ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward Looking Statements

Certain statements contained in, or incorporated by reference in, this report are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, which provide current expectations or forecasts of future events. Such statements can be identified by the use of terminology such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “intend,” “may,” “plan,” “possible,” “project,” “should,” “will,” and similar words or expressions. The Company's forward-looking statements include certain information relating to general business strategy, growth strategies, financial results, liquidity, the Company's ability to continue as a going concern, discontinued operations, research and development, product development, the introduction of new products, the potential markets and uses for the Company's products, the Company's ability to increase its sales campaign effectively, the Company's regulatory filings with the FDA, acquisitions, dispositions, the

development of joint venture opportunities, intellectual property and patent protection and infringement, the loss of revenue due to the expiration on termination of certain agreements, the effect of competition on the structure of the markets in which the Company competes, increased legal, accounting and Sarbanes-Oxley compliance costs, defending the Company in litigation matters and the Company's cost saving initiatives. The reader must carefully consider forward-looking statements and understand that such statements involve a variety of risks and uncertainties, known and unknown, and may be affected by assumptions that fail to materialize as anticipated. Consequently, no forward-looking statement can be guaranteed, and actual results may vary materially. It is not possible to foresee or identify all factors affecting the Company's forward-looking statements, and the reader therefore should not consider the list of such factors contained in its periodic report on Form 10-K for the year ended June 30, 2018 and this Form 10-Q quarterly report to be an exhaustive statement of all risks, uncertainties or potentially inaccurate assumptions.

Executive Overview—Three-month periods Ended September 30, 2018 and 2017

The following highlights are discussed in further detail within this Form 10-Q. The reader is encouraged to read this Form 10-Q in its entirety to gain a more complete understanding of factors impacting Company performance and financial condition.

 

Company Overview

The following discussion should be read in conjunction with the interim unaudited condensed consolidated financial statements and the notes thereto, which are set forth in Item 1 of this report.

The Company operates in the healthcare market specializing in the development, manufacture, marketing and distribution of medical devices and pharmaceuticals in the area of ophthalmology. The Company and its products are subject to regulation and inspection by the FDA. The FDA requires extensive testing of new products prior to sale and has jurisdiction over the safety, efficacy and manufacture of products, as well as product labeling and marketing. The Company's Internet address is www.escalonmed.com . under the trade name of Sonomed-Escalon the Company develops, manufactures and markets ultrasound systems used for diagnosis or biometric applications in ophthalmology, develops, manufactures and distributes ophthalmic surgical products under the Trek Medical Products name, and manufactures and markets digital camera systems for ophthalmic fundus photography and image management systems.

Critical Accounting Policies

The preparation of unaudited condensed consolidated financial statements requires management to make estimates and assumptions that impact amounts reported therein. The most significant of those involve the application of FASB-issued authoritative guidance concerning Revenue Recognition, and Intangible Assets, discussed further in the notes to consolidated financial statements included in the Form 10-K for the year ended June 30, 2018. The unaudited condensed consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America ("US GAAP"), and, as such, include amounts based on informed estimates and judgments of management. For example, estimates are used in determining valuation allowances for deferred income taxes, uncollectible receivables, obsolete inventory, sales returns and rebates, warranty liabilities and valuation of purchased intangible assets. Actual results achieved in the future could differ from current estimates. The Company used what it believes are reasonable assumptions and, where applicable, established valuation techniques in making its estimates.

Accounts Receivable

Accounts receivable are recorded at net realizable value. The Company performs ongoing credit evaluations of customers’ financial condition and does not require collateral for accounts receivable arising in the normal course of business. The Company maintains allowances for potential credit losses based on the Company’s historical trends, specific customer issues and current economic trends. Accounts are written off against the allowance when they are determined to be uncollectible based on management’s assessment of individual accounts. The Company recorded an allowance for doubtful accounts of approximately $119,000 as of September 30, 2018 and June 30, 2018

Inventories

Inventories include freight-in, materials, labor and overhead costs and are stated at the lower of cost (on a first-in, first-out basis) or net realizable value. Provision is made for slow-moving, obsolete or unusable inventory.

