PDEX · Read the filing

ITEM 1A.

RISK FACTORS

Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors, as well as the other information contained in this report, before deciding whether to invest in shares of our common stock. If any of the following risks actually occur, our business, financial condition, operating results, and prospects would suffer. In that case, the trading price of our common stock would likely decline and you might lose all or part of your investment in our common stock. The risks described below are not the only ones we face. Additional risks that we currently do not know about or that we currently believe to be immaterial may also impair our operations and business results.

A substantial portion of our revenue is derived from a few customers. If we were to lose a key customer, it would have a material adverse effect on our business, financial condition, and results of operations.

In fiscal 2020, our top 20 customers accounted for 99% of our sales, with our current largest customer accounting for 65% of our sales. This customer has made purchase commitments to us through a supply agreement to purchase surgical handpieces through calendar 2021. We provide this customer with a device used primarily in elective surgeries and although this customer has not requested a reduction or delay to their planned shipments, if the COVID-19 pandemic continues to adversely impact the United States and other markets where our products are sold, coupled with the recommended deferrals of elective procedures by governments and other authorities, we would expect to see a decline in demand from our principal customer. The loss of this customer or any of our significant customers would severely impact us, including having a material adverse effect on our business, financial condition, cash flows, revenue, and results of operations.

The COVID-19 Pandemic, or the perception of its effects, could have a material adverse effect on our business and results of operations.

To date, COVID-19 has not had a material adverse impact on our business or results of operations, but due to the uncertainties surrounding this pandemic, it may adversely impact us in the future. We may experience disruptions in our supply chain and critical suppliers may delay or be unable to deliver products we have ordered. Additionally, our customers could reduce planned orders, request cancelations of existing orders, and/or delay payment to us due to financial hardship they may experience as a result of this healthcare and resulting economic crisis. Therefore, it is impossible at this time to predict the ultimate short-term or long-term impact of the pandemic on our business.

The ability of our employees to work may be significantly impacted by the COVID-19 crisis.

Our employees are being affected by the COVID-19 pandemic. Some of our office and management personnel are working remotely, but our employees engaged in manufacturing and assembly are continuing to work at our corporate headquarters. The health of our workforce is of primary concern and we may need to enact further precautionary measures to help minimize the risk of our employees being exposed to the coronavirus. Further, our management team is focused on mitigating the adverse effects of the COVID-19 pandemic, which has required and will continue to require a large investment of time and resources across the entire Company, thereby diverting their attention from other priorities that existed prior to the outbreak of the pandemic. To date, we have had a total of six employees including one temporary agency worker test positive for COVID-19. As of August 18, 2020, all six have made full recoveries and returned to work subsequent to obtaining a negative COVID-19 test and a doctor’s release. If more of our employees test positive for COVID-19, or these conditions worsen, or last for an extended period of time, our ability to manage our business may be impaired, and operational risks, cybersecurity risks, and other risks facing us even prior to the pandemic may be elevated.

A substantial portion of our business is derived from our core business area that, if not serviced properly, may result in a material adverse impact upon our business, results of operations and financial condition.

In fiscal 2020, we derived 95% of our revenue from sales of our medical device products and related services. We believe that a primary factor in the market acceptance of our products and services is the value they create for our customers. Our future financial performance will depend in large part on our ability to continue to meet the increasingly sophisticated needs of our customers through the timely development, successful introduction and implementation of new and enhanced products and services, while at the same time continuing to provide the value our customers have come to expect from us. We have historically expended a significant percentage of our revenue on product development and believe that significant continued product development efforts will be required to sustain our growth. Continued investment in our sales and marketing efforts will also be required to support future growth.

There can be no assurance that we will be successful in our product development efforts, that the market will continue to accept our existing products, or that new products or product enhancements will be developed and implemented in a timely manner, meet the requirements of our customers, or achieve market acceptance. If the market does not continue to accept our existing products, or our new products or product enhancements do not achieve market acceptance, our business, results of operations and financial condition could be materially adversely affected.

Our customers may cancel or reduce their orders, change production quantities or delay production, any of which would reduce our sales and adversely affect our operating results.

Since most of our customers purchase our products from us on a purchase order basis, they may cancel, change, or delay product purchase commitments with little notice to us. As a result, we are not always able to forecast with certainty the sales that we will make in a given period and sometimes we may increase our inventory, working capital, and overhead in expectation of orders that may never be placed, or, if placed, may be delayed, reduced, or canceled.

The following factors, among others, affect our ability to forecast accurately our sales and production capacity:

· Changes in the specific products or quantities our customers order; and

Delayed, reduced or canceled purchase orders also may result in our inability to recover costs that we incur in anticipation of those orders, such as costs associated with purchased raw materials and write-offs of obsolete inventory.

In recent years, we have launched many new medical device products and our estimates of warranty claims are based largely on our previous history from similar legacy products. If actual warranty claims exceed our estimates, it could have an adverse effect on our results of operations and financial condition.

In recent years we have completed significant medical device development projects in the CMF and thoracic surgical segments for which we have made estimates of product warranty claims based upon similar, legacy products. If the actual repair volumes or repair costs exceed the estimates that we have been using, we may incur additional costs which could be materially adverse to our results of operations and financial condition.

We face significant competition from a number of different sources, which could negatively impact our results of operations and business conditions.

The markets for products in the industries served by our customers are intensely competitive, and we face significant competition from a number of different sources. Several of our competitors have significantly greater name recognition, as well as substantially greater financial, technical, product development and marketing resources, than us.

We compete in all of our markets with other major surgical device and related companies. As a provider of outsourced products and services, we also compete with our customers’ own internal development groups. Competitive pressures and other factors, such as new product or new technology introductions by us, our customers’ internal development and manufacturing departments, or our competitors, may result in price or market share erosion that could have a material adverse effect on our business, results of operations and financial condition. Also, there can be no assurance that our products and services will achieve broad market acceptance or will successfully compete with other products.

The industry in which we operate is subject to significant technological change and any failure or delay in addressing such change could adversely affect our competitive position or could make our current products obsolete.

The medical device market is generally characterized by rapid technological change, changing customer needs, frequent new product introductions and evolving industry standards. The introduction of products incorporating new technologies and the emergence of new industry standards could render our existing products obsolete and unmarketable. There can be no assurance that we will be successful in developing and marketing new products that respond to technological changes or evolving industry standards.

New product development requires significant research and development expenditures that we have historically funded through operations; however, we may be unable to do so in the future. Any significant decrease in revenues or research funding could impair our ability to respond to technological advances in the marketplace and to remain competitive. If we are unable, for technological or other reasons, to develop and introduce new products in a timely manner in response to changing market conditions or customer requirements, our business, results of operations and financial condition may be materially adversely affected. Although we continue to target new markets for access, develop new products, and update existing products, there can be no assurance that we will do so successfully or that even if we are successful, such efforts will be completed concurrently with or prior to the introduction of competing products. Any such failure or delay could adversely affect our competitive position or could make our current products obsolete.

We rely heavily on our proprietary technology, which, if not properly protected or if deemed invalid, could have a material adverse effect on our business, results of operations and financial condition.

We are dependent on the maintenance and protection of our proprietary technology and rely on patent filings, exclusive development and supply agreements, confidentiality procedures and employee nondisclosure agreements to protect it. There can be no assurance that the legal protections and precautions taken by us will be adequate to prevent misappropriation of our technology or that competitors will not independently develop technologies equivalent or superior to ours. Further, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States and are often not enforced as vigorously as those in the United States.

We do not believe that our operations or products infringe on the intellectual property rights of others. However, there can be no assurance that others will not assert infringement or trade secret claims against us with respect to our current or future products. Assertions or claims by others, whether or not valid, could cause us to incur significant legal costs defending our intellectual property rights and potentially require us to enter into a license agreement or royalty arrangement with the party asserting the claim or to cease our use of the infringing technology, any of which could have a material adverse effect on our business, results of operations and financial condition.

Two of our directors hold voting power with respect to a substantial portion of our outstanding common stock that enables them to have significant influence over the outcome of all matters submitted to our shareholders for approval, which influence may conflict with our interests and the interests of other shareholders.

As of August 13, 2020, two of our directors, Nicholas J. Swenson and Raymond E. Cabillot, directly or indirectly, controlled voting power over approximately 38% (27% and 11%, respectively) of the outstanding shares of our common stock. As a result of such voting control, these directors will have significant influence over all matters submitted to our shareholders for approval, including the election of our directors and other corporate actions, and may have interests that conflict with our interests and the interests of other shareholders.

If our technology infrastructure is compromised, damaged or interrupted by a cybersecurity incident, data security breach or other security problems, our operating results and financial condition could be adversely affected.

We use technology in substantially all aspects of our business operations, and our ability to serve customers most effectively depends on the reliability of our technology systems. We use software and other technology systems, among other things, to generate sales orders, job orders and purchase orders and to monitor and manage our business on a day-to-day basis. Cybersecurity incidents can include computer viruses, computer denial-of-service attacks, worms, and other malicious software programs or other attacks, covert introduction of malware to computers and networks, impersonation of authorized users, and efforts to discover and exploit any design flaws, bugs, security vulnerabilities or security weaknesses, as well as intentional or unintentional acts by employees or other insiders with access privileges, intentional acts of vandalism by third parties and sabotage.

