News Column

MGC DIAGNOSTICS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operation.

June 13, 2014

Overview

The Company, through its Medical Graphics Corporation subsidiary, designs and markets non-invasive cardiorespiratory diagnostic systems that are sold under the MGC Diagnostics and MedGraphics brand and trade names. These cardiorespiratory diagnostic systems have a wide range of applications within cardiorespiratory healthcare. Revenues consist of equipment, supplies and accessories sales as well as service revenues. Equipment, supplies and accessories sales reflect sales of non-invasive cardiorespiratory diagnostic equipment and aftermarket sales of peripherals and supplies. Service revenues consist of revenues from extended service contracts and non-warranty service visits.

Total revenues for the second quarter were $7.4 million, decreased 2% from $7.6 million in 2013. Operating expenses for the second quarter were $3.8 million, decreased 3% from the same period in 2013. Net income for the three months ended April 30, 2014 was $308,000, or $ 0.07 per basic and diluted share, compared to net income of $252,000, or $ 0.06 per basic and diluted share, for the same

period in 2013. Results of Operations



The following table contains selected information from our historical consolidated statements of income (loss), expressed as a percentage of revenue:

Three Months ended April 30, Six Months ended April 30, 2014 2013 2014 2013 Revenues 100.0 % 100.0 % 100.0 % 100.0 % Cost of revenues 44.2 44.3 43.9 44.9 Gross margin 55.8 55.7 56.1 55.1 Operating Expenses

Selling and marketing expenses 25.4 27.7 28.4 29.0 General and administrative expenses 17.3 16.0 17.7 18.0 Research and development expenses 8.6 8.5

9.2 8.8 Amortization of intangibles 0.1 0.1 0.1 0.1 Total operating expenses 51.4 52.3 55.4 55.9 Operating income (loss) 4.4 3.4 0.7 (0.8 ) Interest income - - - - Provision for taxes (0.3 ) (0.1 ) (0.2 ) (0.1 ) Net income (loss) 4.1 % 3.3 % 0.5 % (0.9 )% Seasonality The Company experiences some seasonality in its revenues, with the first and fourth quarter of its fiscal year historically being its lowest and highest revenue quarters, respectively. The Company experiences additional variability in each quarter 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.



Quarterly Comparisons of Operations

The following paragraphs discuss the Company's performance for the fiscal three months ended April 30, 2014 and 2013.

16 Table of Contents Revenues

Total revenues for the three months ended decreased 2% compared to the same period in fiscal 2013. Domestic revenue for the three months ended April 30, 2014 decreased 7% compared to the prior year period which included a large competitive conversion valued in excess of $300,000. International revenue increased 27% from prior year period levels, primarily due to stronger sales in the Europe, Middle East and African markets. Gross Margin Gross margin percentage for the three months ended April 30, 2014 was 55.8%, a 100 basis point increase from 55.7% in the same period in 2013. The increase is primarily due to improved pricing and product mix, and lower product costs. Gross margin for equipment, supplies and accessories was 52.8% for the quarter, compared to 52.9% in the prior year's quarter. Gross margin for services decreased to 66.4% for the quarter, compared to 70.3% for the prior year's quarter primarily due to higher expenses to provide service to customers having extended service agreements. We expect that combined gross margin levels will continue in the mid-50% range for the remaining quarters of fiscal 2014. Selling and Marketing Selling and marketing expenses decreased by 10% to $1.9 million for the three months ended April 30, 2014 from $2.1 million for the comparable fiscal 2013 period. Expenses as a percent of revenues decreased to 25.4%, compared to 27.7% for the same period last year. Expenses decreased primarily due to net lower selling commissions and group purchasing organization fees of $82,000, attributable to lower revenues, comparatively reduced incentive accruals of $80,000, decreased trade shows and meetings expenses of $39,000, and reduced other personnel costs of $26,000. General and Administrative General and administrative expenses for the three months ended April 30, 2014 increased by 6%, or $73,000, to $1.3 million compared to $1.2 million in 2013. Expenses as a percent of revenues increased to 17.3%, compared to 16.0% for the same period last year. The current year period included $296,000 related to corporate development expenses supporting the current acquisition efforts. These costs were offset in part by reduced current year management incentive accruals of $133,000 and performance stock-based compensation accruals of $51,000 and lower legal and directors' costs of $52,000. Research and Development

Research and development expenses for the three months ended April 30, 2014 remained flat at $0.6 million, compared to the same period in fiscal 2013. Expenses as a percent of revenues increased to 8.6%, compared to 8.5% for the same period last year. The decrease in expenses resulted primarily from $40,000 of reduced personnel costs and $22,000 of incentive expenses. These savings were partially offset by an increase of $23,000 for consulting costs and a $16,000 net increase in project-related costs from the Company's expansion of its investment in new product hardware and software development. Internal software development costs capitalized totaled $178,000 and $166,000 in the three months ended April 30, 2014 and 2013, respectively. Amortization of Intangibles



Amortization of patents costs was $6,000 and $4,000 for the three months ended April 30, 2014 and 2013, respectively.