Intangible Assets and Long-Lived Assets

Intangible assets deemed to have indefinite lives (including trademark and trade names) and goodwill are not amortized but, instead, are subject to an annual impairment assessment. additionally, if events or conditions were to indicate the carrying value or a reporting unit may not be recoverable, the Company would evaluate goodwill and other intangible assets for impairment at that time. As it relates to the goodwill assessment the Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment testing described in ASU topic No. 350, Intangibles - Goodwill and other.

Long-lived assets including intangible assets deemed to have finite lives, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment indicators include, among other conditions, cash flow deficits, historic or anticipated declines in revenue or operating profit or material adverse changes in the business climate that indicate that the carrying amount of an asset may be impaired. When impairment indicators are present, the recoverability of the asset is measured by comparing the carrying value of the asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the projected undiscounted cash flows from the asset are less than the carrying value of the asset the asset is considered to be impaired. The impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds the fair value of the asset. During the year ended June 30, 2018 and the three months ended September 30, 2018, no impairments were recorded.

Accrued Warranties

The Company provides a limited one year warranty against manufacturer’s defects on its products sold to customers. The Company’s standard warranties require the Company to repair or replace, at the Company’s discretion, defective parts during such warranty period. The Company accrues for its product warranty liabilities based on estimates of costs to be incurred during the warranty period, based on historical repair information for warranty costs.

Revenue Recognition

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASC 606”), to clarify the principles of recognizing revenue and create common revenue recognition guidance under US GAAP and International Financial Reporting Standards. This ASU can be adopted either retrospectively to each reporting period presented or as a cumulative effect adjustment as of the date of the adoption. The standard supersedes existing revenue recognition guidance and replaces it with a five-step revenue model with a core principle that an entity recognizes revenue to reflect the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services.

The Company adopted the new guidance on July 1, 2018. The timing of revenue recognition and treatment of contract costs remains unchanged under Topic 606. As such, the adoption of Topic 606 did not have a material impact on the Company’s unaudited condensed consolidated financial statements. The information presented for the periods prior to July 1, 2018 has not been restated and is reported under the accounting standard in effect for those periods. See Note 10 for further information regarding the Company’s implementation and disclosures in accordance with ASC 606.

The Company recognizes revenue when its performance obligations with its customers have been satisfied. At contract inception, the Company determines if the contract is within the scope of Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers, and then evaluates the contract using the following five steps: (1) identify the contract with the customer; (2) identify the performance obligations; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations; and (5) recognize revenue when (or as) the entity satisfies a performance obligation. The Company only recognizes revenue to the extent that it is probable that a significant revenue reversal will not occur in a future period.

Income Taxes

The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the unaudited consolidated financial statements. Under this method, the Company determines deferred tax assets and liabilities on the basis of the differences between the financial statement and tax bases of assets and liabilities by using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.

The Company recognizes deferred tax assets to the extent that it believes that these assets are more likely than not to be realized. In making such a determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations. If the Company determines that it would be able to realize its deferred tax assets in the future in excess of their net recorded amount, the Company would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes. As of September 30, 2018 and June 30, 2018, the Company has a fully recorded valuation allowance against its deferred tax assets.

The Company records uncertain tax positions in accordance with ASC 740 on the basis of a two-step process in which (1) the Company determines 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, the Company recognizes the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority.

The Company recognizes interest and penalties related to unrecognized tax benefits on the income tax expense line in the accompanying unaudited consolidated statements of operations. As of September 30, 2018 and June 30, 2018, no accrued interest or penalties were required to be included on the related tax liability line in the unaudited consolidated balance sheets.