In addition, our technology infrastructure and systems are vulnerable to damage or interruption from natural disasters, power loss and telecommunications failures. Any such disruption to our systems, or the technology systems of third parties on which we rely, the failure of these systems to otherwise perform as anticipated, or the theft, destruction, loss, misappropriation, or release of sensitive and/or confidential information or intellectual property, could result in business disruption, negative publicity, loss of customers, potential liability, including litigation or other legal actions against us or the imposition of penalties, fines, fees or liabilities, which may not be covered by our insurance policies, and competitive disadvantage, any or all of which would potentially adversely affect our customer service, decrease the volume of our business and result in increased costs and lower profits. Moreover, a cybersecurity breach could require us to devote significant management resources to address the problems associated with the breach and to expend significant additional resources to upgrade further the security measures we employ to protect information against cyber-attacks and other wrongful attempts to access such information, which could result in a disruption of our operations.

While we have invested, and continue to invest, in technology security initiatives and other measures to prevent security breaches and cyber incidents, as well as disaster recovery plans, these initiatives and measures may not be entirely effective to insulate us from technology disruption that could result in adverse effects on our results of operations.

The agreements governing our various debt obligations impose restrictions on our business and could adversely affect our ability to undertake certain corporate actions.

The agreements governing our debt obligations include covenants imposing significant restrictions on our business. These restrictions may affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities as they arise. These covenants place restrictions on our ability to, among other things:

· incur additional debt;

· declare or pay dividends to stockholders;

· create liens or use assets as security in other transactions;

· engage in transactions with affiliates; and

· sell or transfer assets.

The agreements governing our debt obligations also requires us to comply with a number of financial ratios, borrowing base requirements and additional covenants.

Our ability to comply with these covenants may be affected by events beyond our control, including prevailing economic, financial, and industry conditions. These covenants could adversely affect our business by limiting our ability to take advantage of financing, merger and acquisition, or other corporate opportunities. The breach of any of these covenants or restrictions could result in a default under our debt obligations. If we were unable to repay our debt, or are otherwise in default under any provision governing our secured debt obligations, our lender could proceed against us and against the collateral securing that debt.

To service our indebtedness, we will require a significant amount of cash. However, our ability to generate cash depends on many factors beyond our control.

Our ability to make payments on, and to refinance, our indebtedness and to fund capital expenditures, will depend on our ability to generate cash in the future, which, in turn, is subject to general economic, financial, competitive, regulatory and other factors, many of which are beyond our control.

Our business may not generate sufficient cash flow from operations, and we may not have available to us future borrowings in an amount sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. In these circumstances, we may need to refinance all or a portion of our indebtedness on or before maturity. We may not be able to refinance any of our indebtedness, on commercially reasonable terms, or at all. Without this financing, we could be forced to sell assets or secure additional financing to make up for any shortfall in our payment obligations under unfavorable circumstances. However, we may not be able to secure additional financing on terms favorable to us or at all and, in addition, the agreements governing our debt obligations limit our ability to sell assets. In addition, we may not be able to sell assets quickly enough or for sufficient amounts to enable us to meet our obligations.

We periodically invest surplus cash in marketable securities and other investments in order to realize a positive return, although there can be no assurance that a positive return will be realized, and we could lose some or all of our investments, which could adversely affect our financial condition and results of operation.

We invest a significant portion of our excess capital in marketable securities, including equity securities of publicly traded companies. At June 30, 2020, the fair value of these marketable securities was approximately $4.9 million. Approximately $2.4 million of our investments at June 30, 2020 include equity securities of companies that are thinly traded. As such, these investments are classified as long-term in nature, as we may not be able to liquidate the investments in a timely manner even if we wish to sell them. Further, we obtained an independent valuation of these stocks to determine the fair market value. While we intend to hold our investments, we may have unexpected cash requirements which necessitate the sale of some or all of these marketable securities and we may incur losses.

We may not be able to successfully integrate our business acquisitions, which could adversely affect our business, financial condition, and results of operations.

We have acquired, and may acquire in the future, businesses, products, and technologies that complement or expand our current operations. Acquisitions could require significant capital investments and require us to integrate with companies that have different cultures, management teams, and business infrastructure. Depending on the size and complexity of an acquisition, our successful integration of the acquisition could depend on several factors, including:

· The retention of key employees;

· Management of facilities and employees in separate geographic areas;

· Successfully converting information and accounting systems; and

· Diversion of resources and management attention from our other operations.

If market conditions or other factors require us to change our strategic direction, we may fail to realize the expected value from one or more of our acquisitions. Our failure to successfully integrate our acquisitions or realize the expected value from past or future acquisitions could harm our business, financial condition, and results of operations.

Our quarterly results can fluctuate significantly from quarter to quarter, which may negatively impact the price of our shares and/or cause significant variances in the prices at which our shares trade.

Our sales have fluctuated in the past, and may fluctuate in the future from quarter to quarter and period to period, as a result of a number of factors, including, without limitation: the size and timing of orders from customers; the length of new product development cycles; market acceptance of new technologies; changes in pricing policies or price reductions by us or our competitors; the timing of new product announcements and product introductions by us or our competitors; the financial stability of major customers; our success in expanding our sales and marketing programs; acceleration, deferral, or cancellation of customer orders and deliveries; changes in our strategy; revenue recognition policies in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”); personnel changes; and general market and economic factors.

Because a significant percentage of our expenses are fixed, a variation in the timing of sales can cause significant fluctuations in operating results from quarter to quarter. As a result, we believe that interim period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Further, our historical operating results are not necessarily indicative of future performance for any particular period.

In addition, it is possible that our operating results in future quarters may be below the expectations of public market analysts and investors. In such an event, the price of our common stock could be materially adversely affected.

Our operations are dependent upon our key personnel. If such personnel were to leave unexpectedly, we may not be able to execute our business plan.

Our future performance depends in significant part upon the continued service of our key technical and senior management personnel. Because we have a relatively small number of employees when compared to other companies in the same industry, our dependence on maintaining our relationship with key employees is particularly significant. We are also dependent on our ability to attract and retain high quality personnel, particularly in the areas of product development, operations management, marketing and finance.

A high level of employee mobility and the aggressive recruiting of skilled personnel characterize the medical device industry. There can be no assurance that our current employees will continue to work for us. Loss of services of key employees could have a material adverse effect on our business, results of operations, and financial condition. Furthermore, we may need to provide enhanced forms of incentive compensation to attract and retain such key personnel.

Our operations are subject to a number of complex government regulations, the violation of which could have a material adverse effect on our business.

The manufacture and distribution of medical devices are subject to state and federal requirements set forth by various government agencies including the FDA and EPA. The statutes, regulations, administrative orders, and advisories that affect our businesses are complex and subject to diverse, often conflicting, interpretations. While we make every effort to maintain full compliance with all applicable laws and regulations, we are unable to eliminate the ongoing risk that one or more of our activities may at some point be determined to be non-compliant. The penalties for non-compliance could range from an administrative warning to termination of a portion of our business. Furthermore, even if we are subsequently determined to have fully complied with applicable laws or regulations, the costs to achieve such a determination and the intervening loss of business could adversely affect or result in the cessation of a portion of our business. A change in such laws or regulations at any time may have an adverse effect on our operations.

The FDA designates all medical devices into one of three classes (Class I, II, or III) based on the level of control necessary to assure the safety and effectiveness of the device (with Class I requiring the lowest level of control and Class III requiring the greatest level of control). The surgical instrumentation we manufacture is generally classified into Class I. The FDA has broad enforcement powers to recall and prohibit the sale of products that do not comply with federal regulations, and to order the cessation of non-compliant processes. No claim has been made to date by the FDA regarding any of our products or processes. Nevertheless, as is common in the industry, certain of our products and processes are from time to time subject to routine governmental reviews and investigations. We are also subject to EPA regulations concerning the disposal of industrial waste.

While management believes that our products and processes fully comply with applicable laws and regulations, we are unable to predict the outcome of any such future review or investigation.

The global economic environment may impact our business, operating results or financial condition.

Changes in the global economic environment have caused, and may cause in the future, a general tightening in the credit markets, lower levels of liquidity, increases in rates of default and bankruptcy, and extreme volatility in credit, equity and fixed income markets. These macroeconomic developments could negatively affect our business, operating results or financial condition should they cause, for example, current or potential customers to become unable to fund purchases of our products, in turn resulting in delays, decreases or cancellations of purchases of our products and services, or causing the customer to not pay us or to delay paying us for previously purchased products and services. In addition, financial institution failures may cause us to incur increased expenses or make it more difficult either to obtain financing for our operations, investing activities (including the financing of any future acquisitions), or financing activities. Additional economic risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition or operating results.

We face risks and uncertainties associated with potential litigation by or against us, which could have a material adverse effect on our business, results of operations and financial condition.

We continually face the possibility of litigation as either a plaintiff or a defendant. It is not reasonably possible to estimate the awards or damages, or the range of awards or damages, if any, that we might incur in connection with such litigation.

Many of our products are complex and technologically advanced. Such products may, from time to time, be the subject of claims concerning product performance and construction, including warranty claims. While we are committed to correcting such problems as soon as possible, there is no assurance that solutions will be found on a timely basis, if at all, to satisfy customer demands or to avoid potential claims or litigation. Also, due to the location of our facilities, as well as the nature of our business activities, there is a risk that we could be subject to litigation related to environmental remediation claims. We maintain insurance to protect against claims associated with the manufacture and use of our products as well as environmental pollution, but there can be no assurance that our insurance coverage will adequately cover any claim asserted against us.

