstances. Examples of revenue streams that may track to a capital good are cutting blades, burs, single use batteries and disposable cables.

The last topic on my list of things to cover today is stock value. I have obviously received numerous questions about what is going on, what we are doing about it and a host of other desperate pleas for support. Let’s hit this one head on.

First, we don’t believe that the current stock price reflects the value of our company. We believe that there are not many companies out there who are participating in a strong market like health care and a strong segment like orthopedics while generating what we believe is considerable cash flow relative to our size and trading at what we believe is a relatively low multiple of our fundamental earnings power.

Two. The company is actively repurchasing its own stock. As you know the SEC regulates the volume and timing of shares we can purchase on a daily basis. We are currently purchasing as much as we are legally allowed to each day. Management is authorized to repurchase up to 500,000 shares and we have purchased a total of 111,200 shares so far. Of those 111,000, 35,500 shares have been repurchased since July 17, 2008 when the buy-back program was revitalized.

Three. The insiders of the company are currently restricted from purchasing shares and have been since June 16, 2008. Our next opportunity will occur in November 2008, 48 hours after the announcement of our Q1 earnings assuming that at that time we are not in possession of material information that might affect such trades.

Four. We have not been pursuing an active investor relations program up until now as we knew that one-time charges and fourth quarter losses due to the move would continue to adversely impact our reported performance. I did not believe it would serve the shareholders to introduce the stock to new investors only to have them immediately disappointed with our short-term operating results. Having reported the fourth quarter and clearly identifying the remaining unknowns that exist, I believe it is time to tell the story to others that I have shared with you today. Pro-Dex is a unique company with substantial potential. As investors especially in the small cap market went to cash and gold for protection, I believe that Pro-Dex is one of those securities that deserves a closer look for intrinsic value. Accordingly, we will intentionally increase IR activities going forward. I believe that we are all well aware that such activities in this market may or may not bear fruit.

In conclusion, we set a path for ourselves two years ago and have executed on that path on nearly every front. We have created a machine that our customers value and that can deliver impressive results. We will stay the course adjusting as necessary until the fruits of our efforts are realized later this fiscal year.

I now invite you to ask any questions that you may have.

Question-and-Answer Session


(Operator Instructions) Our first question comes from Michael Potter - Monarch Capital.

Michael Potter - Monarch Capital

I appreciate the new format. I think it’s much more efficient and very, very helpful. You gave a lot of information. With that information, how much visibility do you have going forward into 2009 on our base business right now?

Mark P. Murphy

Can you explain what you mean about how much visibility?

Michael Potter - Monarch Capital

As far as how comfortable are customers with their programs moving forward and their ordering patterns and timing of their orders?

Mark P. Murphy

I would say we have good fundamental visibility in terms of we’ve got no information or any conversations that suggest that there’s a material fundamental shift like their product is dying in their market place or they have plans to replace it with a new product or anything like that. We have the continuing inventory adjustments that are occurring in the one particular customer that appears that is now about now over the next I’d say 30 to 45 days starting to correct itself, and that customer is now talking about “We don’t want to get too low here,” and “What could you do if we did this?” so we’re starting to have those wonderful conversations we were having back in Q2 and Q3 last year. So the visibility of that what I’ll call timing as opposed to fundamental change is just starting to come up and obviously the softness in Q4 that we’re describing now, we have pretty good visibility of it in Q1 and it’s just starting to come up. I don’t know that they’re going to come out of the gates in Q2 gun-slinging and huge but it feels like we’re going to at least get back to a level that represents their sales.

Michael Potter - Monarch Capital

So with this one customer still I guess adjusting their inventory levels, do you expect that other business should more than make up for it for Q1? Do you expect that we’ll have a growth quarter?

Mark P. Murphy


Michael Potter - Monarch Capital

So Q1 will be affected on the top line. Will there be any residual moving expenses in Q1?

