Overview The Company is a medical device manufacturer with revenues from continuing operations of $31.6 million for the year ended October 31, 2013 . Domestic product sales and service revenue accounted for 80.5% of fiscal 2013 revenue while international product sales accounted for the remaining 19.5%. The Company, through its Medical Graphics Corporation subsidiary, designs and markets non-invasive cardiorespiratory diagnostic products that are sold under the MGC Diagnostics and, historically, the MedGraphics brand and trade names. These products provide solutions for disease detection, integrated care and wellness across the spectrum of cardiorespiratory healthcare. Revenue consists of equipment, supplies and accessory sales as well as service sales. Equipment, supplies and accessory sales reflect sales of non-invasive cardiorespiratory diagnostic equipment, interface, test and communication software and accessories, as well as, aftermarket sales of peripherals, supplies and software. Service revenue consists of revenue from extended service contracts and non-warranty service. Seasonality The Company experiences some seasonality in its revenues, with the fourth quarter of its fiscal year traditionally being its strongest quarter. The Company experiences variability in the other three quarters due to a number of factors, including customer budget cycles, product introductions, Company sales incentive programs, general economic conditions and the timing of customer orders. Although the Company currently expects revenues in fiscal 2014 to increase over fiscal 2013 revenues, the Company expects the quarter-over-quarter rate of increase to be uneven during the fiscal year, due to seasonality and the other factors listed above. Recent Key Developments: • The proportion of purchases by customers associated with group purchasing organizations ("GPOs") expanded from 44.8% of revenues from continuing operations in fiscal 2012 to 54.5% in fiscal 2013, as GPO agreements that we entered into from fiscal 2009 through 2012 become a key component of our sales strategy and more fully integrated into our target markets. These GPO agreements include preferential pricing for the GPO member organizations, which enhanced our overall domestic sales, but the related fees paid to the GPOs increase our selling expenses as GPO sales increased as a proportion of Company overall sales. • In line with our strategic objective to grow revenues at a rate greater than the market as a whole, we have focused on converting competitor accounts into MGC Diagnostics customers. In fiscal 2013, we recognized revenues of $6.3 million across 102 such conversions, including several highly recognized national healthcare institutions, by continuing to produce reliable products with data interface solutions and industry leading customer service. • Our focus on promoting extended service agreements of longer duration, sold at the time of the initial systems purchases to ensure continuous high-performance utilization rates, has expanded the percentage of our customer base purchasing these agreements. Extended service contract sales at the time of the initial instrument sale as a percentage of all instrument sales (the "Attachment Rate") expanded to 26.5% in fiscal 2013 compared to 6.2% in fiscal 2012. This achievement ensures higher recurring revenue, together with supplies sales, and improves service gross margin performance. Revenue from continuing operations for fiscal 2013 increased by 17% to $31.6 million compared to $27.2 million in 2012 while continuing operations operating expense for fiscal 2013 was $16.3 million , an increase of 2.7% from $15.9 million in 2012. Fiscal 2013 net income was $1.4 million , or $0.34 per diluted share, compared to fiscal 2012 net loss of $0.0 million , or $0.00 per diluted share. 21 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table contains selected information from our historical consolidated statements of comprehensive income (loss), expressed as a percentage of revenue: Year ended October 31, 2013 2012 Revenues 100.0 % 100.0 % Cost of revenues 44.0 45.5 Gross margin 56.0 54.5 Operating Expenses: Selling and marketing expenses 29.3 29.6 General and administrative expenses 15.0 15.3 Research and development expenses 7.1 12.0 Amortization of intangibles 0.1 1.6 Total operating expenses 51.5 58.5 Operating income (loss) 4.5 (4.0 ) Interest income - - Provision for taxes (0.2 ) (0.1 ) Income (loss) from continuing operations 4.3 (4.1 ) Discontinued operations: Income from operations of discontinued operations - 0.9 Gain on sale of discontinued operations - 3.0 Income from discontinued operations - 3.9 Net income (loss) 4.3 % (0.2 )% The following paragraphs discuss the Company's performance for fiscal years ended October 31, 2013 and 2012. Revenues Fiscal 2013 total revenues from continuing operations increased 17% to $31.6 million compared to $27.2 million in fiscal 2012. In fiscal 2013, the Company significantly increased its equipment, supplies and accessory revenues, primarily related to pulmonary function products, while it also succeeded in growing its service and support business. Domestic equipment, supplies and accessories revenues increased by 16.5% to $25.5 million in 2013 compared to 2012 revenues of $21.8 million . Much of