Apyx Medical Corp: Form 10-Q for the period ended Mar 31, 2010

Cautionary Notes Regarding “Forward-Looking” Statements

This report contains statements that we believe to be “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements give our current expectations or forecasts of future events. Forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “project,” or “continue,” or similar words or the negative thereof. From time to time, we also may provide oral or written forward-looking statements in other materials we release to the public. Any or all of our forward-looking statements in this report and in any public statements we make could be materially different from actual results. They can be affected by assumptions we might make or by known or unknown risks or uncertainties. Consequently, we cannot guarantee any forward-looking statements. Investors are cautioned not to place undue reliance on any forward-looking statements. Investors should also understand that it is not possible to predict or identify all such factors and should not consider the following list to be a complete statement of all potential risks and uncertainties. The following factors and those discussed in ITEM 1A, Risk Factors, included in our Annual Report on Form 10-K for the year ended December 31, 2009, may affect the achievement of forward-looking statements:

• general economic and political conditions, such as political instability, credit market uncertainty, the rate of economic growth or decline in our principal geographic or product markets or fluctuations in exchange rates; continued deterioration in or stabilization of the global economy;
• changes in general economic and industry conditions in markets in which we participate, such as:
• continued deterioration in or destabilization of the global economy;
• the strength of product demand and the markets we serve;
• the intensity of competition, including that from foreign competitors;
• pricing pressures;
• the financial condition of our customers;
• market acceptance of new product introductions and enhancements;
• the introduction of new products and enhancements by competitors;
• our ability to maintain and expand relationships with large customers;
• our ability to source raw material commodities from our suppliers without interruption and at reasonable prices; and
• our ability to source components from third parties, in particular from foreign manufacturers, without interruption and at reasonable prices;
• our ability to access capital markets and obtain anticipated financing under favorable terms;
• our ability to identify, complete and integrate acquisitions successfully and to realize expected synergies on our anticipated timetable;
• changes in our business strategies, including acquisition, divestiture and restructuring activities;
• changes in operating factors, such as continued improvement in manufacturing activities, the achievement of related efficiencies and inventory risks due to shifts in market demand;
• our ability to generate savings from our cost reduction actions;
• unanticipated developments that could occur with respect to contingencies such as litigation, intellectual property matters, product liability exposures and environmental matters; and
• our ability to accurately evaluate the effects of contingent liabilities.

The foregoing factors are not exhaustive, and new factors may emerge or changes to the foregoing factors may occur that would impact our business. We assume no obligation, and disclaim any duty, to update the forward-looking statements in this report. Past performance is no guaranty of future results.

Overview

We are a medical device company engaged in the manufacturing and marketing of electrosurgical devices. Our medical products include a wide range of devices including electrosurgical generators and accessories, cauteries, medical lighting, nerve locators and other products.

We internally divide our operations into three product lines. Electrosurgical products, battery operated cauteries and other products. The electrosurgical line sells electrosurgical products which include desiccators, generators, electrodes, electrosurgical pencils and various ancillary disposable products. These products are used in surgery for the cutting and coagulation of tissue. Battery operated cauteries are used for precise hemostasis (to stop bleeding) in ophthalmology and in other fields. Our other revenues are derived from nerve locators, disposable and reusable penlights, medical lighting, license fees, development fees and other miscellaneous income.

Most of our products are marketed through medical distributors, which distribute to more than 6,000 hospitals, and to doctors and other health-care facilities. New distributors are contacted through responses to our advertising in international and domestic medical journals and domestic or international trade shows. International sales represented 23.0% of total revenues in for the first three months of 2010 as compared with 18.5% in for the first three months of 2009. Our products are sold in more than 150 countries through local dealers which are coordinated by sales and marketing personnel at the Clearwater, Florida facility. Our business is generally not seasonal in nature.

