PRO DEX INC (PDEX) FY 2021 MD&A

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

Overview

The
following discussion and analysis provides information that management believes is relevant to an assessment and understanding of our
results of operations and financial condition for the fiscal years ended June 30, 2021 and 2020.

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

COVID-19 Pandemic

We have adjusted certain policies
and procedures based on applicable national, state, and local emergency orders and safety guidance that may be issued from time to time,
in order to effectively manage our business during the pandemic, including:

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

We
are focused on the health and safety of all those we serve – our customers, our communities, our employees, and our suppliers. We
are supporting our customers according to their priorities and working with them to the degree that we can offer relief in the form of
delayed shipments. We are focused on continuity of supply by working with our suppliers, some of whom have delivered our orders late and
are quoting longer lead times.

While the COVID-19 pandemic
did not materially adversely affect our financial results and business operations in our fiscal year ended June 30, 2021, economic and
health conditions in the United States and across much of the globe have changed rapidly since the end of the quarter, and we cannot predict
the full future impact of the COVID-19 pandemic on our business.

Critical Accounting Policies

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

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Revenue Recognition

Under Accounting Standards Update
(“ASU”) 2014-09, (Topic 606) “Revenue From Contracts with Customers,” we recognize revenue from the sales
of products and services by applying the following steps: (1) identify the contract with a customer; (2) identify the performance obligations
in the contract; (3) determine the transaction price; (4) allocate the transaction price to each performance obligation in the contract;
and (5) recognize revenue when each performance obligation is satisfied. We primarily sell finished products and recognize revenue at
point of sale or delivery. However, we also perform services when we are engaged to design a product for a customer and there is more
judgment involved in determining the amount and timing of revenue recognition under those types of contracts. In fiscal 2021, the revenue
from NRE and Prototype services represents approximately 1% of total revenue.

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

Estimated Losses on Product Development Services

Cost
and revenue estimates related to the product development service portions of development and supply contracts are reviewed and updated
quarterly. An expected loss on development service contracts is recognized immediately in cost of sales. Losses recorded in fiscal 2021
and 2020 related to these services totaled $71,000 and $370,000, respectively.

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

Warranties

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

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

Inventories

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

Accounts Receivable

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

Deferred Costs

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

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Investments

Investments consist of marketable
equity securities of publicly held companies. The investments were made to realize a reasonable return, although there is no assurance
that positive returns will be realized. Investments are marked to market at each measurement date, with unrealized gains and losses, net
of income taxes, presented as adjustments to accumulated other comprehensive income or loss. Some of our investments include the common
stock of public companies that are thinly traded. These investments are classified as long-term in nature, as we may not be able to liquidate
the investments in a timely manner even if we wish to sell them. These investments were subject to an independent valuation as of June
30, 2021 and 2020.

Long-lived Assets

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

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

Intangibles

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

Income Taxes

We recognize deferred tax assets
and liabilities for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities, along
with net operating loss and tax credit carryovers. Deferred tax assets at June 30, 2021 and 2020 consisted primarily of basis differences
related to unrealized gain/loss related to investments, stock-based compensation, fixed assets, accrued expenses and inventories. Deferred
tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

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

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Results of Operations for the Fiscal Year Ended June 30, 2021
Compared to the Fiscal Year Ended June 30, 2020

The following tables set forth results from continuing operations for
the fiscal years ended June 30, 2021 and 2020:

Net
Sales

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

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Net
sales in fiscal 2021 increased by $3.2 million, or 9%, as compared to fiscal 2020, due primarily to an increase
in medical device revenue of $5.5 million generated mostly from our second largest customer offset by a $1.4 million reduction in repair
revenue. During fiscal 2021, sales to our second largest customer increased by $4.2 million to $10.1 million, up from $5.9 million in
fiscal 2020, primarily due to increased sales of the thoracic driver that was launched in the third quarter of fiscal 2020. Details of
our medical device sales by type is as follows:

Sales of our industrial and scientific
products, which consist primarily of our compact pneumatic air motors, increased $67,000,
or 9%, for fiscal 2021 compared to fiscal 2020. The revenue increase relates to a continued interest in these legacy products, but is
not due to any substantive marketing efforts.