The uncertainty associated with potential litigation may have an adverse impact on our business. In particular, litigation could impair our relationships with existing customers and our ability to obtain new customers. Defending or prosecuting litigation could result in significant legal costs and a diversion of management’s time and attention away from business operations, either of which could have a material adverse effect on our business, results of operations and financial condition. There can be no assurance that litigation would not result in liability in excess of our insurance coverage, that our insurance will cover such claims or that appropriate insurance will continue to be available to us in the future at commercially reasonable rates.

We have experienced losses in the past, and we cannot be certain that we will sustain our current profitability; we may need additional capital in the future to fund our businesses, which we may not be able to obtain on acceptable terms.

We have experienced operating losses in the past. Our ability to achieve or sustain profitability is based on a number of factors, many of which are out of our control, including the material costs for our products and the demand for our products.

We currently anticipate that our available capital resources, including our existing cash and cash equivalents and accounts receivable balances will be sufficient to meet our expected working capital and capital expenditure requirements as our business is currently conducted for at least the next 12 months. We may also attempt to raise additional funds through public or private debt or equity financings, if such financings become available on acceptable terms. We cannot be certain that any additional financing we may need will be available on terms acceptable to us, or at all. If adequate funds are not available or are not available on acceptable terms, we may not be able to take advantage of opportunities, develop new products or otherwise respond to competitive pressures, and our operating results and financial condition could be adversely affected.

We are subject to changes in and interpretations of financial accounting matters that govern the measurement of our performance, compliance with which could be costly and time consuming.

We are subject to changes in and interpretations of financial accounting standards that govern the measurement of our performance. Based on our reading and interpretations of relevant pronouncements, guidance, or concepts issued by, among other authorities, the Financial Accounting Standards Board, the SEC and the American Institute of Certified Public Accountants, management believes our performance, including current sales contract terms and business arrangements, has been properly reported. However, there continue to be issued pronouncements, interpretations, and guidance for applying the relevant standards to a wide range of contract terms and business arrangements that are prevalent in the industries in which we operate. Future interpretations or changes by the regulators of existing accounting standards or changes in our business practices may result in future changes in our accounting policies and practices that could have a material adverse effect on our business, financial condition, cash flows, revenue, and results of operations.

Our evaluation of internal controls and remediation of potential problems is costly and time consuming and could expose weaknesses in financial reporting.

Section 404 of the Sarbanes-Oxley Act of 2002, as amended, requires management’s assessment of the effectiveness of our internal control over financial reporting. This process is expensive and time consuming and requires significant attention of management. Management can give no assurance that material weaknesses in internal controls will not be discovered. If a material weakness is discovered, corrective action may be time consuming and costly, and could further divert the attention of management. The disclosure of a material weakness, even if quickly remedied, could reduce the market’s confidence in our financial statements and harm our stock price, especially if a restatement of financial statements for past periods is required.

ITEM 1B.

UNRESOLVED STAFF COMMENTS

None.

ITEM 2.

PROPERTIES

Our executive offices and manufacturing facility are located at 2361 McGaw Avenue, Irvine, California 92614. We lease the 28,000 square foot facility from an unrelated third party at a current base monthly lease rate of $38,716 with 3% annual escalations through the expiration of the lease in September 2027. The building is a one-story, stand-alone structure of concrete “tilt-up” construction, approximately 35 years old and in good condition.

While we believe our Irvine facility to be adequate for our current needs and is in full compliance with applicable state, EPA and other agency environmental standards, we do anticipate continued growth and therefore we are actively seeking an additional commercial facility to satisfy our expected future growth. (See Note 13 of Notes to Financial Statements contained elsewhere in this report.)

ITEM 3.

LEGAL PROCEEDINGS

See Note 8 of Notes to Financial Statements contained elsewhere in this report.

ITEM 4.

MINE SAFETY DISCLOSURES

Not applicable.

PART II

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

Our common stock is quoted under the symbol “PDEX” on the automated quotation system of the Nasdaq Capital Market (“NASDAQ”). The following table sets forth for the quarters indicated the high and low sales prices of our common stock as reported by NASDAQ. The quotations reflect inter-dealer prices, without retail markup, markdown, or commissions, and may not necessarily represent actual transactions. On September 4, 2020, the last sale price of our common stock as reported by NASDAQ was $28.69 per share.

High Low

Holders

As of September 4, 2020, there were 99 holders of record of our common stock. This number does not include beneficial owners including holders whose shares are held in nominee, or “street,” name.

Dividends

We have never paid a cash dividend with respect to our common stock. The current policy of our Board of Directors is to retain any future earnings to provide funds for the operation and expansion of our business. Any determinations to pay dividends in the future will be at the discretion of our Board of Directors.

Repurchases

During the fourth quarter of fiscal 2020 and 2019, we repurchased 26,353 and 96,700 shares, respectively, at an aggregate cost of $411,000 and $1.3 million, respectively, through Board approved prearranged share repurchase plans intended to qualify for the safe harbor under Rule 10b5-1 under the Securities Exchange Act of 1934, as amended.

ITEM 6.

SELECTED FINANCIAL DATA

Not applicable.

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our financial condition and results of operations should be read in conjunction with our Financial Statements and the Notes thereto contained elsewhere in this report, as well as the Risk Factors included in Item 1A of this report. The following discussion contains forward-looking statements. (See “Cautionary Note Regarding Forward-Looking Statements” included in Part 1 of this report.)

Overview

The following discussion and analysis provides information that management believes is relevant to an assessment and understanding of our results of operations and financial condition for the fiscal years ended June 30, 2020 and 2019.

The Company, headquartered in Irvine, California, specializes in the design, development, and manufacture of autoclavable, battery-powered and electric, multi-function surgical drivers and shavers used primarily in the orthopedic, thoracic, and maxocranial facial markets. Additionally, we provide engineering, quality, and regulatory consulting services to our customers. We also sell rotary air motors. Our products are found in hospitals, medical engineering labs, scientific research facilities, and high-tech manufacturing operations around the world.

COVID-19 Pandemic

We are continuing our business operations under the California exemption for “essential critical infrastructure sectors” based on our determination that we fall within the Healthcare and Public Health Sector exemption.

As we continue to operate, we have adjusted certain policies and procedures based on applicable national, state, and local emergency orders and safety guidance that may be issued from time to time, including:

· Non-essential employees that are able to work remotely are doing so;

· Curtailed business travel;

· Provided training, education and appropriate personal protective equipment.

While we have yet to see any decline in our customer orders, we have received and accepted some customer requests to delay the shipment of their existing orders. We provide our largest customer with a device used primarily in elective surgeries and although this customer has not requested a reduction or delay to their planned shipments, if this pandemic continues to adversely impact the United States and other markets where our products are sold, coupled with the recommended deferrals of elective procedures by governments and other authorities, we would expect to see a decline in demand from our principal customer.

We are focused on the health and safety of all those we serve – our customers, our communities, our employees, and our suppliers. We are supporting our customers according to their priorities and working with them to the degree that we can offer relief in the form of delayed shipments. We are focused on continuity of supply by working with our suppliers. To date, a total of six of our employees including one temporary agency worker have tested positive for COVID-19 and all of them have made full recoveries and returned to work as of August 18, 2020.

While the COVID-19 pandemic did not materially adversely affect our financial results and business operations in our fiscal year ended June 30, 2020, economic and health conditions in the United States and across much of the globe have changed rapidly since the end of the quarter, and we cannot predict the full impact of the COVID-19 pandemic on our business.

Critical Accounting Policies

Our financial statements are prepared in accordance with U.S. GAAP. The preparation of our financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosures. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

Revenue Recognition

Effective July 1, 2018, we adopted new revenue recognition guidance issued by the Financial Accounting Standards Board (“FASB”) related to contracts with customers. Under Accounting Standards Update (“ASU”) 2014-09, (Topic 606) “Revenue From Contracts with Customers,” we recognize revenue from the sales of products and services by applying the following steps: (1) identify the contract with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to each performance obligation in the contract; and (5) recognize revenue when each performance obligation is satisfied. We utilized the modified retrospective method of adoption and there was no impact on our financial statements as a result of adopting Topic 606 for the year ended June 30, 2019. We primarily sell finished products and recognize revenue at point of sale or delivery and the timing of revenue recognition has not changed with the adoption of the new guidance. However, we also perform services when we are engaged to design a product for a customer and there is more judgment involved in determining the amount and timing of revenue recognition under those types of contracts. In fiscal 2020, the revenue from NRE and Prototypes represents approximately 2% of total revenue.

Returns of our product for credit are not material; accordingly, we do not establish a reserve for product returns at the time of sale.

Estimated Losses on Product Development Services

Cost and revenue estimates related to the product development service portions of development and supply contracts are reviewed and updated quarterly. An expected loss on development service contracts is recognized immediately in cost of sales.

Owing to the complexity of many of the contracts we have undertaken, the cost estimation process requires significant judgment. It is based upon the knowledge and experience of our project managers, engineers, and finance professionals. Factors that are considered in estimating the cost of work to be completed and ultimate profitability of the fixed price product development portion of development and supply contracts include the nature and complexity of the work to be performed, availability and productivity of labor, the effect of change orders, the availability of materials, performance of subcontractors, and expected costs for specific regulatory approvals.

Warranties

Most of our products are sold with a warranty that provides for repairs or replacement of any defective parts for a period, generally one to two years, after the sale. At the time of the sale, we accrue an estimate of the cost of providing the warranty based on prior experience with such factors as return rates and repair costs, which factors are reviewed quarterly.

Warranty expenses, including changes of estimates, are included in cost of sales in our statements of operations.

