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MESA LABORATORIES INC /CO - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Forward Looking Statements This report contains information that may constitute "forward-looking statements." Generally, the words "believe," "expect," "intend," "anticipate," "estimate," "project," "will" and similar expressions identify forward-looking statements, which generally are not historical in nature. However, the absence of these words or similar expressions does not mean that a statement is not forward-looking. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future - including statements relating to revenue growth and statements expressing general views about future operating results - are forward-looking statements. Management believes that these forward-looking statements are reasonable as and when made. However, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date when made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. These risks and uncertainties include, but are not limited to those described in Part II, "Item 1A. Risk Factors" and elsewhere in this report and in our Annual Report on Form 10-K for the year ended March 31, 2014, and those described from time to time in our subsequent reports filed with the Securities and Exchange Commission. General Discussion We pursue a strategy of focusing primarily on quality control products, which are sold into niche markets that are driven by regulatory requirements. We prefer markets that have limited competition where we can establish a commanding presence and achieve high gross margins. We are organized into three divisions across six physical locations. Our Instruments Division designs, manufactures and markets quality control instruments and disposable products utilized in connection with the healthcare, pharmaceutical, food and beverage, medical device, industrial hygiene, environmental air sampling and semiconductor industries. Our Biological Indicators Division manufactures and markets biological indicators and distributes chemical indicators used to assess the effectiveness of sterilization processes, including steam, gas, hydrogen peroxide, ethylene oxide and radiation, in the hospital, dental, medical device and pharmaceutical industries. Our Continuous Monitoring Division designs, develops and markets systems which are used to monitor various environmental parameters such as temperature, humidity and differential pressure to ensure that critical storage and processing conditions are maintained in hospitals, pharmaceutical and medical device manufacturers, blood banks, pharmacies and a number of other laboratory and industrial environments. We follow a philosophy of manufacturing a high quality product and providing a high level of on-going service for those products. Our revenues come from two main sources - products sales and services. Product sales are dependent on several factors, including general economic conditions, both domestic and international, customer capital spending trends, competition, introduction of new products and acquisitions. Biological indicator products are disposable and are used on a routine basis for quality control, thus product sales are less sensitive to general economic conditions. Instrument products and continuous monitoring systems have a longer life, and their purchase by our customers is somewhat discretionary, so sales are more sensitive to general economic conditions. Service demand is driven by our customers' quality control and regulatory environments, which require periodic repair and recalibration or certification of our instrument products and continuous monitoring systems. We typically evaluate costs and pricing annually. Our policy is to price our products and systems competitively and, where possible, we try to pass along cost increases in order to maintain our margins. Gross profit is affected by our product mix, manufacturing efficiencies and price competition. Historically, as we have integrated our acquisitions and taken advantage of manufacturing efficiencies, our gross margins for some of the products have improved. There are, however, differences in gross margins between different product lines, and ultimately the mix of sales will continue to impact our overall gross margin. Selling expense is driven primarily by labor costs, including salaries and commissions. Accordingly, it may vary with sales levels. Labor costs and amortization of intangible assets drive the substantial majority of general and administrative expense. Research and development expense is predominantly comprised of labor costs and third party consultants. In October 2014, we completed the PCD Acquisition whereby we acquired substantially all of the assets (other than cash and accounts receivable) and certain liabilities of PCD-LLC's business which is focused on the sale of process challenge devices ("PCD's) which are used for quality control purposes in the field of ethylene oxide sterilization of medical devices. In April 2014, we completed the BGI Acquisition whereby we acquired substantially all of the assets (other than cash and accounts receivable) and certain liabilities of BGI's business which is