Earnings (loss) Per Share

Earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the year. All outstanding stock options are considered potential common stock. All

outstanding convertible preferred stock are considered common stock at the beginning of the period or at the time of issuance, if later, pursuant to the if-converted method. The dilutive effect, if any, of stock options is calculated using the treasury stock method. As of September 30, 2018 and 2017, the average market prices for the three months periods then ended are less than the exercise price of all the outstanding stock options and, therefore, the inclusion of the the stock options would be anti-dilutive. In addition, since the effect of common stock equivalents is anti-dilutive with respect to losses, the convertible preferred stock has also been excluded from the Company’s computation of loss per common for the three months ended September 30, 2018. Therefore, basic and diluted loss per common share for the three-month period ended September 30, 2018 and 2017 are the same.

Consolidated net revenue decreased approximately $ 372,000 or 14.1% , to $ 2,258,000 during the three month period ended September 30, 2018 as compared to the same period last fiscal year. The decrease in net revenue is attributed to a decrease in Escalon Digital Solutions, Inc. ("EMI") total product sales of $169,000, related to a decrease in ophthalmic fundus photography system product sales, a decrease in sales of Trek products of $39,000 and a decrease in sales in Sonomed's ultrasound products of $164,000, primarily attributable to decreases within Latin American and Middle Eastern markets.

The following table presents consolidated cost of goods sold and as a percentage of revenues for the thee-month periods ended September 30, 2018 and 2017. Table amounts are in thousands:

Consolidated cost of goods sold totaled approximately $ 1,203,000 , or 53.3% , of total revenue for the thee-month period ended September 30, 2018, as compared to $ 1,467,000 , or 55.8% , of total revenue for the same period of the prior fiscal year. The decrease of 2.5% in cost of goods sold as a percentage of total revenue is mainly due to changes in product sales mix, including a decrease in ophthalmic fundus photography system product sales.

The following table presents consolidated marketing, general and administrative expenses for the thee months ended September 30, 2018 and 2017. Table amounts are in thousands:

Consolidated marketing, general and administrative expenses increased $ 5,000 , or 0.5% , to $ 1,002,000 for the thee-month period ended September 30, 2018, as compared to the same period of the prior fiscal year. The increase is mainly due to increased legal expense, consulting expense and executive retirement benefits adjustment offset by decreased salary expense.

The following table presents consolidated research and development expenses for the thee-month periods ended September 30, 2018 and 2017.

Table amounts are in thousands:

Consolidated research and development expenses decreased $ 97,000 , or 50.3% , to $ 96,000 for the thee-month period ended September 30, 2018, as compared to the same period of the prior fiscal year. Research and development expenses were primarily expenses associated with the introduction of new or enhanced products. The decrease in Research and Development expense is due to the decrease in headcount and consulting expense due to cost savings initiatives.

Liquidity and Capital Resources

Our total cash on hand as of September 30, 2018 was $915,000 excluding restricted cash of $251,000 compared with $874,000 of cash on hand and restricted cash of $250,000 as of June 30, 2018. Approximately $48,000 was available under our line of credit as of September 30, 2018.

Because our operations has not historically generated sufficient revenues to enable profitability we will continue to monitor costs and expenses closely and may need to raise additional capital in order to fund operations.

We expect to continue to fund operations from cash on hand and through capital raising sources if possible and available, which may be dilutive to existing stockholders, through revenues from the licensing of our products, or through strategic alliances. Additionally, we may seek to sell additional equity or debt securities through one or more discrete transactions, or enter into a strategic alliance arrangement, but can provide no assurances that any such financing or strategic alliance arrangement will be available on acceptable terms, or at all. Moreover, the incurrence of indebtedness in connection with a debt financing would result in increased fixed obligations and could contain covenants that would restrict our operations.

As of September 30, 2018 we had an accumulated deficit of approximately $68.0 million, incurred recurring losses from operations and negative cash flows from operating activities in prior years. These factors raise substantial doubt regarding our ability to continue as a going concern.