Our ten largest customers accounted for approximately 67.7% and 72.9% of net revenues for the first three months of 2010 and 2009 respectively. At March 31, 2010 and 2009, our ten largest trade receivables accounted for approximately 65.8% and 71.2% of our net receivables, respectively. In the first three months of 2010 and 2009 one customer accounted for 14.2% and 30% of total sales, respectively.

Our business is generally not seasonal in nature.

Results of Operations –

Sales

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Sales for the first quarter 2010 decreased approximately $1.62 million or 22.4% compared to the same period in 2009. This decrease was due to the following reasons:

• sales of generators were down approximately $487,000 or 15.6% due to lower OEM sales and capital expenditures by domestic hospitals and doctor’s offices in the current economy;
• sales of electrosurgical disposables were down approximately $1.1 million or 49.7% mainly due to a reduction in sales of ablators to a domestic OEM customer; and
• Other product sales decreased by approximately $112,000 or 19.6% mainly due to a reduction in the sale of penlights.

These decreases were offset by the sale of cauteries, which increased approximately $79,000 or 5.5%.

Gross Profit

(in thousands)

Gross profit for the three months ended March 31, 2010 decreased by approximately $ 1.0 million or 31.2% as a percentage of sales as compared to the same period in 2009. This was the result of:

• an approximate $1.1 million decrease in sales of electrosurgical disposables, mainly due to the decrease in the sale of ablators, which have a higher than average profit margin.
• sales of generators were down approximately $487,000 or 15.6% which have an average profit margin; and
• Capitalized overhead costs for the first three months of 2009 were approximately $145,000 higher than the same period in 2010.

Research and Development Expense

(in thousands)

Research and development expense increased approximately $18,000 or 3.9% in the first quarter of 2010 from 2009. This increase was primarily a result of:

• a $38,000 increase in staffing costs to support J-Plasma product line and other new product; and
• a $105,000 increase in consulting costs related to the Seal-N-Cut product line

These increases were partially offset by a reduction of approximately $123,000 in R & D costs at our Canadian facility as result of our plan to consolidate the Canadian operation to our Florida facility.

Professional Fees

(in thousands)

Professional fees decreased approximately $109,000 or 24.6% in the first quarter of 2010 compared to the same period in 2009. This decrease was primarily because:

• Legal fees decreased by approximately $77,000 mainly due to the settlement of the Erbe lawsuit in late 2009; and
• Consulting fees decreased approximately $32,000 mainly due to a reduction in hours of consultant services attributable to the Erbe lawsuit along with reductions for various other consultants compared to 2009.

Salaries

(in thousands)

Salaries decreased by approximately $27,000 or 3.5% in the first quarter of 2010 compared to the same period 2009. This decrease was primarily a result of:

• a decrease of approximately $59,000 in marketing costs due to consolidating the marketing effort for the SEER, MEG and Plasma product lines; and
• a decrease of approximately $9,000 due a reduction of the administrative staff at our Canadian facility;

These decreases were offset by:

• an increase in health insurance of approximately 14,000;
• an increase in Human Resources of approximately $6,000 due to re-classifying one staff position from marketing to HR;
• an increase of approximately $6,000 in administrative costs due to stock option expense related to a new employee; and
• an increase of approximately $15,000 mainly due to the addition of our General Counsel position.

Selling, General & Administrative Expenses

(in thousands)

Selling, general and administrative costs decreased approximately $42,000 or 3.9% in the first quarter of 2010 compared to the same period of 2009. This decrease was primarily a result of:

• a $28,000 decrease in general insurance costs due to an audit premium credit;
• a $17,000 decrease in electricity costs related to cooler weather and consolidating operations in our new Clearwater facility;
• a $15,000 decrease in telephone cost due to our consolidated operations in our new Clearwater facility;
• a $4,000 decrease in water & sewer costs due to our consolidated operations in our new Clearwater facility;
• a $ 28,000 decrease in commissions related to the lower sales compared to the prior year;
• a $41,000 decrease in marketing consulting fees related to SEER and MEG product lines; and
• a $9,000 decrease in travel related costs due to reduction of sales positions.

