PDEX

Business Context and Reporting Period

Company: PRO DEX INC
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2008
Business Overview: Pro-Dex designs, develops, and manufactures rotary drive systems, motion control software/hardware, and fractional horsepower motors for medical, dental, aerospace, military, and industrial applications. The company operates facilities in Irvine, California; Beaverton, Oregon; and Carson City, Nevada.

Key Financial Metrics

Note: Total Debt includes $2.6M Credit Line, $333k Term Note (current), $31k Real Estate Loan (current), $1.55M Real Estate Loan (long-term), and $44k Patent Payable.

Material Changes vs. Prior Period

• Revenue Decline: Net sales decreased by $336,000 (6%) primarily due to reduced volume from a single major medical customer, partially offset by increased aerospace revenues.
• Margin Compression: Gross margin dropped 5 percentage points to 31% due to lower sales volume and a less favorable sales mix.
• Expense Increases:
  • R&D: Increased $156,000 (27%) to $731,000 due to higher labor costs for medical and small motor product development.
  • S,G&A: Increased $122,000 (12%) to $1.18M, driven by higher labor costs and $61,000 in Sarbanes-Oxley compliance costs.
• Operating Loss: The company reported an operating loss of $156,000 compared to an operating profit of $520,000 in the prior year.
• Cash Flow: Operating cash flow turned negative, using $459,000 compared to providing $1.09M in the prior year, largely due to increased accounts receivable and reduced payables.

Guidance, Outlook, Risks, and Contingencies

• Backlog: Order backlog decreased to $8.0 million as of September 30, 2008, from $9.4 million in the prior year and $10.4 million at the end of the previous fiscal year. Management expects to ship most of the backlog in fiscal year 2009.
• Liquidity: Management believes current cash, operating cash flows, and available credit facilities ($3.4M remaining capacity) are sufficient for the next 12 months.
• Debt Covenant Waiver: The company violated a quarterly loss covenant in its Wells Fargo credit facility. A waiver was obtained for a $5,000 fee, resulting in the reclassification of $83,000 of term note debt to current liabilities.
• Legal Proceedings: Pro-Dex is a defendant in a lawsuit filed by the Orange County Water District regarding alleged groundwater contamination at a former Santa Ana site. The company moved out of the site in April 2008. Liability and defense costs are currently unestimable due to the early stage of the investigation and the presence of multiple defendants.
• Stock Listing Risk: The company received a notice from Nasdaq regarding failure to maintain the $1.00 minimum bid price. A compliance period was granted until June 26, 2009, to regain compliance or meet initial listing criteria to avoid delisting.
• Subsequent Event: On October 1, 2008, the company converted the full $2.0M term commitment availability into a term loan, expected to be amortized over 60 months.

Investor Verification Checklist

• Customer Concentration: Verify the stability of the two major customers representing over 40% of revenue, specifically the medical customer cited as the cause for revenue decline.
• Debt Covenants: Monitor future compliance with Wells Fargo covenants given the recent loss and the reclassification of debt.
• Legal Exposure: Track the progression of the Orange County Water District litigation to assess potential future liabilities.
• Nasdaq Compliance: Monitor the stock price to ensure it meets the $1.00 bid price requirement by the June 26, 2009 deadline to avoid delisting.
• Cash Burn: Review the trend of negative operating cash flow and the reliance on the credit line to fund operations and debt service.