this growth was supported by increased sales through group purchasing organizations ("GPOs"), which had an increase of $5.1 million and comprised 54.5% of total revenues versus 44.8% in fiscal 2012, reflecting the increased penetration from GPO agreements the Company entered into during the last few years. International equipment, supplies and accessories revenue increased 15.7% to $6.2 million in 2013 compared to $5.3 million in 2012, due primarily to an increase in sales in the Canadian market. Service revenues increased 18.6% to $5.1 million in 2013 compared to $4.3 million in 2012. In fiscal 2013, domestic and international revenues from supplies increased $30,000 , while equipment and clinical service revenues increased by $0.8 million . Recurring revenue, consisting of supplies and services revenues, grew to $11.5 million accounting for 36.3% of fiscal 2013 revenues compared to 39.5% of fiscal 2012 revenues. The Company anticipates revenue growth in the near term, within historic seasonal revenue patterns, excluding major clinical research projects. This expectation relies on continued improved general and healthcare industry conditions and specific sales and marketing targeted spending and should benefit from planned market introductions of new and improved products resulting from research and development spending in the past several years. 22 -------------------------------------------------------------------------------- Table of Contents Gross Margin Gross margin percentage for 2013 increased to 56.0% of revenues compared to 54.5% in fiscal 2012 due in large part to improved pricing, absence of separation costs incurred in fiscal 2012 and production volume increases. These improvements were offset in part by the effects of the newly enacted Medical Device Excise Tax, amortization of newly released software and increased obsolescence provisions. The Company expects to maintain gross margins in the mid-50% range, as it continues to grow revenues. Selling and Marketing Selling and marketing expenses for fiscal 2013 increased by 15.3%, or $1,227,000 , to $9.3 million compared to $8.0 million for fiscal 2012. The increase was primarily driven by increased personnel related costs, which included $799,000 in sales volume related costs. Additionally, increases for fiscal 2013 compared to fiscal 2012, resulted from $199,000 of increased fees for GPO sales, $101,000 of costs of newly adopted selling tool software and $223,000 of sales related costs for telemarketing, conventions, meetings, sales demos and travel. In connection with its GPO agreements, the Company is generally required to pay a GPO administrative fee of up to three percent of its product sales. The Company includes these fees under selling and marketing expenses. Fiscal 2013 expenses also included $109,000 for achievement of short-term management incentive awards. General and Administrative General and administrative expenses for 2013 increased by 14.9%, or $616,000 , to $4.8 million compared to $4.1 million in 2012. Expense increases include $230,000 and $34,000 of cash and stock-based incentive compensation not present in fiscal 2012, $225,000 related to abandoned acquisition efforts during fiscal 2013, $133,000 in additional personnel costs and $49,000 of increased reserves for doubtful accounts receivable. Research and Development Research and development expenses for 2013 decreased by 31.0%, or $1,005,000 , to $2.2 million compared to 2012. The decrease resulted primarily from $472,000 of savings from fiscal 2012 personnel separations, $264,000 net cost reductions arising from the conversion of consultants to full-time personnel, $294,000 from research and development credit claims the Company will be filing with the State of Minnesota , $122,000 from the absence of prior-year separation costs and a $145,000 net reduction in expensed project-related costs. The decrease in expensed project-related costs results principally from the increase in the capitalized costs of internal software development of $154,000 . The hardware and software development costs expensed included proportionally more new research efforts versus sustaining development of existing products. The Company capitalized software development costs of $769,000 in 2013. Amortization of Intangibles Amortization of developed technology costs was $21,000 in fiscal 2013 and $437,000 in fiscal 2012. The developed technology costs were established as part of the Company "fresh-start" accounting in connection with the Company's 2002 emergence from Bankruptcy, and were fully amortized as of October 31, 2012 . The Company's fiscal 2013 amortization expenses include $21,000 related to patent amortization. In addition, the Company had approximately $98,000 related to capitalized software development costs currently placed in service. The amortization of software development costs is included in the cost of equipment revenues due to the direct relationship to equipment units sold. 23 -------------------------------------------------------------------------------- Table of Contents Interest Income Interest income in fiscal 2013 decreased to $1,000 from $9,000 in 2012. The decrease in interest income is principally due to the Company's use of short-term money market investments for the majority of 2013, which