Mark P. Murphy


Michael Potter - Monarch Capital

So we took all those in Q4?

Mark P. Murphy


Michael Potter - Monarch Capital

Overall, what’s our target for I guess operating profitability on an EBITDA basis and on a gross margin basis for this company? Where do you think we can get to or what’s the next target from here?

Mark P. Murphy

I think we’ve said in the past that our target for our margins is about 40% consolidated and we still believe that’s possible. We’ve had some one-times and some softness that has prevented us from getting there sooner rather than later, but I think that is the answer. You can look at our operating expenses and derive EBITDA, pre-tax, EPS, pretty much everything from that. I’d rather just keep it at that if I could.

Michael Potter - Monarch Capital

With the tight credit markets are we seeing any increased activity on the potential for acquisitions?

Mark P. Murphy

For us to buy?

Michael Potter - Monarch Capital

For us to buy, that’s correct.

Mark P. Murphy

I think it’s fair to say that given the value of our currency right now -

Michael Potter - Monarch Capital

Not using our currency. Using the strong free cash generation that we have.

Mark P. Murphy

We are in conversations with potential targets but nothing serious at this point; just exploratory “Would you be interested?” but nothing that is on the horizon.


Our next question comes from [Alex Black - York Capital].

[Alex Black - York Capital]

I was wondering if you could just go over your debt. I think you said you’ve drawn about $2 million on that line. Could you just go over how the interest rate resets? What do you expect your interest expense to be next year? Is it LIBOR tied?

Jeffrey J. Ritchey

We have the option of prime or LIBOR plus the margin. So the effective rate’s actually been a little bit below prime, around 4.25% where prime’s at 5%. The TI line the margin’s a little bit higher so that’s right around prime. Our blended effect of interest rate’s pretty good right now. And the mortgage is fixed at 6.7% so that stays flat for the next eight years.


Our next question comes from Gary Simon - UVE Partners.

Gary Simon - UVE Partners

Other than the $499,000 for the move in the fourth quarter were there any one-time costs in that fourth quarter and would you have what they were for the fiscal year so we could start seeing how this operation would run without any of the moves and the inventory adjustments and so on that’s taken place?

Jeffrey J. Ritchey

There are move costs, some move-in efficiencies so that’s built into the move costs. We had some double rent in there as we had to take rent charges even for the time we weren’t in the building in the first quarter. That was a little over $100,000 there. Some SOX compliance costs where those will ramp down as we move into testing phase. That’s $100,000 or so in the year that may or may not repeat.

Mark P. Murphy

I would say if you use the $499,000 plus $110,000 for the rent you would have the hard tangible and then you want to take $20,000 off the SOX those would be your big hard numbers that really were not associated with shipments in Q4.

Jeffrey J. Ritchey

For the year we had that inventory reserve adjustment in Q3 so that was there for $300,000.

Mark P. Murphy

And then we had $160,000 charge earlier in the year for a warranty accrual catch up for previously shipped products. So those are all the numbers that I used when I got to the $1.3 million operating profit and $0.084. I kind of did that math for you.

Gary Simon - UVE Partners

That’s the important piece and I appreciate you putting that together.


There are no further questions at this time.

Mark P. Murphy

First of all we want to thank you all for taking the time to listen to this call whether it be live or in the future. Believe me I think your leadership team is as frustrated as you are with our stock performance and we’ll do anything we can to ethically and professionally drag it up and get the recognition for it. So we’re on that. And I think we also know we’re in a market that’s kind of big right now in terms of what’s impacting us because of the market and what’s impacting us because of our own performance. I also want to make a comment that I apologize the 10K did not get filed prior to this conference call so you would be able to have that at your fingertips. We’ve got a couple signatures floating to be able to file that. If not today, then tomorrow. If not tomorrow, for sure on Monday at the absolute latest. But it is forthcoming. Thank you again for your time and attention, and have a great day and weekend.

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