focused on the sale of equipment primarily used for particulate air sampling. Page 11 --------------------------------------------------------------------------------In April 2014, we completed a business combination (the "Amilabo Acquisition") whereby we acquired all of the common stock of Amilabo SAS ("Amilabo"), a distributor of our biological indicator products. In November 2013, we completed a business combination (the "TempSys Acquisition") whereby we acquired all of the common stock of TempSys, Inc. ("TempSys"), a company in the business of providing continuous monitoring systems to regulated industries. In November 2013, we completed a business combination (the "Amega Acquisition") whereby we acquired substantially all the assets and certain liabilities of Amega Scientific Corporation's ("Amega") business which provides continuous monitoring systems to regulated industries. In August 2013, we entered into an agreement whereby we sold our NuSonics product line. In July 2013, we completed a business combination (the "Suretorque Acquisition") whereby we acquired substantially all of the assets of ST Acquisitions, LLC's ("ST Acquisitions") business involving the design, manufacturing, sale and service of its SureTorque line of bottle cap torque testing instrumentation. General Trends and Outlook Our strategic objectives include growth both organically and through further acquisitions. During the year ended March 31, 2014, we continued to build our infrastructure to prepare for future growth, including the addition of key personnel to our operations, research and development, and finance teams. We also invested in upgrading our information systems and intend to continue doing so. The markets for our biological indicators remain strong, as the disposable nature of these products makes them less sensitive to general economic conditions. The worldwide market for biological indicators is growing as more countries focus on verifying the effectiveness of sterilization processes. General economic conditions over the past few years have, at times, hampered the organic growth of our instruments business, due to the discretionary nature of these products. Additionally, uncertainty about global economic conditions may cause businesses to postpone spending in response to tighter credit, unemployment, negative financial news and/or declines in income or asset values. Worldwide and regional economic conditions could also reduce the demand for our products and services, as our customers reduce or delay capital equipment and other types of purchases. Demand for our instruments products and our newly acquired continuous monitoring systems, however, is still strong and we strive to maintain or grow revenues going forward. We are working on several research and development projects that, if completed, may result in new products for both existing customers and in new markets. We are hopeful that all of our divisions will have new products available for sale in the coming year. Results of Operations The following table sets forth, for the periods indicated, condensed consolidated statements of income data. The table and the discussion below should be read in conjunction with the accompanying condensed consolidated financial statements and the notes thereto appearing elsewhere in this report (in thousands, except percent data): Three Months Ended September 30, Percent 2014 2013 Change Change Revenues $ 18,540 $ 12,676 $ 5,864 46 % Cost of revenues 7,417 5,076 2,341 46 % Gross profit $ 11,123 $ 7,600 $ 3,523 46 % Gross profit margin 60 % 60 % -- % Operating expenses Selling $ 1,342 $ 1,419 $ (77 ) (5 )% General and administrative 4,005 3,136 869 28 % Research and development 876 530 346 65 % $ 6,223 $ 5,085 $ 1,138 22 % Operating income $ 4,900 $ 2,515 $ 2,385 95 % Net income 3,060 1,932 1,128 58 % Net profit margin 17 % 15 % 2 % Page 12-------------------------------------------------------------------------------- Six Months Ended September 30, Percent 2014 2013 Change Change Revenues $ 34,940 $ 23,894 $ 11,046 46 % Cost of revenues 14,112 9,497 4,615 49 % Gross profit $ 20,828 $ 14,397 $ 6,431 45 % Gross profit margin 60 % 60 % -- % Operating expenses Selling $ 3,405 $ 2,502 $ 903 36 % General and administrative 7,841 5,222 2,619 50 % Research and development 1,627 1,115 512 46 % 12,873 $ 8,839 $ 4,034 46 % Operating income $ 7,955 $ 5,558 $ 2,397 43 % Net income 4,941 3,792 1,119 30 % Net profit margin 14 % 16 % (2 )% Revenues The following table summarizes our revenues by source (in thousands, except percent data): Three Months Ended September 30, Percent 2014 2013 Change Change Biological Indicators $ 6,441 $ 6,010 $ 431 7 % Instruments 9,065 6,666 2,399 36 % Continuous Monitoring 3,034 -- 3,034 100 % Total $ 18,540 $ 12,676 $ 5,864 46 % Six Months Ended September 30, Percent 2014 2013 Change Change Biological Indicators $ 12,858 $ 10,864 $ 1,994 18 % Instruments 16,750 13,030 3,720 29 % Continuous Monitoring 5,332 -- 5,332 100 % Total $ 34,940 $ 23,894 $ 11,046 46 % Three and six months ended September 30, 2014 versus September 30, 2013 Biological Indicators revenues for the three and six months ended September 30, 2014 increased as a result of the