(1)          Basis of Presentation and Description of Business

MGC Diagnostics Corporation (the “Company”), through its Medical Graphics Corporation and Medisoft SA subsidiaries, designs and markets non-invasive cardiorespiratory diagnostic systems that are sold under the MGC Diagnostics and Medisoft brand and trade names. These cardiorespiratory diagnostic systems have a wide range of applications within cardiorespiratory healthcare.

The consolidated balance sheet as of January 31, 2017, the consolidated statements of comprehensive loss for the three months ended January 31, 2017 and 2016, the consolidated statements of cash flows for the three months ended January 31, 2017 and 2016 and the related information presented in these notes have been prepared by management in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X, without audit. Accordingly, they do not include all of the information and notes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation of results have been included. The consolidated balance sheet at October 31, 2016 was derived from the audited consolidated financial statements as of that date. Operating results for the three months ended January 31, 2017 are not necessarily indicative of the results that may be expected for the year ending October 31, 2017. For further information, refer to the consolidated financial statements and notes thereto included in MGC Diagnostics Corporation’s Annual Report on Form 10-K for the year ended October 31, 2016.

Preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities made in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Estimates include accounts receivable reserves, product warranty and inventory reserves, realizability of deferred tax assets and depreciable lives of property, equipment and intangible assets (including internal software development costs).

(2)          Summary of Significant Accounting Policies

(3)           Shareholders' Equity

The MGC Diagnostics Corporation 2007 Stock Incentive Plan (the “2007 Plan”) provides that incentive stock options and nonqualified stock options to purchase shares of common stock may be granted at prices determined by the Human Capital Committee of the Company's Board of Directors, except that the purchase price of incentive stock options may not be less than the fair market value of the stock at the date of grant. Options under the 2007 Plan are subject to vesting schedules established on the date of grant. In addition, the 2007 Plan allows the granting of restricted stock awards, stock appreciation rights and performance stock. 

Total stock-based compensation expense included in the Company’s statements of comprehensive loss was $174,000 and $144,000 for the three months ended January 31, 2017 and 2016, respectively.

Stock Options

A summary of the Company’s stock option activity for the three months ended January 31, 2017 and 2016 is presented in the following table:

The following table summarizes information concerning stock options outstanding as of January 31, 2017:

The total intrinsic values for outstanding options and exercisable options as of January 31, 2017 were $823,000 and $275,000, respectively, calculated using the closing stock price at the end of the first quarter less the option price of in-the-money options. The Company issues new shares when stock options are exercised. Unrecognized compensation expense related to outstanding stock options as of January 31, 2017 was $678,000 and is expected to be recognized over a weighted average period of 1.84 years.

Valuation Assumptions

The Company uses the Black-Scholes option-pricing model (“Black-Scholes model”) to determine the fair value of stock options as of the grant date. In determining the fair value of stock options under the Black-Scholes model, management must make assumptions regarding projected employee stock option exercise behaviors, risk-free interest rates, volatility of the Company’s stock price and expected dividends. The expense recognized for options granted under the 2007 Plan is equal to the fair value of stock options as of the grant date. The following table provides the weighted average fair value of options granted to employees and the related assumptions used in the Black-Scholes model for stock option grants made during the three months ended January 31, 2017:

Restricted Stock Awards

Restricted stock awards are awards of common stock that are subject to restrictions on transfer and to a risk of forfeiture if the holder leaves the Company before the restrictions lapse. The holder of a restricted stock award is generally entitled at all times on and after the date of issuance of the restricted shares to exercise the rights of a shareholder of the Company, including the right to vote the shares. The value of stock awards that vest over time was established by the market price on the date of its grant. A summary of the Company’s restricted stock activity for the three months ended January 31, 2017 and 2016 is presented in the following table:

Unrecognized compensation expense related to outstanding restricted stock awards to employees and directors as of January 31, 2017 was $71,000 and is expected to be recognized over a weighted average period of 0.92 years.

Director Stock Awards in Lieu of Cash Retainer Fees

The Company has a program that allows non-employee Board members to elect and receive shares from the 2007 Plan in lieu of some or all of their quarterly cash retainer fees. During the three months ended January 31, 2017 and 2016, the Company issued 1,489 and 1,703 shares, respectively, under this program. The expense was recognized at the time of share issuance and totaled $11,000 in each of the three months ended January 31, 2017 and 2016.