Inventories

Inventories are stated at the lower of cost (first-in, first-out method) or net realizable value. Reductions to estimated net realizable value are recorded, and charged to cost of sales, when indicated based on a formula that compares on-hand quantities to both historical usage and estimated demand over the ensuing 12 months from the measurement date.

Accounts Receivable

Trade receivables are stated at their original invoice amounts, less an allowance for doubtful portions of such accounts. Management determines the allowance for doubtful accounts based on facts and circumstances related to specific accounts, and on historical experience related to the age of accounts. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously reserved are offset against the allowance when received.

Deferred Costs

Deferred costs reflect costs incurred related to non-recurring engineering services under the terms of the related development and supply contracts. These costs get recorded to cost of sales in the period that the revenue is recognized.

Investments

Investments consist of marketable equity securities of publicly held companies. The investments were made to realize a reasonable return, although there is no assurance that positive returns will be realized. Investments are marked to market at each measurement date, with unrealized gains and losses, net of income taxes, presented as adjustments to accumulated other comprehensive income or loss. We hold investments in the common stock of public companies that are thinly traded. These investments were subject to an independent valuation as of June 30, 2020.

Long-lived Assets

We review the recoverability of long-lived assets, consisting of equipment and leasehold improvements, when events or changes in circumstances occur that indicate carrying values may not be recoverable.

Equipment and leasehold improvements are recorded at historical cost and depreciation is provided using the straight-line method over the following periods:

Equipment Three to ten years

Intangibles

Other intangibles consist of legal fees incurred in connection with patent applications. The legal fees will be amortized over the estimated life of the product(s) that will be utilizing the technology, or expensed immediately in the event the patent office denies the issuance of the patent. The expense associated with the amortization of the patent costs is recognized in research and development costs.

Income Taxes

We recognize deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities, along with net operating loss and tax credit carryovers. Deferred tax assets at June 30, 2020 and 2019, consisted primarily of basis differences related to unrealized gain/loss related to investments, fixed assets, accrued expenses and inventories. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

Significant management judgment is required in determining our provision for income taxes and the recoverability of our deferred tax assets. Such determination is based on our historical taxable income, with consideration given to our estimates of future taxable income and the periods over which deferred tax assets will be recoverable. In evaluating our ability to recover our deferred tax assets, we consider all available positive and negative evidence, including reversals of deferred tax liabilities, projected future taxable income, and results of recent operations. The assumptions about future taxable income require significant judgment and are consistent with the plans and estimates we are using to manage the underlying business. In evaluating the objective evidence that historical results provide, we consider three years of cumulative operating income (loss).

Results of Operations for the Fiscal Year Ended June 30, 2020 Compared to the Fiscal Year Ended June 30, 2019

The following tables set forth results from continuing operations for the fiscal years ended June 30, 2020 and 2019:

Years Ended June 30,

Dollars in thousands

% of Net Sales % of Net Sales

General and administrative expenses 3,189 9 % 2,492 9 %

Gain from disposal of equipment (5 ) — (7 ) —

Net Sales

The majority of our revenue is derived from designing, developing, and manufacturing powered surgical instruments for medical device original equipment manufacturers and rotary air motors. The proportion of total sales by product/service type is as follows:

Years Ended June 30, Increase (Decrease) From 2019 To 2020

Dollars in thousands

% of Net Sales % of Net Sales

Net sales:

Discounts & Other (27 ) — 10 — (370 %)

Net sales in fiscal 2020 increased by $7.7 million, or 28%, as compared to fiscal 2019, due primarily to an increase in repair revenue of $5.2 million generated mostly from our largest customer. During fiscal 2020, sales to our largest customer increased by $5.6 million to $22.7 million, up from $17.1 million in fiscal 2019. We manufacture a surgical handpiece designed to be used in orthopedic surgery applications for this customer and we have continued to see increased demand from this customer.

Sales of our industrial and scientific products, which consists primarily of our compact pneumatic air motors, decreased $153,000, or 16% for fiscal 2020 compared to fiscal 2019. The revenue decline relates to a lack of marketing efforts for these legacy products.

Our dental and component revenue is generated from sales to many distributors and end-users whose purchasing activity can vary widely from year to year. These are legacy products which have not had a product line refresh in several years. In January 2018, we sent notifications to our dental product customers that we were discontinuing the manufacture of these products and that same month we accepted final purchase orders to be fulfilled over the next six months. At this point we are focusing our product development and sales efforts almost exclusively on our medical device products, which prompted our decision to terminate the sales of our dental products. Sales of our dental products and components have declined as we are no longer manufacturing this line of products, but rather are simply selling remaining component inventory. The cessation of our dental line of products is not expected to have a material impact on our financial position or results of operations.

Our fiscal 2020 repair revenue has increased approximately $5.2 million, or 458%, over fiscal 2019 to $6.3 million, due largely to repairs of the orthopedic device we sell to our largest customer. Typically, upon initial product launch, repair revenue is minimal as most repairs are typically covered under warranty, but as the products mature in the marketplace and after a certain number of routine duty cycles in the operating room, repairs generally increase. We expect similar repair revenue in fiscal 2021.

At June 30, 2020, we had a backlog of $7.0 million compared with a backlog of $17.7 million at June 30, 2019. Our backlog represents firm purchase orders received and acknowledged from our customers and does not include all revenue expected to be generated from existing customer contracts. Our entire backlog at June 30, 2020, as well as purchase orders received and yet to be received subsequent to June 30, 2020, is expected to be delivered during fiscal 2021. We have experienced, and may continue to experience, variability in our new order bookings due to, among other reasons, the launch of new products, the timing of customer orders based on end-user demand, and customer inventory levels. We do not typically experience seasonal fluctuations in our shipments and revenues.

Cost of Sales and Gross Margin

Years Ended June 30, Increase (Decrease) From 2019 To 2020

Dollars in thousands

% of Net Sales % of Net Sales

Cost of sales:

Under (over)-absorption of manufacturing overhead (140 ) — 166 — (184 %)

Inventory and warranty charges 224 1 % 261 1 % (14 %)

Cost of sales in fiscal 2020 increased $4.3 million, or 25%, from fiscal 2019, primarily due to the increase in product costs, consistent with the 28% increase in net sales. During fiscal 2020, we incurred costs of $1.2 million to generate $834,000 in revenue related to NRE and Proto-type services, netting losses in the amount of $370,000 from the development services portion of certain contracts compared to none in fiscal 2019. During fiscal 2020, we experienced over-absorption of manufacturing costs compared to an under-absorption in fiscal 2019, due primarily to adjustments to our standard labor and overhead rates at the beginning of fiscal 2020 in anticipation of higher manufacturing volumes. Costs related to inventory and warranty charges remained relatively flat in fiscal 2020 compared to fiscal 2019.

Operating Expenses

Years Ended June 30, Increase (Decrease) From 2019 To 2020

(Dollars in thousands)

% of Net Sales % of Net Sales

Operating expenses: $ $

Selling expenses consist of salaries and other personnel-related expenses related to our business development department, as well as trade show attendance, advertising and marketing expenses, and travel and related costs incurred in generating and maintaining customer relationships. Selling expenses increased $162,000, or 39%, compared to fiscal 2019, primarily related to increased personnel expenses in the amount of $95,000 as well as consulting expenses of $96,000, offset by decreases in recruitment fees of $40,000 due to filling the previously vacant position of Director of Business Development during the first quarter of fiscal 2019.

General and administrative expenses (“G&A”) consist of salaries and other personnel-related expenses for corporate, accounting, finance, and human resource personnel, as well as costs for outsourced information technology services, professional fees, directors’ fees, and costs associated with being a public company. The $697,000 increase in G&A expenses from fiscal 2019 to 2020 is due primarily to $277,000 in increased fiscal 2020 bonus accruals, $93,000 in increased personnel expenses, $249,000 in increased equity compensation expense due to the reallocation of previously forfeited performance awards, and increased professional fees related to outsourced information technology services and audit fees in the amount of $85,000.

Research and development costs consist of salaries and other personnel-related costs of our product development and engineering personnel, related professional and consulting fees, and costs related to intellectual property, laboratory usage, materials, and travel and related costs incurred in the development and support of our products. The $433,000 increase in research and development costs from fiscal 2019 to fiscal 2020 is due primarily to increased personnel-related costs in the amount of $386,000 and increased recruiting expenses as we hired new engineers during the fiscal 2020.

Although the majority of our research and development costs relate to sustaining activities related to products we currently manufacture and sell, we have created a product roadmap to develop future products. Research and development costs represent between 38% and 39% of total operating expenses during fiscal 2019 and 2020 and are expected to increase in the future as we continue to invest in product development. The amount spent on projects under development is summarized below (in thousands):

Years Ended June 30, Expected Market Launch Estimated Annual Revenue

Dollars in thousands

Total Research and Development costs: $ 2,315 $ 1,882

Products in development:

Arthroscopic Attachment — 17 (2) $ 150

We substantially completed this product and began initial shipments of a private-labeled version to an existing CMF customer beginning in the third quarter of fiscal 2020, generating $3.1 million in revenue during fiscal 2020.

(1)

This project has been internally pushed back to focus on our new internal Pro-Dex branded ENT shaver.

(2)

Internal development of this project is complete, but we are looking for the most attractive sales channel and have yet to sell this product.

As we previously discussed, in early fiscal 2019 we entered a development contract with a current significant customer to private-label our thoracic driver for their unique specifications. We shipped initial launch quantities of this product during the third quarter ended March 31, 2020. Additionally, the customer CMF driver listed in the prior year was completed during fiscal 2020 and we began shipping initial quantities to this customer during the fourth quarter of fiscal 2020 and generated $556,000 in revenue related to this new product.