carried lower rates compared to 2012. This outcome reflects the Company's continuing main investment goal as the preservation of capital for these funds. Provision for Taxes Under the application of fresh-start accounting, as amended by Accounting Standards Codification ("ASC") 805 Business Combination effective September 15, 2009 , when the valuation allowance relating to pre-emergence bankruptcy net operating loss and other deferred tax assets is reversed, tax benefits will be recorded as a reduction to income tax expense. For additional information, see Note 12 to the consolidated financial statements, "Income Taxes." The Company recorded $70,000 of income tax expense for fiscal 2013 compared to $25,000 of income tax expense for fiscal 2012. The income tax expense for the current year includes $28,000 of federal alternative minimum tax, state income tax expenses and minimum fees of approximately $40,000 and an increase in reserves for uncertain tax positions of $2,000 . The fiscal 2012 income tax expense includes $24,000 related to state income tax expense and minimum fees and an increase in reserves for uncertain tax positions of $1,000 . The Company's annual effective tax rate is lower than the federal statutory rate due to the effect of utilizing net operating losses available from prior years. The associated deferred tax assets for these carried forward loss and other benefits are presented net of a valuation allowance given the current historical pattern of taxable earnings and losses. However, given the volatility of historical results and the uncertainty of the further success of the present new strategies, the Company believes it has not yet achieved the more-likely-than-not threshold, requiring the valuation allowance to remain in place at October 31, 2013 . The Company will continue to assess the potential realization of its deferred tax assets on a quarterly basis to determine if sufficient evidence exists to remove all or a portion of the Company's valuation allowance on its deferred tax assets. If the Company concludes its recent profitability has stabilized and is more predictable, the realization of the Company's deferred tax assets could occur sometime in fiscal 2014 or later, as facts become known. Realization in this reserve may have a substantial impact on profitability in the period of the reduction. Liquidity and Capital Resources The Company has financed its liquidity needs over the last several years through revenue generated by the operations of its wholly-owned subsidiary, Medical Graphics Corporation . The Company had cash, cash equivalents and investments of $10.6 million and working capital of $15.4 million as of October 31, 2013 . During 2013, the Company generated $2.5 million in cash from operating activities, with $2,148,000 generated before changes in working capital items. Net increases in 2013 cash from working capital of $348,000 consisted principally of $2,712,000 from deferred revenue collected offset by $2,387,000 of increased accounts receivable outstanding. Days sales outstanding ("DSO"), which measures how quickly receivables are collected, increased by 18 days to 80 days from 2012 to 2013, decreasing cash flows. Inventory decreased by $289,000 , as days of inventory on hand fell by 12 days to 81 days in 2013. The accounts payables balance decreased by $223,000 , reducing cash flow. Employee compensation accruals as of October 31, 2013 were $196,000 higher compared to October 31, 2012 levels, given effects of the current year short-term management incentives accrued, offset by the reduction in unpaid separation costs. 24 -------------------------------------------------------------------------------- Table of Contents During 2013, the Company used $1,055,000 in cash in the purchase of property, equipment and intangible assets. The Company had no material commitments for capital expenditures for fiscal year 2013. Operating plans for fiscal 2014 include the costs of continuing the initiative to migrate its products' operating software to a next-generation software platform, including expensed development efforts and capitalized costs to complete the production software. The Company also received net proceeds from the sale of its New Leaf business totaling $665,000 after sale-related expenses in fiscal 2012 and $150,000 in fiscal 2013 pursuant to the terms of the sale agreement. During 2013, the Company paid $1,805,000 in a special, one-time cash dividend. The Company raised net proceeds of $1,120,000 and $101,000 in 2013 and 2012, respectively, within financing activities, related to share issuances under employee stock option and employee stock purchase programs, offset by amounts paid for share withholding to support statutory minimum income tax withholding requirements. During 2011, the Company announced that its Board of Directors had adopted a stock repurchase program. The program was amended and extended several times and authorized the Company to repurchase $3.0 million of its outstanding shares of common stock in the open market or in privately negotiated transactions. The Company purchased a total $264,505 under the stock repurchase program and the program expired on October 31, 2013 . The Company's Board of Directors will continue to periodically assess the Company's capital resources. If