    

The following table presents overall liquidity and capital resources as of September 30, 2018 and June 2018. Table amounts are in thousands:

 

Working Capital Position

Working capital decreased $ 48,000 as of September 30, 2018 , and the current ratio decreased to 1.99 to 1 from 2.04 to 1 when compared to June 30, 2018.

Overall total current assets increased $ 26,000 to $ 4,610,000 in 2018 from $ 4,584,000 as of June 30, 2018. Total current liabilities, which consists of line of credit, current portion of post-retirement pension benefits, accounts payable, accrued expenses, deferred revenue and liabilities of discontinued operations, increased $ 74,000 to $ 2,321,000 in 2018 from $ 2,247,000 as compared to June 30, 2018. The increase in current assets and current liabilities is mainly as result of an increase in the line of credit.

Debt to Total Capital Ratio was 8.6% and 7.0% as of September 30, 2018 and June 30, 2018, respectively. The decrease in the working capital ratio and increase in the debt to total capital ratio is due to the increase in the line of credit. On June 29, 2018 the Company entered a business loan agreement with TD bank receiving a promissory note of $250,000 . Upon signing the agreement the Company also authorizes TD bank to payoff the line of credit of $165,000 with Netwtek with a total payment of $201,575 .

Cash Used In or Provided By Operating Activities

During the three-month period ended September 30, 2018 the Company generated approximately $12,000 of cash from operating activities as compared to using approximately $175,000 for operating activities during the same period of the prior fiscal year.

For the three-month period ended September 30, 2018 , the Company had a net loss of approximately $ 48,000 . Cash inflows were mainly due to the cash inflow from an increase in accounts payable and accrued expenses of $ 20,000 , a decrease

in inventory of $ 58,000 . The cash inflow is offset by an increase in accounts receivable of $ 35,000 , an increase in other current assets of $ 7,000 , and a decrease in accrued post retirement benefits of $ 6,000 .

For the three-month period ended September 30, 2017, the Company had a net loss of $61,000, experienced net cash out-flows from a decrease in post-retirement benefits of $18,000, an increase in accounts receivable of $46,000, an increase in inventory of $101,000 and an increase in other current assets of $21,000. The cash outflows were partially offset by an increase in accounts payable, accrued expense and deferred revenue of $57,000.

Cash Flows Used In Investing Activities

Cash flows used in investing activities for the three-month period ended September 30, 2018 were due to purchase of equipment of $7,000.

Cash flows used in investing activities during the three-month periods ended September 30, 2017 were appropriately $15,000, among which, $2,000 was used for purchase of equipment and $13,000 was for purchase of licenses.

Any necessary capital expenditures have generally been funded out of cash from operations, and the Company is not aware of any factors that would cause historical capital expenditure levels to not be indicative of capital expenditures in the future and, accordingly, does not believe that the Company will have to commit material resources to capital investment for the foreseeable future.

Cash Flows Provided by Financing Activities

For the three-month period ended September 30, 2018 the cash inflow from financing activities of $36,000 were due to the increase in the line of credit. On June 29, 2018 the Company entered a business loan agreement with TD bank receiving a line of credit evidenced by a promissory note of $250,000 . Upon signing the agreement the Company also authorizes TD bank to payoff the line of credit of $165,000 with Newtek with a total payment of $201,575 .

Cash flows provided by financing captivities during the three-month periods ended September 30, 2017 includes proceeds from related party note payable of $100,000 and repayment of principal for line of credit of $25,000.