Approximately $6,000 in expenses included in fiscal 2020 sustaining and other is related to the Jet Propulsion Laboratory’s Ventilator Intervention Technology Accessible Locally (“VITAL”), a high-pressure, lower cost ventilator. In the fourth quarter, we were one of eight US-based companies awarded a license to manufacture the VITAL. We are currently in the process of creating proto-types for testing and look forward to adding this as a formal product under development in our next fiscal quarter. We are excited about the opportunity to commercialize this product, which may alleviate some of the ventilator supply chain shortages experienced by hospitals during the COVID-19 pandemic.

Other Income (Expense)

Interest and Dividend Income

Our interest and dividend income earned in fiscal 2020 includes $95,000 earned from our interest-bearing money market accounts and portfolio of equity investments. The fiscal 2019 interest and dividend income included $183,000 of interest related to an investment in a hotel as well as $83,000 of interest and dividend income earned from our interest-bearing money market accounts and portfolio of equity investments.

Other Income

During the fourth quarter of fiscal 2020, the Monogram Orthopaedics Inc. (“Monogram”) note was repaid with interest and we collected a total of $952,000 during fiscal 2020. We invested in Monogram, a medical device start-up specializing in precision, patient-specific orthopedic implants in April 2017. In conjunction with making the loan to Monogram, we were granted the exclusive right to develop, engineer, manufacture, and supply certain products on behalf of Monogram. We impaired our entire $800,000 investment during the fourth quarter of fiscal 2018 due to indications that Monogram had exhausted its cash and had been unable to obtain additional financing to enable continued research to commercialize their technology.

Gain on Sale of Investments

During the fourth quarter of fiscal 2020, we liquidated one of the stocks in our portfolio of equity investments receiving proceeds of $128,000 and recording a gain of $25,000. During the quarter ended December 31, 2018, we liquidated one of the stocks in our portfolio of equity investments receiving proceeds of $1.9 million and recording a gain on the sale in the amount of $356,000.

Interest Expense

Interest expense incurred in fiscal 2020 and 2019, consists primarily of interest expense related to the Term Loan from Minnesota Bank & Trust (“MBT”) described more fully in Note 6 to the Financial Statements contained elsewhere in this report and capital lease obligations for leased equipment.

Income Taxes

The effective tax rate for the years ended June 30, 2020 and 2019, was consistent at 23% and 24%, respectively.

Liquidity and Capital Resources

The following table is a summary of our Statements of Cash Flows and Cash and Working Capital as of and for the fiscal years ended June 30, 2020 and 2019:

As of and for the Years Ended June 30,

(In thousands)

Cash provided by (used in):

Investing activities $ (2,287 ) $ (1,222 )

Financing activities $ (3,979 ) $ 450

Cash, cash equivalents and working capital:

Cash and cash equivalents $ 6,421 $ 7,742

Cash Flows from Operating Activities

Cash provided by operating activities during fiscal 2020 relates primarily to our net income of $6.1 million, the non-cash depreciation and amortization and stock compensation expense of $573,000 and $286,000, respectively, offset by a gain on collection of a note receivable in the amount of $952,000, an increase in inventory in the amount of $2.0 million due to projected increased demand relating to two of our newest product launches, and an increase in accounts receivable in the amount of $1.1 million. Offsetting the use of cash for inventory purchases and accounts receivable increases, our accounts payable, accrued expenses and deferred rent increased by $604,000 and our income taxes payable increased by $642,000, while our prepaid expenses and other assets decreased by $476,000.

Cash provided by operating activities during fiscal 2019 was $3.3 million and relates primarily to our net income of $4.1 million, non-cash depreciation and amortization in the amount of $438,000, and the non-cash decrease in the deferred income taxes of $1.4 million, offset by an increase in inventory in the amount of $1.8 million due to projected increased sales, and an increase in accounts receivable of $1.1 million.

Cash Flows from Investing Activities

Net cash used in investing activities in fiscal 2020 was $2.3 million and related primarily to the purchase of $2.8 million in marketable equity securities as well as purchases of $519,000 in equipment and leasehold improvements offset by the collection of a previously impaired note receivable due from Monogram in the amount of $952,000.

Net cash used in investing activities in fiscal 2019 was $1.2 million. During the 2019 fiscal year, we invested $3.0 million in the purchase of marketable equity securities and generated $1.9 million in proceeds from sales of marketable equity securities under the direction of the Investment Committee of our Board, made capital expenditures in the amount of $1.4 million primarily for manufacturing equipment, and collected $1.2 million from collection of a note receivable.

Cash Flows from Financing Activities

Net cash used in financing activities for fiscal 2020 totaled $4.0 million and related primarily to the $3.4 million repurchase of 231,274 shares of our common stock pursuant to our share repurchase program, as well as $630,000 of principal payments on our term loan from Minnesota Bank and Trust (“MBT”) and an equipment lease more fully described in Note 6 to the Financial Statements contained elsewhere in this report.

Net cash provided by financing activities for fiscal 2019 included $5.0 million in a term loan from MBT more fully described in Note 6 to the Financial Statements contained elsewhere in this report, offset by $433,000 of principal payments on the MBT term loan and an equipment lease, as well as $4.0 million related to the repurchase of 322,068 shares of our common stock pursuant to our share repurchase program.

Liquidity Requirements for the Next 12 Months

As of June 30, 2020, our working capital was $17.4 million. We currently believe that our existing cash and cash equivalent balances, together with our account receivable balances, and anticipated cash flows from operations will provide us sufficient funds to satisfy our cash requirements as our business is currently conducted for at least the next 12 months. We may also borrow against our $2.0 million revolving loan with MBT, which we anticipate renewing (See Note 6 of Notes to Financial statements contained elsewhere in this report).

We are focused on preserving our cash balances by monitoring expenses, identifying cost savings, and investing only in those development programs and products that we believe will most likely contribute to our profitability. As we execute our current strategy, however, we may require debt and/or equity capital to fund our working capital needs and requirements for capital equipment to support our manufacturing and inspection processes. In particular, we have experienced negative operating cash flow in the past, especially as we procure long-lead time materials to satisfy our backlog, which can be subject to extensive variability. We believe that if we need additional capital to fund our operations, we can borrow against our revolving loan with MBT.

Surplus Capital Investment Policy

During fiscal 2013, our Board approved a Surplus Capital Investment Policy (the “Policy”) that provides, among other items, for the following:

The Investment Committee is comprised of Messrs. Swenson (Chair), Cabillot, and Van Kirk.

The Investment Committee approved each of the investments comprising the $4.9 million of marketable public equity securities held at June 30, 2020, which amount includes unrealized holding losses in the amount of $1.6 million at June 30, 2020.

In December 2019, our Board approved a new share repurchase program authorizing us to repurchase up to 1 million shares of our common stock, as the prior repurchase plan, authorized by our Board in 2013, authorizing the repurchase of 750,000 shares of common stock was nearing completion. In accordance with, and as part of, these share repurchase programs, our Board has approved the adoption of several prearranged share repurchase plans intended to qualify for the safe harbor Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (“10b5-1 Plan” or “Plan”).

During the fiscal year ended June 30, 2020, we repurchased 231,274 shares at an aggregate cost, inclusive of fees under the Plan, of $3.4 million. During the fiscal year ended June 30, 2019, we repurchased 322,068 shares at an aggregate cost, inclusive of fees under the Plan, of $4.0 million. On a cumulative basis, we have repurchased a total of 819,325 shares under the share repurchase programs at an aggregate cost, inclusive of fess under the Plan, of $8.5 million. All repurchases under the 10b5-1 Plans were administered through an independent broker.

Recent Accounting Pronouncements

On July 1, 2019, we adopted ASU 2016-02, (Topic 842) “Leases,” using a modified retrospective approach through a cumulative effect adjustment to retained earnings as of the beginning of fiscal 2020. The objective of this update is to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The impact of adoption was an increase to long-term assets and total liabilities each in the amount of approximately $3.3 million as of July 1, 2019.

On July 1, 2018, we adopted ASU 2014-09, (Topic 606) "Revenue from Contracts with Customers." This guidance outlines a single, comprehensive model of accounting for revenue from contracts with customers. We adopted the standard using the modified retrospective transition method, under which prior periods were not revised to reflect the impacts of the new standard. Our revenue is primarily generated from the sale of finished product to customers. Those sales predominantly contain a single delivery element and revenue is recognized at a single point in time when ownership, risks and rewards transfer. We also perform services when we are engaged to design a product for a customer and there is more judgment involved in determining the amount and timing of revenue recognition under those types of contracts. In fiscal 2020, the revenue from these activities represented approximately 2% of total revenue. Accordingly, the timing of revenue recognition is not materially impacted by the new standard.

No other new accounting pronouncement issued or effective during the fiscal year had or is expected to have a material impact on our Financial Statements.

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

PRO-DEX, INC.

INDEX TO FINANCIAL STATEMENTS

Page

Report of Independent Registered Public Accounting Firm 24

Financial Statements:

Statements of Shareholders’ Equity, Years Ended June 30, 2020 and 2019 27

Statements of Cash Flows, Years Ended June 30, 2020 and 2019 28

Notes to Financial Statements 30

Report of Independent Registered Public Accounting Firm

To the Shareholders and the Board of Directors

Pro-Dex, Inc.