Amilabo Acquisition and organic growth of 7% and 10%, respectively which was achieved through existing customers, expansion into new markets and price increases. The three month period ended September 30, 2013 was positively impacted due to the fulfillment of backlog from the previous quarter end which resulted from the requirement to replace three product batches that had longer than expected incubation times. Instruments revenues for the three months ended September 30, 2014 increased as a result of the BGI Acquisition and organic growth of 10% in our existing product lines, partially offset by the disposal of the Nusonics product line. Instruments revenues for the six months ended September 30, 2014 increased as a result of the BGI Acquisition, organic growth of 8% in our existing product lines and the timing of the prior year acquisition of the Sure Torque product line, partially offset by the disposal of the Nusonics product. Page 13 -------------------------------------------------------------------------------- Gross Profit The following summarizes our gross profit by segment (in thousands, except percent data): Three Months Ended September 30, Percent 2014 2013 Change Change Biological Indicators $ 4,051 $ 3,482 $ 569 16 % Gross profit margin 63 % 58 % 5 % Instruments 5,455 4,118 1,337 32 % Gross profit margin 60 % 62 % (2 )% Continuous Monitoring 1,617 -- 1,617 100 % Gross profit margin 53 % -- % 53 % Total gross profit $ 11,123 $ 7,600 $ 3,523 46 % Gross profit margin 60 % 60 % -- % Six Months Ended September 30, Percent 2014 2013 Change Change Biological Indicators $ 7,835 $ 6,043 $ 1,792 30 % Gross profit margin 61 % 56 % 5 % Instruments 10,382 8,354 2,028 24 % Gross profit margin 62 % 64 % (2 )% Continuous Monitoring 2,611 -- 2,611 100 % Gross profit margin 49 % -- % 49 % Total gross profit $ 20,828 $ 14,397 $ 6,431 45 % Gross profit margin 60 % 60 % -- % Three and six months ended September 30, 2014 versus September 30, 2013 Biological Indicators gross profit margin percentage for the three and six months ended September 30, 2014 increased as a result of the Amilabo Acquisition, price increases and volume-based efficiencies associated with revenues growth. The six months ended September 30, 2013 was negatively impacted by the cost of replacement product (as discussed above in Revenues). Instruments gross profit margin percentage for the three and six months ended September 30, 2014 decreased as a result of integration activities associated with the BGI Acquisition and a change in our product/service mix, partially offset by the application of purchase accounting associated with the Suretorque Acquisition in the prior year. In addition, the majority of our product-related growth during both periods was in product lines which historically have been on the lower end of our gross margin percentage spectrum. Continuous Monitoring gross profit margin percentage for the three and six months ended September 30, 2014 was negatively impacted by integration activities that commenced soon after the acquisitions were completed. These integration activities were decreased during the three months ended September 30, 2014 and are now substantially complete. As a result, we believe that the Continuous Monitoring gross profit margin percentages on a go forward basis will be impacted more by total revenues available to cover fixed costs and product mix as opposed to ongoing integration activities. Page 14 -------------------------------------------------------------------------------- Operating Expenses Operating expenses for the three and six months ended September 30, 2014 increased as compared to the prior year as follows (in thousands): Increase (Decrease) Three Months Ended Six Months Ended September 30, 2014 September 30, 2014 Selling $ (77 ) $ 903 General and administrative ERP system upgrade and SOX compliance 55 100 Acquisition costs 160 389 Amortization 508 1,019 Personnel costs 1,188 1,983 Sales tax accrual (1,106 ) (1,106 ) Other, net 64 234 869 2,619 Research and development 346 512 Operating expenses $ 1,138 $ 4,034 Selling Three and six months ended September 30, 2014 versus September 30, 2013 Selling expenses for the three months ended September 30, 2014 was relatively flat with minor fluctuations due to timing of certain expenses. Selling expenses for the six months ended September 30, 2014 increased primarily due to the BGI, Amilabo, Amega and TempSys Acquisitions, along with negligible increases from other product lines. As a percentage of revenues, selling expense decreased to 9.7% as compared to 10.5% in the prior period. The decrease was due primarily to streamlining sales processes associated with acquisitions along with increased revenues associated with Continuous Monitoring resulting from our integration activities. General and administrative Three and six months ended September 30, 2014 versus September 30, 2013 General and administrative expenses for the three and six months ended September 30, 2014 increased primarily due to increased amortization, personnel and acquisition costs resulting from the BGI, Amilabo, Amega, and TempSys acquisitions, partially offset by the recording of a $1,106,000 accrual in the prior