17 Table of Contents The Company began amortizing capitalized software development costs when its Breeze WebReview software was released to the market in mid-December 2012. The amortization of software development assets is included in the cost of equipment revenues due to the direct relationship to equipment units sold. The Company expects the level of future amortization expense related to capitalized software development costs to increase as current capital projects in progress are released to the market.



Six Month Comparisons of Operations

The following paragraphs discuss the Company's performance for the six months ended April 30, 2014 and 2013.

Revenues Total revenues for the six months ended April 30, 2014 decreased 6% compared to the same period in fiscal 2013. Domestic revenue for the six months ended April 30, 2014 decreased 6% compared to the prior year period which included certain large competitive conversions in fiscal 2013 not matched in the current year period. International revenue decreased 6% from prior year period levels, primarily due to weaker sales in the Latin American and Canadian markets. Gross Margin

Gross margin percentage for the six months ended April 30, 2014 was 56.1%, a 100 basis point increase from 55.1% in the same period in 2013. The increase is primarily due to improved pricing and product mix, and lower product costs. Gross margin for equipment, supplies and accessories was 53.2% for the quarter, compared to 52.1% in the prior year's quarter. Gross margin for services decreased to 66.8% for the quarter, compared to 70.6% for the prior year's quarter primarily due to higher expenses to provide service to customers having extended service agreements. We expect that combined gross margin levels will continue in the mid-50% range for the remaining quarters of fiscal 2014. Selling and Marketing

Selling and marketing expenses decreased by 8% to $3.9 million for the six months ended April 30, 2014 from $4.2 million for the comparable fiscal 2013 period. Expenses as a percent of revenues decreased to 28.4%, compared to 29.0% for the same period last year due to lower sales volume. Expenses decreased primarily due to net lower selling commissions and group purchasing organization fees of $147,000, attributable to lower revenues, decreased trade shows and meetings expenses of $41,000, and reduced other personnel cost and incentive accruals of $151,000. These savings were offset in part by increased telemarketing costs of $12,000. General and Administrative

General and administrative expenses for the six months ended April 30, 2014 decreased by 8%, or $202,000, to $2.4 million compared to $2.6 million in 2013. Expenses as a percent of revenues decreased to 17.7%, compared to 18.0% for the same period last year. The current year included $349,000 of corporate development expenses supporting our current acquisition effort. The prior year period included $234,000 related to an abandoned acquisition effort, intellectual property legal fees and net executive separation costs. The remaining decrease is due to reduced current year personnel costs of $56,000, management incentive and other bonus accruals of $270,000 and legal cost of $72,000, partially offset by $39,000 related to an increase in the allowance for doubtful accounts. 18 Table of Contents Research and Development Research and development expenses for the six months ended 2014 decreased by 2%, or $23,000, to $1.3 million, compared to $1.3 million for the same period in fiscal 2013. Expenses as a percent of revenues increased to 9.2%, compared to 8.8% for the same period last year. The decrease in expenses resulted primarily from $51,000 of reduced personnel and consulting costs and $37,000 of incentive expenses. These savings were partially offset by a $36,000 net increase in project-related costs from the Company's expansion of its investment in new product hardware and software development. Internal software development costs capitalized totaled $350,000 and $466,000 in the six months ended April 30,

2014 and 2013, respectively.



Amortization of Intangibles

Amortization of patents costs was $13,000 and $11,000 for the six months ended April 30, 2014 and 2013, respectively.

The Company began amortizing capitalized software development costs when its Breeze WebReview software was released to the market in mid-December 2012. The amortization of software development assets is included in the cost of equipment revenues due to the direct relationship to equipment units sold. The Company expects the level of future amortization expense related to capitalized software development costs to increase as current capital projects in progress are released to the market. 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 8 to the consolidated financial statements, "Income Taxes." The Company recorded $19,000 and $7,000 of income tax expense for the three months ended April 30, 2014 and 2013, respectively and $36,000 and $14,000 for the six months ended April 30, 2014 and 2013, respectively. The income tax expense includes state income tax expenses and minimum fees and increases in reserves for uncertain tax positions, as well as anticipated federal alternative minimum taxes in fiscal 2014.