Opinion on the Financial Statements

We have audited the accompanying balance sheets of Pro-Dex, Inc. (the “Company”) as of June 30, 2020 and 2019, the related statements of operations and comprehensive income, shareholders’ equity and cash flows for each of the two years in the period ended June 30, 2020, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of June 30, 2020 and 2019, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

Change in Accounting Principle

As disclosed in Note 2 to the financial statements, the Company changed its method of accounting for leases for the year ended June 30, 2020, due to the adoption of Accounting Standards Codification Topic No. 842.

Basis for Opinion

These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.

Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ Moss Adams LLP

Moss Adams LLP

Irvine, California

We have served as the Company’s auditor since 2003.

PRO-DEX, INC.

BALANCE SHEETS

(In thousands, except share data)

ASSETS

Current assets:

Cash and cash equivalents $ 6,421 $ 7,742

Prepaid expenses and other current assets 145 623

Plant, equipment and leasehold improvements, net 2,686 2,726

Right of use asset, net 2,943 —

Deferred income taxes, net 259 260

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current liabilities:

Note payable and capital lease obligations 651 622

Non-current liabilities:

Deferred rent — 146

Lease liability, net of current portion 2,750 —

Notes and capital lease payable, net of current portion 3,283 3,934

Total non-current liabilities 6,837 4,242

Commitments and Contingencies:

Shareholders’ equity:

Accumulated other comprehensive loss (1,586 ) (549 )

Total liabilities and shareholders’ equity $ 31,126 $ 25,520

See notes to financial statements.

PRO-DEX, INC.

STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME

(In thousands, except per share data)

Years Ended June 30,

Operating (income) expenses:

General and administrative expenses 3,189 2,492

Gain on disposal of equipment (5 ) (7 )

Research and development costs 2,315 1,882

Other income (expense):

Interest and dividend income 95 268

Gain on sale of investments 25 356

Other comprehensive loss, net of tax:

Basic & Diluted income per share:

Basic net income per share $ 1.56 $ 0.99

Diluted net income per share $ 1.50 $ 0.97

Weighted-average common shares outstanding:

See notes to financial statements.

PRO-DEX, INC.

STATEMENTS OF SHAREHOLDERS’ EQUITY

For The Years Ended June 30, 2020 and 2019

(In thousands, except share data)

Common Shares Accumulated Other Retained Earnings/

Number of Comprehensive (Accumulated

Shares Amount Income (Loss) Deficit) Total

Exercise of stock options 3,000 6 — — 6

Shares issued in connection with performance award vesting 40,000 — — — —

Share-based compensation — 37 — — 37

Cumulative effect of change in accounting principle 42 42

Share-based compensation — 286 — — 286

See notes to financial statements.

PRO-DEX, INC.

STATEMENTS OF CASH FLOWS

(In thousands)

Years Ended June 30,

CASH FLOWS FROM OPERATING ACTIVITIES:

Depreciation and amortization 573 438

Gain on collection of note receivable (952 ) —

Gain on sale of investments (25 ) (356 )

Non-cash lease expense 41 —

Gain on sale or disposal of equipment (5 ) (7 )

Amortization of loan fees 9 7

Share-based compensation 286 37

Deferred income taxes (22 ) 1,418

Bad debt expense (recovery) 6 (14 )

Changes in operating assets and liabilities:

Prepaid expenses and other assets 476 (326 )

Accounts payable, accrued expenses and deferred rent 604 1,133

Deferred revenue (15 ) 184

Income taxes payable 642 39

Net cash provided by operating activities 4,945 3,326

CASH FLOWS FROM INVESTING ACTIVITIES:

Purchases of equipment and leasehold improvements (519 ) (1,387 )

Proceeds from dividend reclassified as return of principal 15 23

Proceeds from sale of equipment 5 7

Proceeds from collection of notes receivable 952 1,219

Proceeds from sale of investments 128 1,905

Increase in intangibles (46 ) (11 )

Purchase of investments (2,822 ) (2,978 )

Net cash used in investing activities (2,287 ) (1,222 )

CASH FLOWS FROM FINANCING ACTIVITIES:

Principal payments on capital lease and note payable (630 ) (433 )

Borrowing from Minnesota Bank & Trust, net of loan origination fees — 4,940

Repurchases of common stock (3,388 ) (3,984 )

Payments of employee taxes on net issuance of common stock — (101 )

Proceeds from exercise of stock options and ESPP contributions 39 28

Net cash provided by (used in) financing activities (3,979 ) 450

Net increase (decrease) in cash and cash equivalents (1,321 ) 2,554

Cash and cash equivalents, beginning of year 7,742 5,188

Cash and cash equivalents, end of year $ 6,421 $ 7,742

See notes to financial statements.

PRO-DEX, INC.

STATEMENTS OF CASH FLOWS - CONTINUED

(In thousands)

Years Ended June 30,

Supplemental disclosures of cash flow information:

Cash paid during the period for:

Income taxes, net of refunds $ 683 $ 320

See notes to financial statements.

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

1. DESCRIPTION OF BUSINESS

We specialize in the design, development and manufacture of autoclavable, battery-powered and electric, multi-function surgical drivers and shavers used primarily in the orthopedic, thoracic, and maxocranial facial markets. We have patented adaptive torque-limiting software and proprietary sealing solutions which appeal to our customers, primarily medical device distributors. We also manufacture and sell rotary air motors to a wide range of industries.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The summary of significant accounting policies presented below is designed to assist the reader in understanding our financial statements. Such financial statements and related notes are the representations of management, who is responsible for their integrity and objectivity. In the opinion of management, these accounting policies conform to accounting principles generally accepted in the United States of America (“U.S. GAAP”) in all material respects, and have been consistently applied in preparing the accompanying financial statements.

Revenue Recognition

Revenue from product sales is recognized as promulgated by the Financial Accounting Standards Board (“FASB”) in Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers once our contract(s) with a customer and the performance obligations in the contract have been identified, and the transaction price has been allocated to the performance obligations and revenue is recorded when (or as) we satisfy each performance obligation, generally upon shipment.

Revenue from services, typically non-recurring engineering services related to the design or customization of a medical device, is typically recognized over-time.

Returns of our product for credit are minimal; accordingly, we do not establish a reserve for product returns at the time of sale.

Estimated Losses on Product Development Services

Warranties

Certain of our products are sold with a warranty that provides for repairs or replacement of any defective parts for a period, generally one to two years, after the sale. At the time of the sale, we accrue an estimate of the cost of providing the warranty based on prior experience with such factors as return rates and repair costs, which factors are reviewed quarterly.

The warranty accrual is based on historical costs of warranty repairs and expected future identifiable warranty expenses, and is included in accrued expenses in the accompanying balance sheets. Warranty expenses are included in cost of sales in the accompanying statements of operations. Changes in estimates to previously established warranty accruals result from current period updates to assumptions regarding repair costs and warranty return rates, and are included in current period warranty expense.

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

Cash and Cash Equivalents

We consider all highly liquid investments with an original maturity of ninety days or less to be cash equivalents. At June 30, 2020 and 2019, cash equivalents consisted of investments in money market funds.

Accounts Receivable

Trade receivables are stated at their original invoice amounts, less an allowance for doubtful portions of such accounts. Management determines the allowance for doubtful accounts based on facts and circumstances related to specific accounts and the age of accounts. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously reserved are offset against the allowance when received.

Deferred Costs

Deferred costs reflect costs incurred related to non-recurring engineering services under the terms of the related development and/or supply contracts. These costs get recorded to cost of sales in the period that the revenue is recognized.

Inventories

Inventories are stated at the lower of cost (first-in, first-out method) or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Reductions to estimated market value are recorded, and charged to cost of sales, when indicated based on a formula that compares on-hand quantities to both historical usage and estimated demand over the ensuing 12 months from the measurement date. On an on-going basis, we evaluate inventory for obsolescence and slow-moving items. This evaluation includes analysis of historical sales and usage, existing demand, as well as specific factors known to management. As of June 30, 2020 and 2019, there was approximately $303,000 and $276,000, respectively, of inventory in-transit.

Investments

Investments at June 30, 2020 and 2019, consist of marketable equity securities of publicly held companies. The investments were made to realize a reasonable return, although there is no assurance that positive returns will be realized. Investments are marked to market at each measurement date, with unrealized gains and losses, net of income taxes, presented as adjustments to accumulated other comprehensive income or loss. Our long-term investments consist of common stocks of public companies that are thinly traded. These investments were subject to an independent valuation as of June 30, 2020.

Long-lived Assets

Equipment and leasehold improvements are recorded at historical cost and depreciation is provided using the straight-line method over the following periods:

Equipment Three to ten years

Intangibles

Intangibles consist of legal fees incurred in connection with patent applications. Certain of our patent costs are being amortized over a period of seven years, the estimated life of the product that is currently utilizing the patented technology. The remaining patent costs will be amortized over the estimated life of the product(s) that will be utilizing the technology or expensed immediately in the event the patent office denies the issuance of the patent. The expense associated with the amortization of the patent costs is recognized in research and development costs.

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

Income Taxes

We recognize deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities along with net operating losses and tax credit carryovers. Deferred tax assets at both June 30, 2020 and 2019, consisted primarily of basis differences related to unrealized gain/loss related to investments, fixed assets, accrued expenses, and inventories.

Significant management judgment is required in determining the provision for income taxes and the recoverability of deferred tax assets. Such determination is based on historical taxable income, with consideration given to estimates of future taxable income and the periods over which deferred tax assets will be recoverable. We record a valuation allowance against deferred tax assets to reduce the net carrying value to an amount that we believe is more likely than not to be realized. When we establish or reduce the valuation allowance against deferred tax assets, the provision for income taxes will increase or decrease, respectively, in the period such determination is made.