year associated with not properly collecting and remitting sales tax in states in which we most likely had established nexus during prior periods. Research and Development Three and six months ended September 30, 2014 versus September 30, 2013 Research and development expenses for the three and six months ended September 30, 2014 increased as a result of the Amega, TempSys and BGI Acquisitions and standard increases in personnel costs, partially offset by timing of external research and development consulting projects. Net Income Other (expense) income, net increased primarily as a result of additional interest expense associated with our Credit Facility as well as the gain on disposal of our Nusonics line of business in the prior period. Our income tax rate varies based upon many factors but in general, we anticipate that on a go forward basis, our effective tax rate will approximate our current rate of 35.3%. Otherwise, net income varied with the changes in revenue, gross profit and operating expenses (which includes $2,247,000 of non-cash amortization of intangible assets). Page 15--------------------------------------------------------------------------------Liquidity and Capital Resources Our sources of liquidity may include cash generated from operations, working capital, capacity under our Credit Facility and potential equity and debt offerings. We believe that cash generated from these sources will be sufficient to meet our short-term and long-term needs. Our more significant uses of resources include quarterly dividends to shareholders, payment of debt obligations, long-term capital equipment expenditures and potential acquisitions. In addition, over the next 6-9 months, we are implementing a new ERP system which may require a significant use of cash. Working capital is the amount by which current assets exceed current liabilities. We had working capital of $17,484,000 and $16,351,000, respectively, at September 30, 2014 and March 31, 2014. The increase in working capital is primarily due to increases in both accounts receivable and inventories related to organic growth and the acquisitions of BGI and Amilabo, partially offset by $3,000,000 of required principal payments under the Term Loan being classified as current liabilities. In February 2012, we entered into the Credit Facility for a $20,000,000 revolving line of credit and up to $1,000,000 of letters of credit. Funds from the Credit Facility may be used for general working capital and corporate needs, retiring existing debt, or to support acquisitions and capital expenditures. Under the Credit Facility, indebtedness bears interest at either: (1) LIBOR, as defined plus an applicable margin, ranging from 1.25% to 2.00%, or (2) the bank's commercial bank floating rate ("CBFR"), which is the greater of the bank's prime rate or one month LIBOR + 2.50%, adjusted down, from 1.25% to 0.50%. In April 2014, the Credit Facility was amended to include a $15,000,000 term loan and to extend the maturity date of the Credit Facility to June 30, 2017. The Term Loan bears interest at LIBOR, as defined, plus 2% and requires 11 quarterly principal payments (the first due date was July 15, 2014) in the amount of $750,000 with the remaining balance of principal and accrued interest due on April 15, 2017. The proceeds from the Term Loan were used to support acquisition financing and to repay amounts outstanding under the Line of Credit. The Credit Facility is secured by all of our assets and requires us to maintain a ratio of funded debt to our trailing four quarters of EBIDTA, as defined, of 2.5 to 1.0, and a minimum fixed charge coverage ratio of 1.35 to 1.0. We were in compliance with these covenants as of September 30, 2014. As of October 31, 2014, we had $28,500,000 in outstanding indebtedness and unused capacity under our Credit Facility of $5,000,000. We routinely evaluate opportunities for strategic acquisitions. Future material acquisitions may require that we obtain additional capital, assume third party debt or incur other long-term obligations. We believe that we have the option to utilize both equity and debt instruments as vehicles for the long-term financing of our investment activities and acquisitions. On November 7, 2005, our Board of Directors authorized a program to repurchase up to 300,000 shares of our outstanding common stock. Under the plan, the shares may be purchased from time to time in the open market at prevailing prices or in negotiated transactions off the market. Shares purchased will be canceled and repurchases will be made with existing cash reserves. We do not maintain a set policy or schedule for our buyback program. We have purchased 162,306 shares of common stock under this program from inception through September 30, 2014. We have been paying regular quarterly dividends since 2003. Dividends per share paid by quarter were as follows: Year Ending March 31, 2015 2014 First quarter $ 0.15 $ 0.14 Second quarter 0.15 0.14 Third quarter - 0.15 Fourth quarter - 0.15 In October 2014, our Board of Directors declared a quarterly cash dividend of $0.16 per share of common stock, payable on December 15, 2014, to shareholders of record at the close of business on November 