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 Medical Graphics Corporation subsidiary.

As of April 30, 2014, the Company had cash and cash equivalents of $11.4 million and working capital of $15.4 million. During the six months ended April 30, 2014, the Company generated $1,408,000 in cash from operating activities, with $670,000 provided by operations before changes in working capital items. Accounts receivable decreased $1,762,000, while days sales outstanding ("DSO"), which measures how quickly receivables are collected, decreased 4 days to 75 days from October 31, 2013 to April 30, 2014. Inventory increased by $723,000, as days of inventory on hand increased to 113 days as of April 30, 2014, 4 days more than at April 30, 2013. The accounts payables balance increased by $436,000. Employee compensation accruals as of April 30, 2014 were $742,000 lower than October 31, 2013 levels, reflecting the payments of accrued sales commissions, management incentive compensation and separation costs since year end. 19 Table of Contents During the six months ended April 30, 2014, the Company used $611,000 in cash to purchase property, equipment and intangible assets. The Company has no material commitments for capital expenditures for the remainder of fiscal 2014. The Company's 2014 operating plans include costs of advancing the migration of the Company's software platform for its products to a next-generation software platform, including expensed development efforts and capitalized costs for

the production software. Cash was generated in the first two quarters of 2014 and 2013 within financing activities, mostly related to share issuances under employee stock benefit programs (including share purchases within the employee stock purchase plan), offset by amounts paid for share withholding to support statutory minimum income tax withholding requirements on vesting restricted share arrangements. In the fiscal 2013 second quarter, the Company declared and paid $1,800,000 in a special one-time dividend. Approximately $14,000 remains to be paid concurrent with the expected vesting of outstanding restricted share awards. The Company believes that it will meet its liquidity and capital resource needs over the next twelve months through its cash flows resulting from operations, as well as current cash and cash equivalents. In addition, the Company has implemented a market-focused strategic plan leveraging the strength of its MGC Diagnostics/MedGraphics brand and improving its worldwide selling and distribution capability. Pursuant to this plan, the Company has held discussions with various potential strategic product and technology partners and may use some of its cash and capital resources in the acquisition of new technologies or businesses. The Company's Board of Directors will continue to review and assess the Company's capital position and working capital and capital resource needs. If the Board determines that the Company's capital exceeds the amount necessary to enable it to meet its working capital and liquidity needs, as well as to retain a reasonable cushion for contingencies and strategic opportunities, 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 or paying cash dividends.



Forward Looking Statements.

The discussion above contains forward-looking statements about our future financial results and business prospects that by their nature involve substantial risks and uncertainties. You can identify these statements by the use of words such as "anticipate," "believe," "estimate," "expect," "project," "intend," "plan," "will," "target," and other words and terms of similar meaning in connection with any discussion of future operating or financial performance or business plans or prospects.



Our actual results may differ materially depending on a variety of factors including:

national and worldwide economic and capital market conditions;

continuing cost-containment efforts in our hospital, clinic and office markets;

our ability to remain as qualified providers for group purchasing organizations

ensuring continued access to our markets;

any changes in the patterns of medical reimbursement that may result from

national healthcare reform;

our ability to successfully operate our business, including successfully

converting our increasing research and development expenditures into new and

improved cardiorespiratory diagnostic products and services and selling these

products and services into existing and new markets;

our ability to complete our software development initiatives and migrate our

software platform to next-generation technology; 20 Table of Contents



our ability to maintain our cost structure at a level that is appropriate to

our near to mid-term revenue expectations that will enable us to increase

revenues and profitability as opportunities develop;

our ability to expand our international revenue through our distribution

partners;

our ability to defend ourselves from product liability claims related to our

cardiorespiratory diagnostic products;

our ability to defend our existing intellectual property and obtain protection

for intellectual property we develop in the future;

our ability to develop and maintain an effective system of internal controls

and procedures and disclosure controls and procedures;

the Company's ability to identify, acquire and integrate products or businesses

that enable the Company to increase revenues and profitability; and

our dependence on third-party vendors.

Additional information with respect to the risks and uncertainties faced by the Company may be found in, and the above discussion is qualified in its entirety by, the other risk factors that are described from time to time in the Company's Securities and Exchange Commission reports, including the Annual Report on Form 10-K for the year ended October 31, 2013.


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Source: Edgar Glimpses


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