Uncertain Tax Positions

We record uncertain tax positions in accordance with Accounting Standards Codification (“ASC”) 740 on the basis of a two-step process whereby (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position, and (2) for those tax positions that meet the more-likely-than-not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority.

Shipping and Handling

Payments from customers for shipping and handling are included in net sales. Shipping expenses, consisting primarily of payments made to freight companies, are included in cost of sales.

Concentration of Credit Risk

Financial instruments that potentially subject us to credit risk consist principally of cash, cash equivalents, and trade receivables. We place our cash and cash equivalents with major financial institutions. At June 30, 2020 and 2019, and throughout the fiscal years then ended, we had deposits in excess of federally insured limits. Credit sales are made to original equipment manufacturers and resellers throughout the world, and sales to such customers account for a substantial portion of our trade receivables. While such receivables are not collateralized, we evaluate their collectability based on several factors including customers’ payment histories.

Compensation Plans

We recognize compensation expense for the share-based awards that vest subject to market conditions under ASC 718, Compensation-Stock Compensation by estimating their fair value using a Monte Carlo simulation. The fair value using a Monte Carlo simulation model is affected by assumptions regarding a number of complex judgments including expected stock price volatility, risk free interest rates, and the forecasted future value and trading volume of our stock. The awards are considered granted for accounting purposes on the date the awards were approved by the Compensation Committee and we recognize compensation expense, based on the estimated fair value of the award, on a straight-line basis over the requisite service period.

Use of Estimates

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

Our operations are affected by numerous factors including market acceptance of our products, changes in technologies, and new laws, government regulations, and policies. We cannot predict what impact, if any, the occurrence of these or other events might have on our operations. Significant estimates and assumptions made by management include, but are not limited to, revenue recognition, share-based compensation, the allowance for doubtful accounts, accrued warranty expense, inventory valuation, the carrying value of long-lived assets, the recoverability of notes receivable, and the recovery of deferred income tax assets.

Basic and Diluted Per Share Information

Basic per share amounts are computed on the basis of the weighted-average number of common shares outstanding during each period presented. Diluted per share amounts assume the issuance of all potential common stock equivalents, consisting of outstanding stock options and performance awards as discussed in Note 9, unless the effect of such exercise is to increase income, or decrease loss, per common share.

Fair Value Measurements

Fair value is measured based on the prices that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are based on a three-tier hierarchy that prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions.

Cash and cash equivalents: The carrying value of cash and cash equivalents is considered to be representative of their fair values based on the short-term nature of these instruments. As such, cash and cash equivalents are classified within Level 1 of the valuation hierarchy.

Investments: Investments consist of marketable equity securities of publicly held companies. As such, most of our investments are classified within Level 1 of the valuation hierarchy. Our long-term marketable securities consist of investments of common stock of publicly traded companies that are thinly traded. Due to the thinly traded nature of these stocks they are classified within Level 2 of the valuation hierarchy. The fair value of these investments was based upon an independent valuation.

Although the methods above may produce a fair value calculation that may not be indicative of the net realizable value or reflective of future fair values, we believe our valuation methods are appropriate.

Advertising

Advertising costs are charged to selling or general and administrative expense as incurred and amounted to $1,000 and $2,000 for the fiscal years ended June 30, 2020 and 2019, respectively.

Recently Adopted Accounting Standards

On July 1, 2019, we adopted ASU 2016-02, (Topic 842) “Leases,” using a modified retrospective approach through a cumulative effect adjustment to retained earnings in the amount of $42,000 as of the beginning of fiscal 2020. The objective of this update is to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The impact of adoption was an increase to long-term assets and total liabilities of approximately $3.3 million as of July 1, 2019.

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

Effective July 1, 2018, we adopted new revenue recognition guidance issued by the FASB related to contracts with customers. Under ASU 2014-09, (Topic 606) “Revenue From Contracts with Customers,” we recognize revenue from the sales of products and services by applying the following steps: (1) identify the contract with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to each performance obligation in the contract; and (5) recognize revenue when each performance obligation is satisfied. We utilized the modified retrospective method of adoption and there was no impact on our financial statements as a result of adopting Topic 606 for the year ended June 30, 2019. We primarily sell finished products and recognize revenue at point of sale or delivery and the timing of revenue recognition has not changed with the adoption of the new guidance. However, we also perform services when we are engaged to design a product for a customer and there is more judgment involved in determining the amount and timing of revenue recognition under those types of contracts. In order to disclose the amount of revenue related to these services, where more judgment is required, we have added “NRE & Prototypes” to our net sales table included under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this report, which in our prior reports had been reflected in “Medical device and services”.

Reclassifications

We have reclassified certain of our marketable equity securities from current to long-term, to conform to the current year presentation, as we have concluded that these marketable securities are thinly traded. This balance sheet reclassification had no impact on our net income.

3. COMPOSITION OF CERTAIN FINANCIAL STATEMENT ITEMS

Investments

Investments are stated at market value and consist of the following (in thousands):

Marketable equity securities – short-term $ 2,560 $ 1,711

Marketable equity securities – long-term 2,360 1,520

Total Marketable equity securities $ 4,920 $ 3,231

Investments at June 30, 2020 and 2019, had an aggregate cost basis of $6,483,000 and $3,780,000, respectively. The long-term investments include equity securities of public companies that are thinly traded and therefore we classified the assets as long term in nature because even if we decide to sell the stocks we may not be able to sell our position within one year. At June 30, 2020, the investments included net unrealized losses of $1,563,000 (gross unrealized losses of $1,703,000 offset by gross unrealized gains of 140,000). At June 30, 2019, the investments included gross unrealized losses of $549,000 and no unrealized gains.

Of the total long-term marketable equity securities at June 30, 2020 and 2019, $847,000 and $938,000, respectively, represent an investment in the common and preferred stock of Air T, Inc. Two of our Board members Messrs. Swenson and Cabillot, are also Board members of Air T, Inc. and both either individually or through affiliates own an equity interest in Air T, Inc. Mr. Swenson, our Chairman, also serves as the chief executive officer and chairman of Air T, Inc. The shares have been purchased through 10b5-1 Plans, which in accordance with our internal policies regarding the approval of related-party transactions, was approved by our three Board members that are not affiliated with Air T, Inc.

We invest surplus cash from time to time through our Investment Committee, which is comprised of one management director, Mr. Van Kirk, and two non-management directors, Mr. Cabillot and Mr. Swenson, who chairs the committee. Both Mr. Cabillot and Mr. Swenson are active investors with extensive portfolio management expertise. We leverage the experience of these committee members to make investment decisions for the investment of our surplus operating capital or borrowed funds. Additionally, many of our securities holdings include stocks of public companies that either Messrs. Swenson or Cabillot or both may own from time to time either individually or through the investment funds that they manage, or other companies whose boards they sit on, such as Air T, Inc.

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

Inventory

Inventory is stated at the lower of cost (first-in, first-out) or net realizable value and consists of the following (in thousands):

Raw materials /purchased components $ 4,241 $ 3,132

Sub-assemblies /finished components 1,438 1,524

Equipment and Leasehold Improvements

Equipment and leasehold improvements consist of the following (in thousands):

Office furnishings and fixtures $ 2,143 $ 2,067

Less: accumulated depreciation and amortization (7,219 ) (6,757 )

Depreciation expense for the years ended June 30, 2020 and 2019, amounted to $559,000 and $416,000, respectively. During fiscal 2020, fully depreciated assets in the amount of $58,000 were retired and an additional $39,000 of fully depreciated assets were sold. During fiscal 2019, fully depreciated assets in the amount of $103,000 were retired and an additional $280,000 of fully depreciated assets were sold.

Intangibles

Intangibles consist of the following (in thousands):

Patent-related costs $ 222 $ 175

Less accumulated amortization (60 ) (46 )

Amortization expense for the years ended June 30, 2020 and 2019, amounted to $14,000 and $22,000, respectively.

Patent-related costs consist of legal fees incurred in connection with both patent applications and a patent issuance, and will be amortized over the estimated life of the product(s) that is or will be utilizing the technology, or expensed immediately in the event the patent office denies the issuance of the patent. Since we do not know when, or if, our patent applications will be issued, the future amortization expense is not predictable.

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

Accrued Liabilities

Accrued liabilities consist of the following (in thousands):

Payroll and related items $ 689 $ 480

Accrued inventory in transit 303 276

Accrued legal and professional fees 141 130

Current portion of lease liability 339 —

Accrued losses on development contracts — 83

Accrued sales, use and excise taxes 7 2

4. WARRANTY ACCRUAL

Information relating to the accrual for warranty costs for the years ended June 30, 2020 and 2019, is as follows (in thousands):

Balance at beginning of year $ 136 $ 107

Accruals during the year 204 119

Change in estimates of prior period accruals (27 ) (18 )

Warranty amortization (100 ) (72 )

Balance at end of year $ 213 $ 136

Warranty expense relating to new product sales and changes to estimates was $177,000 and $101,000, respectively, for the fiscal years ended June 30, 2020 and 2019.

5. INCOME TAXES

On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”). The CARES Act, among other things, includes provisions relating to refundable payroll tax credits, deferment of employer side social security payments, net operating loss carryback periods, alternative minimum tax credit refunds, modifications to the net interest deduction limitations, and technical corrections to tax depreciation methods for qualified improvement property (“QIP”). Under ASC 740, the effects of new legislation are recognized upon enactment.