Employee Stock Purchase Plan

The MGC Diagnostics Corporation 2003 Employee Stock Purchase Plan, as amended (“Purchase Plan”), allows participating employees to purchase up to 200,000 shares of the Company’s common stock at a discount through payroll deductions. The Purchase Plan is available to all employees subject to eligibility requirements. Under the Purchase Plan, participating employees may purchase the Company’s common stock on a voluntary after-tax basis at a price that is the lower of 85% of the fair market value of one share of common stock at the beginning or end of each stock purchase phase. The Purchase Plan is carried out in six-month phases, with phases beginning on January 1 and July 1 of each calendar year. For the phase that ended on December 31, 2016, employees purchased 5,343 shares at a price of $5.54 per share. As of January 31, 2017, the Company has withheld approximately $5,000 from employees participating in the phase that began on January 1, 2017. As of January 31, 2017, 44,010 shares of common stock were available for future purchase under the Purchase Plan.

The following table presents the classification of pre-tax stock-based compensation expense recognized in the consolidated statements of comprehensive loss for the three months ended January 31, 2017 and 2016:

Tax Impact of Stock-Based Compensation

The Company reports the benefit of tax deductions in excess of recognized stock-based compensation expense on the consolidated statements of cash flows as operating cash flows. For the three months ended January 31, 2017 and 2016, there were no excess tax benefits recognized.

Dividend

On January 25, 2017, the Company declared a special cash dividend of $0.70 per share on its outstanding common stock to all shareholders of record as of February 10, 2017. The dividend was paid on February 24, 2017.

(4)          Inventories

Inventories consisted of the following as of January 31, 2017 and October 31, 2016:

(5)          Intangible Assets

Intangible assets consisted of the following as of January 31, 2017 and October 31, 2016:

The Company amortizes the intangible assets related to developed technology, patents and trademarks using the straight-line method over the estimated useful lives of the assets, which range from five to ten years. Total amortization expense was $75,000 and $70,000 for the three months ended January 31, 2017 and 2016, respectively. Of the total, amortization expenses of $33,000 and $12,000 related to software costs are included in the cost of equipment, supplies and accessories revenues for the three months ended January 31, 2017 and 2016, respectively. The Company estimates it will incur the following amortization expense in future fiscal years based on the intangible assets the Company expects to have placed in service at the end of fiscal 2017:

This table does not include estimated amortization expense of $86,000 for patents included in “Developed technology,” or of $160,000 for capitalized software costs the Company expects to place into service after the current fiscal year. The Company capitalized software development costs of $159,000 and $170,000 during the three months ended January 31, 2017 and 2016, respectively. Upon completion of these development projects, the Company expects to amortize the capitalized software costs over a ten year period.

(6)          Warranty Reserve

Sales of the Company’s equipment are subject to a warranty obligation. Equipment warranties typically extend for a period of twelve months from the date of installation. Standard warranty terms are included in customer contracts. Under the terms of these warranties, the Company is obligated to repair or replace any components or assemblies that it deems defective in workmanship or materials. The Company reserves the right to reject warranty claims if it determines that failure is due to normal wear, customer modifications, improper maintenance or misuse. The Company maintains a warranty reserve that reflects the estimated expenses it will incur to honor the warranties on its products. The Company adjusts the warranty reserve based on the number and type of equipment subject to warranty and the remaining months of warranty coverage. The warranty reserve adjustment reflects the Company’s historical warranty experience based on the type of equipment.

Warranty provisions and claims for the three months ended January 31, 2017 and 2016 were as follows:

(7)          Financing Arrangements

On July 24, 2014, the Company entered into a credit agreement with BMO Harris Bank NA. The Agreement, as amended, included a $4.0 million term loan and a $250,000 revolving credit facility. The term loan, which bore interest at a floating rate, was payable in equal monthly principal installments of $66,667 over a five-year period commencing August 31, 2014 and was evidenced by a term note. The Company borrowed the $4.0 million under the term loan on July 24, 2014 and used these proceeds in connection with its August 1, 2014 acquisition of Medisoft SA. On June 14, 2016, the Company paid off the remaining balance of the term loan and terminated the revolving credit facility.