the Board of Directors determines that the Company's capital resources exceed the amount necessary to meet its working capital and liquidity needs, as well as to retain a reasonable cushion for contingencies and strategic opportunities, then the Company will consider various options for increasing shareholder value, including, but not limited to, purchasing its own shares in the open market and in privately negotiated transactions and paying cash dividends. The Company believes that its cash and cash equivalents balance of approximately $10.6 million will be sufficient to fund our operations and working capital requirements and permit anticipated capital expenditures during the remainder of 2014. We may pursue acquisitions of other companies or product lines, which if successful may require additional funding sources. Critical Accounting Policies Significant accounting policies adopted and applied by the Company are summarized in Note 2 to the consolidated financial statements, "Summary of Significant Accounting Policies," which is included in this Form 10-K. Some of the more critical policies include revenue recognition, reserve for inventory obsolescence, allowance for doubtful accounts, internal software development costs, income taxes, stock-based compensation and impairment of long-lived assets. Management considers the following accounting policies to be the most critical to the presentation of the consolidated financial statements because they require the most difficult, subjective and complex judgments. Revenue Recognition. The Company recognizes revenue when persuasive evidence of an arrangement exists, transfer of title has occurred or services have been rendered, the selling price is fixed or determinable and collectability is reasonably assured. The Company's products are sold for cash or on credit terms requiring payment based on the shipment date. Credit terms can vary between customers due to many factors, but are generally 30 to 60 days. Revenue, net of discounts, is generally recognized upon shipment or delivery to customers in accordance with written sales terms. Standard sales terms do not include customer acceptance conditions, future credits, rebates or general rights of return. The terms of sales to both domestic customers and international distributors are similar though in some instances longer for international customers. In instances when a customer order specifies final acceptance of the system, the Company defers recognition of revenue until all customer acceptance criteria have been met. In fiscal 2013, one customer requested a short term bill-and-hold arrangement, which was accommodated and accounted for in accordance with authoritative literature. Estimated warranty obligations are recorded upon shipment. Sales and use taxes are reported on a net basis, excluding them from revenues and cost of revenues. 25 -------------------------------------------------------------------------------- Table of Contents Service contract revenue is based on a stated contractual rate and is deferred and recognized ratably over the service period, which is typically from one to five years. Deferred revenue associated with service contracts and supplies was $4,974,000 and $2,615,000 as of October 31, 2013 and 2012, respectively. Revenue from installation and training services provided to domestic customers is deferred until the service has been performed. The Company recognizes revenue related to installation and training if service is not performed within six months from equipment shipment date, since the probability these services will be used by the customer after that time is remote, based on continued analysis of historical information. The amount of deferred installation and training revenue was $411,000 and $146,000 as of October 31, 2013 and 2012, respectively. When a sale involves multiple deliverables, such as equipment, installation services and training, the amount of the consideration from an arrangement is allocated to each respective element based on the relative selling price and recognized as revenue when revenue recognition criteria for each element is met. Consideration allocated to delivered equipment is equal to the total arrangement consideration less the selling price of installation and training. The selling price of installation and training services is based on specific objective evidence, including third-party invoices. The assumptions used in allocating the amount of consideration to each deliverable represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. Reserve for Inventory Obsolescence. We analyze the level of inventory on hand on a periodic basis in relation to estimated customer requirements to determine whether write-downs for excess, obsolete or slow-moving inventory are required. Any significant or unanticipated changes in these factors could have a significant impact on the value of our inventories and on our reported operating results. We provide reserves of obsolete inventory when we deem the value to be impaired considering the age of the item, recent and expected usage and expected resale value in current and alternative markets, within current economic conditions. Allowance for Doubtful Accounts. The Company establishes estimates of the uncollectable accounts