Sales of our dental products
and components in fiscal 2021 declined $98,000, or 38%, as compared to fiscal 2020, and we expect future declines in this area as we are
no longer manufacturing dental products, but rather are simply selling remaining component inventory.

Our
fiscal 2021 repair revenue has decreased approximately $1.4 million, or 22%, over fiscal 2020 to $5.0 million, due to decreased repairs
of the orthopedic handpiece we sell to our largest customer. We expect repair revenue to continue to decrease based upon a downward trend
we have seen in the volume of repairs of this orthopedic handpiece.

At June 30, 2021, we had
a backlog of $9.7 million compared with a backlog of $7.0 million at June 30, 2020. Our backlog represents firm purchase orders received
and acknowledged from our customers and does not include all revenue expected to be generated from existing customer contracts. Our entire
backlog at June 30, 2021, as well as certain purchase orders received subsequent to June 30, 2021, are expected to be delivered during
fiscal 2022. We have experienced, and may continue to experience, variability in our new order bookings due to, among other reasons, the
launch of new products, the timing of customer orders based on end-user demand, and customer inventory levels. We do not typically experience
seasonal fluctuations in our shipments and revenues.

Cost of Sales and Gross Margin

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Cost of sales in fiscal 2021
increased $2.8 million, or 13%, from fiscal 2020, primarily due to the increase in product costs, consistent with the 9% increase
in net sales. During fiscal 2021, we incurred costs of $395,000 to generate $324,000 in revenue related to NRE and Prototype services,
netting losses in the amount of $71,000 compared to $370,000 in fiscal 2020. During fiscal 2021, we experienced a $370,000 under-absorption
of manufacturing costs compared to a $140,000 over-absorption in fiscal 2020, due primarily to reduced
production hours in fiscal 2021 resulting in part from paid absences related to COVID-19. Costs related to inventory and warranty
charges increased $372,000 in fiscal 2021 compared to fiscal 2020. Both inventory and warranty related
expenses tend to increase in periods of higher volume sales and in periods with higher product development activity.

Operating
Expenses

Selling expenses consist of
salaries and other personnel-related expenses related to our business development department, as well as trade show attendance, advertising
and marketing expenses, and travel and related costs incurred in generating and maintaining customer relationships. Selling expenses increased
$13,000, or 2%, compared to fiscal 2020, primarily related to severance accruals in the amount of $43,000 offset by decreases in travel
expenses due to the COVID-19 pandemic. We expect a decrease in selling expenses in the near term as we have filled the vacancy caused
by the departure of our Director of Business Development late in the fourth quarter of fiscal 2021, with our Director of Engineering,
who already had a close working relationship with most of our significant customers and prospects.

General and administrative expenses
(“G&A”) consist of salaries and other personnel-related expenses for corporate, accounting, finance, and human resource
personnel, as well as costs for outsourced information technology services, professional fees, directors’ fees, and costs associated
with being a public company. The $887,000 increase in G&A expenses from fiscal 2020 to 2021 is due primarily to $615,000 in increased
stock compensation expense related to non-qualified stock options awarded in fiscal 2021. We also incurred $267,000 in expenses related
to operating the Franklin Property while we complete its build-out. We incurred no similar expenses during the prior fiscal year, as we
purchased the Franklin Property during the second quarter of fiscal 2021.

Research and development costs
generally consist of salaries, employer-paid benefits, and other personnel- related costs of our engineering and support personnel, as
well as allocated facility and information technology costs, professional and consulting fees, patent-related fees, lab costs, materials,
and travel and related costs incurred in the development and support of our products. Research and development costs increased $2.1 million
from fiscal 2020 to 2021 due to $1.0 million in increased personnel-related expense primarily due to increased engineering consultants
and $1.2 million in increased spending on internal product development projects.