28, 2014. Page 16 -------------------------------------------------------------------------------- Cash Flows Our cash flows from operating, investing and financing activities were as follows (in thousands): Six Months Ended September 30, 2014 2013 Net cash provided by operating activities $ 3,744 $ 5,579 Net cash used in investing activities (14,725 ) (1,831 ) Net cash provided by (used in) financing activities 9,063 (4,330 ) Net cash provided by operating activities for the six months ended September 30, 2014 decreased primarily due to increases in accounts receivable and inventories resulting from the BGI, Amilabo, Amega and TempSys acquisitions, partially offset by decreases in payments of accounts payable and increases in net income. Net cash used in investing activities for the six months ended September 30, 2014 resulted primarily from the $10,268,000 BGI Acquisition and the purchase of $908,000 of property, plant and equipment. Net cash used in investing activities for the six months ended September 30, 2013 resulted from the $1,721,000 Suretorque Acquisition and the purchase of $771,000 of property, plant and equipment, partially offset by the proceeds from the disposal of the NuSonics product line of $661,000. Net cash provided by financing activities for the six months ended September 30, 2014 resulted from borrowings under our Credit Facility of $18,000,000 and proceeds from the exercise of stock options of $865,000, partially offset by the repayment of debt of $8,750,000 and the payment of dividends of $1,052,000. Net cash used in financing activities for the six months ended September 30, 2013 resulted from the repayment of debt of $4,000,000 and the payment of dividends of $952,000, partially offset by the proceeds from the exercise of stock options of $637,000. At September 30, 2014, we had contractual obligations for open purchase orders of approximately $7,700,000 for routine purchases of supplies and inventory, which are payable in less than one year. Under the terms of the Amega Agreement, we are required to pay contingent consideration if the cumulative revenues for our Continuous Monitoring Division for the three years subsequent to the acquisition meet certain levels. The potential consideration payable ranges from $0 to $10,000,000 and is based upon a sliding scale of three-year cumulative revenues between $31,625,000 and $43,500,000. Based upon both historical and projected growth rates, we recorded $500,000 of contingent consideration payable which represents our best estimate of the amount that will ultimately be paid. Any changes to the contingent consideration ultimately paid will result in additional income or expense in our condensed consolidated statements of income. We will continue to monitor the results of our Continuous Monitoring Division and we will adjust the contingent liability on a go forward basis, based on then current information. The contingent consideration is payable in the third quarter of our year ending March 31, 2017. Under the terms of the Bios Agreement, we are required to pay contingent consideration if the cumulative revenues related to the acquisition for the three years subsequent to the acquisition exceed $22,127,000. The potential future payment that we could be required to make ranges from $0 to $6,710,000. Based upon historical growth rates, we initially recorded $2,140,000 of contingent consideration payable which represented our best estimate of the amount that would ultimately be paid. Based upon actual results and current run rates, during the year ended March 31, 2014, we revised our estimate of the ultimate contingent liability that would be paid, which resulted in reducing the contingent consideration payable to $1,120,000. Any further changes to the contingent consideration ultimately paid would result in additional income or expense in our condensed consolidated statements of income. We will continue to monitor the results associated with the Bios Acquisition and we will adjust the contingent liability on a go forward basis, based on then current information. The contingent consideration is payable in the first quarter of our year ending March 31, 2016. Critical Accounting Estimates Our condensed consolidated financial statements and accompanying notes have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires management to make estimates, judgments and assumptions that affect reported amounts of assets, liabilities, revenues and expenses. We continually evaluate the accounting policies and estimates used to prepare the condensed consolidated financial statements. The estimates are based on historical experience and assumptions believed to be reasonable under current facts and circumstances. Actual amounts and results could differ from these estimates made by management. Certain accounting policies that require significant management estimates and are deemed critical to our results of operations or financial position are discussed in our Annual Report on Form 10-K for the year ended March 31, 2014 in the Critical Accounting Policies and Estimates section of "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." 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