receivable. Management analyzes accounts receivable, historical write-offs of bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. The Company maintains an allowance for doubtful accounts at an amount that it estimates to be sufficient to provide adequate protection against losses resulting from collecting less than full payment on receivables. A considerable amount of judgment is required when assessing the realizability of receivables, including assessing the probability of collection and the current credit-worthiness of each customer. If the financial condition of the Company's customers were to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for doubtful accounts might be required. The allowance for doubtful accounts as of October 31, 2013 increased by $49,000 from the prior year end to a reserve balance of $147,000 . Internal Software Development Costs. Internal software development costs consist primarily of internal salaries and consulting fees for developing software platforms for sale to or use by customers within equipment the Company sells. We capitalize costs related to the development of our software products, as all of these software products will be used as an integral part of a product or process that we sell or lease. This software is primarily related to our BreezeSuite platform and its underlying support products. We have also purchased software development services for specific other development efforts. We capitalize costs related to software developed for new products and significant enhancements of existing products once technological feasibility has been reached and all research and development for the components of the product have been completed. These costs are amortized on a straight-line basis over the estimated useful life of the related product, not to exceed seven years, commencing with the date the product becomes available for general release to our customers. In fiscal 2013, we initiated the amortization of capitalized software costs when we released a software element for use. The achievement of technological feasibility and the estimate of a product's economic life require management's judgment. Any changes in key assumptions, market conditions or other circumstances could result in an impairment of the capitalized asset and a charge to our operating results. 26 -------------------------------------------------------------------------------- Table of Contents Income Taxes. The Company uses the asset and liability method of accounting for income taxes in accordance with FASB ASC 740, Income Taxes. The Company recognizes deferred tax assets or liabilities for the expected future tax consequences of temporary differences between the book and tax bases of assets and liabilities. Each quarter, the Company assesses the likelihood that its deferred tax assets will be recovered from future taxable income. The analysis to determine the amount of the valuation allowance is highly judgmental and requires weighing positive and negative evidence including historical and projected future taxable income and ongoing tax planning strategies. See Note 12 to the consolidated financial statements, "Income Taxes," for further discussion of the Company's valuation allowance. Stock-Based Compensation. The Company amortizes stock-based compensation expense for stock option and restricted stock awards on a straight-line basis over the vesting period of the underlying award. Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires the input of highly subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We use the Black-Scholes option-pricing model to value our stock option awards. The assumptions used in calculating the fair value of share-based payment awards represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and management uses different assumptions, share-based compensation expense could be materially different in the future. We are required to estimate the expected term and forfeiture rate and only recognize expense for those shares we expect to vest. If the actual forfeiture rate is materially different from the estimate, share-based compensation expense could be significantly different from what we recorded in the current period. Impairment of Long-Lived Assets. The Company assesses the recoverability of long-lived assets whenever events or changes in circumstances indicate that expected future undiscounted cash flows might not be sufficient to support the carrying value of an asset. We measure recoverability of assets to be held and used by comparing the carrying value of an asset to future net cash flows we expect the asset to generate. If these assets are considered to be impaired, we recognize the impairment in the amount by which the carrying value of the assets exceeds the fair value of the assets. We report assets to be disposed of at the lower of the carrying amount or fair value less costs to sell. The Company has determined that no impairment of long-lived assets exists at the current time. Foreign Currency Exchange Risk All sales made by the Company's Medical Graphics subsidiary are denominated in U.S. dollars. The Company does not currently and does not intend in the future to use derivative financial instruments for trading or hedging purposes.
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