(8)          Net Income (Loss) per Share

 Basic income (loss) per share is computed by dividing net income (loss) by the weighted average shares outstanding during the reporting period. Diluted income per share is computed similarly to basic income (loss) per share except that the weighted average shares outstanding are increased to include additional shares issuable from the assumed exercise of warrants and stock options, if dilutive, as well as the dilutive effects of any unvested restricted share awards. Diluted loss per share does not include any of these dilutive effects in its calculation. The number of additional shares is calculated by assuming that outstanding warrants and stock options are exercised, outstanding restricted share grants vest and that the cash proceeds from the exercise together with the assumed employment value represented by the unamortized stock-based compensation were used to reacquire shares of common stock at the average market price during the reporting period.

 The Company had unexpired options and warrants for the purchase of its common stock and unvested restricted awards as of January 31, 2017 and 2016 of 603,572 and 420,874 shares, respectively.

Shares used in the net income per share computations are as follows: 

As a result of the net loss for the three months ended January 31, 2017 and 2016, all outstanding warrants, stock options and unvested restricted stock shares were considered anti-dilutive and, therefore, were excluded from diluted loss per share for each period.

(9)         Income Taxes

The Company has recorded a provision for income taxes of $1,000 and $62,000 for the three months ended January 31, 2017 and 2016, respectively. The decrease in income tax expense for the fiscal 2017 period was due to tax benefits for the domestic pre-tax book loss incurred offset by tax expense related to the foreign activities. The Company records its interim provision for income taxes based on its estimated worldwide annual effective rate for the year.  The Company excluded MGC Diagnostics Belgium S.P.R.L. net losses of $94,000 and $88,000 for the three-month periods ended January 31, 2017 and 2016, respectively, and Medisoft net loss of $64,000 for the three-month period ended January 31, 2017, for which no tax benefit can be recognized due to expected future losses; the Company has established a valuation allowance related to these losses. As such, the $1,000 fiscal 2017 first quarter tax expense and the $62,000 fiscal 2016 first quarter tax expense compared to the world wide consolidated pre-tax (loss) income of $(239,000) and $58,000, respectively, (which includes the foreign entity net losses) results in an effective rate of approximately (0.4)% and 106.9%, respectively.

For the three months ended January 31, 2017, the Company recorded a domestic income tax benefit of $37,000 based on an estimated U.S. annual effective tax rate of 45.3%.  The differences from the federal statutory rate result from the effects of anticipated federal alternative minimum tax whose available AMT credit cannot be offset due to the partial valuation allowance currently in place, state taxes expected to be paid and permanent differences whose effects are to increase the effective rate, including non-deductible meals and entertainment expenses, stock-based compensation expenses related to incentive stock options and restricted stock awards and expense related to reserves for uncertain tax positions. This domestic benefit is offset by tax expense of $38,000 from the reduction of deferred tax assets for Medisoft Belgium.

The $62,000 provision for 2016 income taxes includes federal alternative minimum tax expense, state and foreign income tax expense and expense related to reserves for uncertain tax positions expected for 2016 and included in the projected effective rate.

As of January 31, 2017, the Company had a reserve for uncertain tax positions of $93,000 compared to the October 31, 2016 balance of $92,000. If recognized, approximately $59,000 of these benefits would lower the effective tax rate. The remaining $34,000, if recognized, would result in a deferred tax asset subject to a valuation allowance and therefore would not affect the effective rate.

Estimated interest and penalties related to potential underpayment of income taxes are classified as a component of tax expense in the consolidated statements of comprehensive loss. The Company does not expect the amount of reserves for uncertain tax positions to change significantly in the next twelve months. Similarly, the Company does not anticipate that the total reserve for uncertain tax positions will significantly change due to the settlement of audits and the expiration of statutes of limitations within the next twelve months.

The Company files a consolidated federal income tax return in the United States federal jurisdiction and files various combined and separate tax returns in several state and local jurisdictions. For United States federal tax, the Company is no longer subject to examinations by the authorities for fiscal years ending prior to November 1, 1998. The expiration dates of the statute of limitations related to the various state income tax returns vary by state. There is no statute of limitations for assessments related to jurisdictions where the Company may have a nexus but has chosen not to file an income tax return.