These decreases were partially offset by:

• a $27,000 increase in property taxes related to our new facility in Clearwater, Florida;
• a $10,000 increase in bank fees and credit card discount fees due to more customers using credit cards and bank charges related to additional bank accounts;
• a $6,000 increase in royalty payments as a result of the Henvil (MEG) agreement;
• a $4,000 increase in depreciation expense;
• a $13,000 increase in regulatory expenses related to the verification process of our BOSS and Seal-N-Cut product lines;
• a $28,000 increase in building repair and maintenance and computer related expenses attributable to settling into our new facility;
• a $7,000 increase in shareholder and exchange related costs; and
• a $5,000 increase in trade show related costs.

Other Income

(in thousands)

Net interest expense increased by $111,000 or 165% in the three months ended March 31, 2010 as compared to the same period in 2009 primarily because interest of approximately $89,000 was capitalized during the quarter ended March 31 due to renovations made to our new facility.

Income Taxes

(in thousands)

For the three months ended March 31, 2010 and 2009, we recorded tax benefit for income taxes of $150,000 and a deferred tax provision of $207,000, respectively. The effective tax rates for the three months ended March 31, 2010 and 2009 were 40.0% and 33.9%, respectively.

Product Development

We have developed most of our products and product improvements internally. Funds for this development have come primarily from our internal cash flow and from the proceeds of the exercise of stock options. We maintain close working relationships with physicians and medical personnel in hospitals and universities who assist in product research and development. New and improved products play a critical role in our sales growth. We continue to emphasize the development of proprietary products and product improvements to complement and expand our existing product lines. We have a centralized research and development focus, with our Florida and Canadian manufacturing locations responsible for new product development and product improvements. Our research, development and engineering units at the manufacturing locations maintain relationships with distribution locations and customers to provide an understanding of changes in the market and product needs. During 2010, we continued to invest in ICON GS (J-Plasma technology), ICON VS, vessel sealing technology, Aaron 1450, and BOSS. We intend to pay the ongoing costs for this development from operating cash flows.

In the next year, we do not contemplate any material purchase or acquisition of assets that our ordinary cash flow and/or credit line would be unable to sustain.

Reliance on Collaborative, Manufacturing and Selling Arrangements

We depend on certain contractual OEM customers for product development. In these situations, we plan to manufacture the products developed. The customer has no legal obligation, however, to purchase the developed products. If the collaborative customer fails to give us purchase orders for the product after development, our future business and value of related assets could be negatively affected. Furthermore, we can give no assurance that a collaborative customer may give sufficient high priority to our products. In addition, disagreements or disputes may arise between us and our contractual customers, which could adversely affect production of our products. We also have informal collaborative arrangements with two foreign suppliers in which we request the development of certain items and components, and we purchase them pursuant to purchase orders. Our purchase orders are never longer than one year and are supported by orders from our customers.

Liquidity and Capital Resources

Our working capital at March 31, 2010 remained the same as December 31, 2009 at approximately $10.6 million. Accounts receivable days sales outstanding were 36.8 days and 39.5 days at March 31, 2010 and 2009 respectively. The number of days worth of sales in inventory, which is the total inventory available for production divided by the 12 month average cost of materials, increased 83 days to 260 days equating to an inventory turn ratio of 1.4 at March 31, 2010 from 172 days and an inventory turn ratio of 1.7 at December 31, 2009. The higher number of days worth of sales in inventory which translated into a lower inventory turnover rate is mainly due to the decrease in sales related to our generator product lines which contain a greater number of parts compared to all our other products.

We generated cash from operations of approximately $546,000 for the three months ended March 31, 2010, compared to approximately $252,000 for the same period of 2009, an increase of approximately $294,000.

In the three month period ended March 31, 2010 we used approximately $67,000 for the purchase of property and equipment as compared to purchases amounting to approximately $753,000 for the same period in 2009. The decrease relates to the difference between the amounts expended to refurbish our new facility in the first quarter of 2009.