Financing Facilities

On December 29, 2016, the Company entered into a credit agreement providing the Company up to an aggregate of $250,000 in cash, secured by the Company’s inventory. The Company, and its wholly owned subsidiary Sonomed, Inc., entered into an Inventory Advance Agreement as of December 29, 2016 (the "Agreement"), with CDS Business Services, Inc., doing business as Newtek Business Credit ("Newtek"). Newtek made in its discretion loans against the Company’s Eligible Inventory in an aggregate amount outstanding at any time up to the lesser of (i) fifty percent (50%) of the Inventory Value or (ii) the Inventory Advance Limit, as those terms were defined in the Agreement, which was $250,000. The credit agreement renewed annually and could be terminated upon 90 days written notice from the Company or 30 days written notice from Newtek.

Interest accrued on the daily balance at the per annum rate of 5.00% above the Prime Rate, but not less than 5.0%. All interest payable by under the financing documents was computed on the basis of a 360 day year for the actual number of days elapsed on the daily balance. The Company was also obligated to pay to Newtek a closing fee equal to 1.00% of the Advance Limit.

Upon any renewal of the Agreement, an annual fee was due from Company equal to 1.00% of the Advance Limit. In consideration of monitoring, ledgering and other administrative functions undertaken by Newtek in connection with the Company’s inventory, and the merchant processor, Company was obligated pay Newtek a monthly collateral monitoring fee calculated by multiplying (i) seventy basis points (0.70%) (approximately an annual rate of 8.5%) (except during the existence of an Event of Default at which time it shall be 1%) by (ii) the amount of the average daily balances during the calendar month preceding the month for which the calculation is made.

On June 29, 2018 the Company entered a business loan agreement with TD bank receiving a line of credit evidenced by a promissory note of $250,000. The interest is subject to change based on changes in an independent index which the Wall Street Journal Prime. The index rate at the date of the agreement is 5.000% per annum. Interest on the unpaid principal balance of the note will be calculated using a rate of 0.740 percentage points over the index, adjusted if necessary for any minimum and maximum rate limitations, resulting in an initial rate of 5.740% per annum based on a year of 360 days. The Company was required to put $250,000 in the TD bank savings account as collateral. Upon signing the agreement the Company also authorizes TD bank to payoff the line of credit with Netwtek. The total payment was $201,575, which includes $165,000 of outstanding line of credit, $2,579 accrued interest, administrative/legal fee of $1,000 , prime plus fee through July 12, 2018 of

$ 1,895 and underminimum fees of $28,797 . The underminimum fees of $28,797 was included in accrued expense as of June 30, 2018.

As of September 30, 2018 and June 30, 2018 , the line of credit balance was $201,575 and $165,000. The line of credit interest expense was $6,580 and $10,336 for the three-month periods ended September 30, 2018 and September 30, 2017 respectively.

Richard J. DePiano, Sr., (“Mr. DePiano”), the Company’s Chairman, participated in an accounts receivable factoring program that was implemented by the Company. Under the program, Mr. DePiano advanced the Company $545,000 as of June 30, 2017 and advanced an additional $100,000 during fiscal year 2018 prior to the Debt Exchange Agreement noted below. Interest on the transaction was  1.25% per month. The transactions excluded fees typically charged by the factoring agent and provided much needed liquidity to the Company. Related party interest expense for the three-month periods ended September 30, 2018 and 2017 was $0 and $ 23,112 , respectively. As of both September 30, 2018 and June 30, 2018, accrued interest of $112,389 was recorded in accrued expenses.

On February 14, 2018, the Company entered into a Debt Exchange Agreement (the “Exchange Agreement”) with Mr. DePiano, the Company's Chairman and DP Associates Inc. Profit-Sharing Plan of which Mr. DePiano is the sole owner and sole trustee (the “Holders”).  Pursuant to the terms of the Exchange Agreement, effective February 15, 2018, the Holders exchanged a total of $645,000 principal amount of debt related to the accounts receivable factoring program the Company owes the Holders for 2,000,000 shares of Series A Convertible Preferred Stock (the “Preferred Stock”). As of September 30, 2018 and June 30, 2018 the cumulative dividends payable was $32,373 ($0.0162 per share) and $19,368 ( $0.0097 per share).