The Company has federal net operating loss (“NOL”) and general business tax credit carry forwards; however, the utilization of some of these tax loss and tax credit carry forwards is limited under Internal Revenue Code (“IRC”) §382 and §383, respectively, as a result of an IRS-deemed change in ownership that occurred in the fourth quarter of fiscal 2006. The Company’s estimated domestic NOL carry forwards of $6.5 million that are not limited as of October 31, 2016 include $2.8 million of income tax deductions in excess of previously recorded tax benefits. The tax benefit of these excess deductions was added to deferred tax assets as of October 31, 2016 as a result of the adoption of ASU 2016-09 retroactively to November 1, 2015; however the additional benefit was offset by an equivalent increase to the valuation allowance for domestic net deferred tax assets. These loss carry forwards will expire in years 2018 through 2032. Additionally, the Company has general business credit carry forwards of $461,000 that will expire in 2033. Use of this general business credit carry forward is not limited because it was generated after the change in ownership. The Company also has $266,000 of alternative minimum tax credit carry forwards that do not have expiration dates. The alternative minimum tax credit carry forwards are limited by IRC §383, but their ultimate use is not affected since these do not expire. In addition, as of October 31, 2016, the Company has foreign NOL carry forwards of approximately $4.8 million. Foreign NOL expiration varies by country; however, a substantial portion of the foreign NOLs are in Belgium, and do not expire. As of October 31, 2016, the Company had a remaining valuation allowances for domestic and international entities of approximately $1,951,000 and $772,000, respectively.

(10)       Segment Reporting

The Company operates in a single industry segment, the manufacture and sale of cardiorespiratory diagnostic products. The Company sells its products into many countries throughout the world. Net sales and long-lived assets by geographic area are shown in the following tables.

(11)       Litigation

The Company is also subject to certain claims and lawsuits that have been filed in the ordinary course of business. From time to time, the Company initiates lawsuits against others to enforce patents or to seek collection of debts in the ordinary course of business. The Company is not subject to any significant litigation, except as set forth below.

MGC Diagnostics Corporation v. Mr. Guy Martinot and Dr. Jean-Benoît Martinot

In November 2015, the Company commenced litigation in the French-speaking courts of Brussels, Belgium against the selling shareholders of Medisoft for violations of representations and warranties in the stock purchase agreement dated as of July 10, 2014 under which the Company purchased Medisoft. The Company alleged that these violations resulted in Company damages of approximately €985,400 ($1,084,000). In May 2015, the Company received payment of €406,700 ($447,000) with respect to these alleged violations pursuant to a bank guaranteed contractual escrow fund and has reflected that payment on its books and records. On May 30, 2016, the defendant selling shareholders filed an answer and asserted a counterclaim against the Company seeking to recover the €406,700 that was paid to the Company in May 2015 and legal costs. The Company continues to believe the Medisoft selling shareholders are liable to it for violations of representations and warranties in the stock purchase agreement and intends to continue to pursue this matter. The Company has not accrued any losses related to the litigation or accrued any related legal costs it has not yet incurred. The Company currently expects that this litigation process may continue until the fall of 2017.

Neurovirtual USA, Inc. v. MGC Diagnostics Corporation

The Company was also involved in litigation with Neurovirtual USA that it settled in June 2016.  In that settlement the Company made a one-time cash payment of $650,000 to Neurovirtual and each party agreed to dismiss with prejudice the lawsuit and all claims against the other party. As part of the settlement, the Company has retained Neurovirtual sleep diagnostics inventory that it purchased and Neurovirtual agreed to support this inventory pursuant to the distribution agreement. The Company has no continuing obligation to purchase additional Neurovirtual diagnostics products. 

The Company recorded a loss of $650,000, which was included in general and administrative expense for the quarter ended April 30, 2016. For the quarter ended October 31, 2016, the Company recorded an impairment loss of $354,000 with respect to a portion of its sleep diagnostic inventory, which resulted from its ongoing analysis of projected unit sales in future periods. The Company continues to carry inventory and other noncurrent assets valued at $77,000 and $86,000, respectively, as of  January 31, 2017.