We generated cash from financing activities of approximately $11,000 during the first three months of 2010, a decrease of approximately $450,000 compared with the same period in 2009. The decrease in cash from financing resulted primarily from receiving and using in 2009 the portion of industrial revenue bonds proceeds that were held in escrow.

During fiscal 2008, we borrowed $4.0 million through the issuance of industrial revenue bonds for the purchase and renovation of our new facility through RBC Bank, of which we received $2.7 million in 2008 and the remaining escrow portion of approximately $1.3 million in 2009. The bonds, which are being amortized over a 20 year term, balloon in 10 years and bear interest at a fixed interest rate of 4.6%. Scheduled maturities of this indebtedness are $135,000, $140,000, $145,000, $155,000 and $165,000 for 2010, 2011, 2012, 2013 and 2014 respectively.

We had approximately $2.6 million in cash and cash equivalents at March 31, 2010. We believe our cash on hand, as well as anticipated cash flows from operations, will be sufficient to meet our operating cash commitments for the next year. Should additional funds be required, we have secured additional borrowing capacity with RBC Bank (USA). (see below)

On December 2, 2009 RBC Bank (USA) increased our secured revolving line of credit facility to $8 million from the previous $5 million and on the same date provided us with a separate additional credit facility for up to $1 million specific to financing new equipment purchases.

Advances under the $8 million line of credit are due on demand and bear interest at a rate of LIBOR plus 2% with a minimum floor rate of 4.0% and are secured by a perfected first security interest in our inventory, accounts receivable, and equipment.

The $1 million facility related to equipment purchases provides for a 2 year draw up period followed by a 5 year term period and bears interest also at LIBOR plus 2% with a minimum floor of 4% and will be secured by a perfected first security interest in the new equipment purchased. This equipment credit facility also allows us the option of financing purchased equipment at 75% of the cost through either a traditional loan or through RBC leasing at the time of purchase.

Subsequent available borrowings for both these credit facilities is subject to a borrowing base utilizing a percentage of eligible receivables, inventories, and any assigned cash along with certain financial ratios, specifically maintaining: a ratio of debt to tangible net worth of less than 2.0 to 1.0, a ratio of total funded debt to EBITDA of less than 3.25 to 1.0 excluding the industrial revenue bond note balance which had an original principal amount of $4.0 million, and a ratio of minimum debt service coverage of 1.5 to 1.0 measured on a rolling four quarter basis.

At March 31, 2010 we were in full compliance with the loan covenants and ratios of both the credit facilities. According to our most recent borrowing base calculation we had approximately $3.6 million total availability under the $8 million credit line, of which we have a current balance of $1.0 million. We also have available all of the $1 million under the equipment line of credit.

On April 18, 2010, we entered into a Securities Purchase Agreement with certain investors who purchased common stock and warrants in a private placement pursuant to Section 4(2) of the Securities Act of 1933, as amended, and/or Regulation D promulgated. This offering, which closed on April 28, 2010, resulted in gross proceeds of approximately $3 million. (See subsequent event in ITEM 5. OTHER INFORMATION)

Our future contractual obligations for agreements with initial terms greater than one year and agreements to purchase materials in the normal course of business are summarized as follows (in thousands):

Off Balance Sheet Arrangements

We have no off balance sheet arrangements at this time.

Critical Accounting Estimates

In preparing the consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP), we have adopted various accounting policies. Our most significant accounting policies are disclosed in Note 2 to the consolidated financial statements included in our Report on Form 10-K filed in March 2010.

The preparation of the consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Our estimates and assumptions, including those related to inventories, intangible assets, property, plant and equipment, legal proceedings, research and development, warranty obligations, product liability, sales returns and discounts, and income taxes are updated as appropriate, which in most cases is at least quarterly. We base our estimates on historical experience, or various assumptions that are believed to be reasonable under the circumstances and the results form the basis for making judgments about the reported values of assets, liabilities, revenues and expenses. Actual results may materially differ from these estimates.

Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the accounting estimates are made, and (2) other materially different estimates could have been reasonably made or material changes in the estimates are reasonably likely to occur from period to period. Our critical accounting estimates include the following:

Inventory reserves

When necessary we maintain reserves for excess and obsolete inventory resulting from the potential inability to sell our products at prices in excess of current carrying costs. The markets in which we operate are highly competitive, with new products and surgical procedures introduced on an ongoing basis. Such marketplace changes may cause our products to become obsolete. We make estimates regarding the future recoverability of the costs of these products and record a provision for excess and obsolete inventories based on historical experience, and expected future trends. If actual product life cycles, product demand or acceptance of new product introductions are less favorable than projected by management, additional inventory write-downs may be required, which would unfavorably affect future operating results.

Long-lived assets

We review long-lived assets which are held and used, including property and equipment and intangible assets, for impairment whenever changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Such evaluations compare the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset over its expected useful life and are significantly impacted by estimates of future prices and volumes for our products, capital needs, economic trends and other factors that are inherently difficult to forecast. If the asset is considered to be impaired, we record an impairment charge equal to the amount by which the carrying value of the asset exceeds its fair value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique.

Share-based Compensation

Under the Company’s stock option plan, options to purchase Common Shares of the Company may be granted to key employees, officers and directors of the Company by the Board of Directors. The Company accounts for stock options in accordance with FASB ASC Topic 718, Compensation-Stock Compensation with option expense amortized over the vesting period based on the binomial lattice option-pricing model fair value on the grant date, which includes a number of estimates that affect the amount of our expense.

Income Taxes

The provision for income taxes includes federal, foreign, state and local income taxes currently payable and those deferred because of temporary differences between the financial statement and tax bases of assets and liabilities. Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using enacted marginal tax rates. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. Deferred income tax expenses or credits are based on the changes in the asset or liability from period to period.

We periodically have net operating loss and tax credit carry forwards available to reduce future taxable income. Future tax benefits for net operating loss and tax credit carry forwards are recognized to the extent that realization of these benefits is considered more likely than not. This determination is based on the expectation that related operations will be sufficiently profitable or various tax, business and other planning strategies will enable us to utilize the operating loss and tax credit carry forwards. We cannot be assured that we will be able to realize these future tax benefits or that future valuation allowances will not be required. To the extent that available evidence raises doubt about the realization of a deferred income tax asset, a valuation allowance is established.

It is our policy to provide for uncertain tax positions and the related interest and penalties based upon management’s assessment of whether a tax benefit is more likely than not to be sustained upon examination by tax authorities. To the extent that the probable tax outcome of these uncertain tax positions changes, such changes in estimate will impact the income tax provision in the period in which such determination is made. At March 31, 2010, we believe we have appropriately accounted for any unrecognized tax benefits. To the extent we prevail in matters for which a liability for an unrecognized tax benefit is established or we are required to pay amounts in excess of the liability, our effective tax rate in a given financial statement period may be affected.

Our short term investments consist of cash, cash equivalents and overnight investments. As such we do not believe we are exposed to significant interest rate risk. The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we invest in highly liquid overnight money market investments. If a 10% change in interest rates were to have occurred on March 31, 2010, this change would not have had a material effect on the fair value of our investment portfolio as of that date.

Evaluation of Disclosure Controls and Procedures

We have carried out an evaluation, under the supervision of and with the participation of our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended), as of March 31, 2010. Based upon that evaluation, our CEO and CFO concluded that, as of March 31, 2010, our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Changes in Internal Controls

There were no changes in our internal control over financial reporting during the quarter ended March 31, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

There have been no material changes to the Risk Factors previously disclosed in our Form 10K for the year ended December 31, 2009, in response to Item 1A to Part 1 of Form 10K.