As of June 30, 2020, we have, as a result of the technical amendments made by the CARES Act to QIP, accelerated tax depreciation expenses of approximately $94,000, which represents favorable temporary book-to-tax timing differences (i.e., no effective tax rate impact) for income tax purposes and are recorded as components within our deferred income tax assets and income tax receivable, included in prepaid expenses and other current assets, on our balance sheets. We do not expect the other provisions of the CARES Act to materially impact our business or our tax provision. The provision for income taxes consists of the following amounts (in thousands):

Years Ended June 30,

Current:

Deferred:

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

The effective income tax rate from income (loss) from continuing operations differs from the United States statutory income tax rates for the reasons set forth in the table below (in thousands, except percentages).

Years Ended June 30,

Amount Percent Pretax Income Amount Percent Pretax Income

State tax, net of federal benefit 440 6 % 281 5 %

Tax incentives (85 ) (1 %) (85 ) (1 %)

Change in valuation allowance (227 ) (3 %) 11 —

Tax law changes — — (8 ) —

Domestic production deduction — — 8 —

Other 3 — (43 ) (1 %)

Deferred income taxes reflect the net effects of loss and credit carryforwards and temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets and liabilities for federal and state income taxes are as follows (in thousands):

Deferred tax assets:

Federal & state NOL carryforward $ 21 $ 23

Research & other credits 65 347

Stock based compensation 110 9

Unrealized losses 455 —

Other intangibles — 37

Total gross deferred tax assets $ 1,423 $ 1,351

Less: valuation allowance (543 ) (477 )

Total deferred tax assets 880 874

Deferred tax liabilities:

Deferred state tax (33 ) (81 )

Other (11 ) (6 )

Total gross deferred tax liabilities (621 ) (614 )

Net deferred tax assets $ 259 $ 260

Realization of our deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. As of June 30, 2020, our deferred tax asset valuation allowance primarily consists of unrealized capital loss for investments held and the state net operating loss carryforwards for states in which we have filed a final return. For the year ended June 30, 2020, we recorded a net increase to our valuation allowance of $66,000, on the basis of management’s reassessment of the amount of our deferred tax assets that are more likely than not to be realized.

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

As of June 30, 2020, we did not have any net operating losses for federal and state income tax purposes for state jurisdictions in which we currently operate. We have no federal research and development and alternative minimum tax credit carry forwards at June 30, 2020. State tax research credit carry forwards at June 30, 2020, amount to $65,000, the majority of which do not expire.

As of June 30, 2020, we have accrued $524,000 of unrecognized tax benefits related to federal and state income tax matters that would reduce our income tax expense if recognized. If we are eventually able to recognize our uncertain tax positions, our effective tax rate would be reduced. Any adjustment to our uncertain tax positions would result in an adjustment of our tax credit carryforwards rather than resulting in a cash outlay.

Information with respect to our accrual for unrecognized tax benefits is as follows (in thousands):

Unrecognized tax benefits:

Additions based on federal tax positions related to the current year 15 11

Additions based on state tax positions related to the current year 13 11

Additions for tax positions of prior years 55 6

Reductions due to lapses in statutes of limitation (49 ) —

Although it is reasonably possible that certain unrecognized tax benefits may increase or decrease within the next twelve months due to tax examinations, settlement activities, expirations of statute of limitations, or the impact on recognition and measurement considerations related to the results of published tax cases or other similar activities, we do not anticipate any significant changes to unrecognized tax benefits over the next twelve months.

We recognize accrued interest and penalties related to unrecognized tax benefits in income tax expense when applicable. As of June 30, 2020, no interest or penalties applicable to our unrecognized tax benefits have been accrued since we have sufficient tax attributes available to fully offset any potential assessment of additional tax.

We are subject to U.S. federal income tax, as well as income tax of California, Maryland, Massachusetts, and Colorado. We are currently open to audit under the statute of limitations by the Internal Revenue Service for the years ended June 30, 2017, and later. However, because of our prior net operating losses and research credit carryovers, substantially all of our tax years are open to audit.

6. NOTES PAYABLE AND FINANCING TRANSACTIONS

Minnesota Bank & Trust

On September 6, 2018, we entered into a Credit Agreement with Minnesota Bank & Trust, a Minnesota state banking corporation (“MBT”), providing for a $5,000,000 term loan (the “Term Loan”) as well as a $2,000,000 revolving loan (the “Revolving Loan” and together with the Term Loan, collectively the “Loans”), evidenced by a Term Note A and a Revolving Credit Note made by us in favor of MBT. The Loans are secured by substantially all of our assets pursuant to a Security Agreement entered into on September 6, 2018, between us and MBT. We paid loan origination fees to MBT in the amount of $60,000, which is being amortized to loan fees over the term of the underlying debt.

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

The Term Loan matures on October 1, 2025, and bears interest at a fixed rate of 5.53% per annum. An initial payment of interest only in the amount of $18,433 was paid on October 1, 2018. Commencing November 1, 2018 and continuing on the first day of each subsequent month thereafter until the maturity date, we are required to make payments of principal and interest on the Term Loan of approximately $72,000, plus any additional accrued and unpaid interest through the date of payment. The balance owed on the Term Loan at June 30, 2020, is $3.9 million, net of unamortized loan fees. The Revolving Loan matures on November 6, 2020, unless earlier terminated pursuant to its terms and bears interest at the greater of (a) 4.5% or (b) the difference of the prime rate as published in the Money Rates section of the Wall Street Journal minus 0.50%. Commencing on the first day of each month after we initially borrow against the Revolving Loan, which we have yet to do, and each month thereafter until maturity, we are required to pay all accrued and unpaid interest on the Revolving Loan through the date of payment. Any principal on the Revolving Loan that is not previously prepaid shall be due and payable on the maturity date (or earlier termination of the Revolving Loan).

Any payment on the Loans not made within seven days after the due date is subject to a late payment fee equal to 5% of the overdue amount. Upon the occurrence and during the continuance of an event of default, the interest rate of both Loans will be increased by 3% and MBT may, at its option, declare the Loans immediately due and payable in full.

The Credit Agreement and Security Agreement contain representations and warranties, affirmative, negative and financial covenants, and events of default that are customary for loans of this type.

Scheduled maturities of our Term Loan, exclusive of unamortized loan origination fees, for future fiscal years ending June 30 are as follows (in thousands):

Term Loan Payments

Fiscal Year:

Total principal payments $ 3,978

Jules & Associates/Hitachi Capital America Corporation

On July 21, 2016, we entered a master equipment lease agreement with Jules and Associates, Inc. to lease a specific machine used in our inspection process. The cost of the equipment was approximately $106,000 and the lease provided for 36 monthly payments in the amount of $3,121, as well as interim rent in the amount of $7,388. The lease was subsequently assigned to Hitachi Capital America Corporation. The lease was paid off in full during the first quarter of fiscal 2020.

7. LEASES

Effective July 1, 2019, we adopted the new lease accounting standard using the modified retrospective method of applying the new standard at the adoption date. In addition, we elected the practical expedient which allowed us to carry forward the historical lease classification of our sole operating lease for our corporate office, which includes our manufacturing and research and development facilities. Adoption of this standard resulted in the recording of net operating lease right-of-use (“ROU”) asset and corresponding operating lease liability each in the amount of $3.3 million. Our financial position for reporting periods beginning on or after July 1, 2019, is presented under the new guidance, while prior period amounts are not adjusted and continue to be reported in accordance with previous guidance.

PRO-DEX, INC.

NOTES TO FINANCIAL STATEMENTS

Our operating lease ROU asset and long-term liability are presented separately on our balance sheet. The current portion of our operating lease liability, exclusive of imputed interest, as of June 30, 2020, in the amount of $339,000, is presented within accrued expenses on the balance sheet. As of June 30, 2020, the maturity of our lease liability is as follows:

Operating Lease

Fiscal Year:

Total lease payments 3,783

Less imputed interest: (694 )

As of June 30, 2020, our operating lease has a remaining lease term of seven years and three months and an imputed interest rate of 5.3%. Cash paid for amounts included in the lease liability for the year ended June 30, 2020, was $461,000. As previously disclosed in our 2019 Annual Report on Form 10-K and under the previous lease accounting standard, future minimum lease payments for our only operating lease having an initial or remaining noncancellable lease term in excess of one year would have been as follows:

Operating Leases at June 30, 2020

Fiscal Year:

Total minimum lease payments $ 3,783

8. COMMITMENTS AND CONTINGENCIES

Leases

We lease our office, production and warehouse facility in Irvine, California, (our “corporate office”) under an agreement that expires in September 2027. Our corporate office lease requires us to pay insurance, taxes, and other expenses related to the leased space.

Rent expense in fiscal 2020 and 2019 was $561,000 and $548,000, respectively.

Compensation Arrangements

Retirement Savings 401(k) Plan

The Pro-Dex, Inc. Retirement Savings 401(k) Plan (the “401(k) Plan”) is a defined contribution plan we administer that covers substantially all our employees and is subject to the provisions of the Employee Retirement Income Security Act of 1974, as amended. Employees are eligible to participate in the 401(k) Plan when they have attained 19 years of age and then can enter into the 401(k) Plan on the first day of each calendar quarter. Participants are eligible to receive non-discretionary matching contributions by the Company equal to 25% of their contributions up to 5% of eligible compensation. For the fiscal years ended June 30, 2020 and 2019, we recognized compensation expense amounting to $67,000 and $42,000, respectively, in connection with the 401(k) Plan. During our fiscal year ended June 30, 2020 and 2019, we used approximately $7,000 and $16,000, respectively, of forfeited match contributions to reduce our match expense.

PRO-DEX, INC.

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