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Although the majority of our
research and development costs relate to sustaining activities related to products we currently manufacture and sell, we have created
a product roadmap to develop future products. Research and development costs represent between 38% and 48% of total operating expenses
during fiscal 2020 and 2021 and are expected to increase in the future as we continue to invest in product development. The amount spent
on projects under development is summarized below (in thousands):

As we introduce new products
into the market, we expect to see an increase in sustaining and other engineering expenses. Typical examples of sustaining engineering
activities include, but are not limited to, end-of- life component replacement, especially in electronic components found in our printed
circuit board assemblies, analysis of customer complaint data to improve process and design, replacement and enhancement of tooling and
fixtures used in the machine shop, assembly operations, and inspection areas to improve efficiency and through-put. Additionally, these
costs include development projects that may be in their infancy and may or may not result in a full-fledged product development effort.

Other Income (Expense)

Interest and Dividend Income

Our interest and dividend income
earned in fiscal 2021 and 2020 includes income earned from our interest-bearing money market accounts and portfolio of equity investments.

Other Income

During the fourth quarter of
fiscal 2020, the Monogram Orthopaedics Inc. (“Monogram”) note was repaid with interest and we collected a total of $952,000
during fiscal 2020.

Gain on Sale of Investments

During fiscal 2021, we liquidated
some of the investments in our portfolio of equity investments receiving proceeds of $4.6 million and recording a gain of $1.3 million.
During the fourth quarter of fiscal 2020, we liquidated one of the stocks in our portfolio of equity investments receiving proceeds of
$128,000 and recording a gain of $25,000.

Interest Expense

Interest expense incurred in
fiscal 2021 and 2020 consists primarily of interest expense related to our debt with Minnesota Bank & Trust (“MBT”) described
more fully in Note 6 to the consolidated financial statements contained elsewhere in this report.

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Income Taxes

The
effective tax rate for the fiscal years ended June 30, 2021 and 2020, decreased slightly from 23% to 21% due to increases in our research
and development credit and tax benefits related to stock compensation, as well as, reduced state income taxes resulting from a shift in
nexus to states with a more favorable tax rate.

Liquidity and Capital Resources

The
following table is a summary of our Statements of Cash Flows and Cash and Working Capital as of and for the fiscal years ended June 30,
2021 and 2020:

Cash Flows from Operating Activities

Cash
used in operating activities during fiscal 2021 totaled $2.1 million. Our net income was $4.5 million and included $1.3 million of gains
on the sales of certain equity investments and $901,000 of non-cash stock compensation. Offsetting this net inflow of cash, our accounts
receivable balance increased by $5.8 million primarily because our largest customer changed their payment terms from net 30 to net 90
in conjunction with a contract extension.

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

Cash Flows from Investing Activities

Net
cash used in investing activities in fiscal 2021 was $3.7 million. During the 2021 fiscal year, we generated $4.6 million in proceeds
from sales of marketable equity securities under the direction of the Investment Committee of our Board, purchased the Franklin Property
for $6.5 million and made capital expenditures in the amount of $1.8 million primarily for the Franklin Property.

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

Cash Flows from Financing Activities

Net
cash provided by financing activities for fiscal 2021, totaled $3.1 million and included $9.1 million in various loans from Minnesota
Bank and Trust (“MBT”) more fully described in Note 6 to the consolidated financial statements contained elsewhere in this
report, offset by $5.5 million related to the repurchase of 216,171 shares of our common stock pursuant to our share repurchase program,
$351,000 of principal payments on our loans with MBT, as well as payment of $259,000 of employee payroll taxes related to the award of
40,000 shares of common stock to employees under previously granted performance awards.

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Net cash used in financing activities
for fiscal 2020 totaled $4.0 million and related primarily to the $3.4 million repurchase of 231,274 shares of our common stock pursuant
to our share repurchase program, as well as $630,000 of principal payments primarily related to our term loan from MBT more fully described
in Note 6 to the consolidated financial statements contained elsewhere in this report.

Liquidity Requirements for the Next 12 Months

As of June 30, 2021, our working
capital was $19.1 million. We currently believe that our existing cash and cash equivalent balances, together with our account receivable
balances, and anticipated cash flows from operations will provide us sufficient funds to satisfy our cash requirements as our business
is currently conducted for at least the next 12 months. We may also borrow against our $2.0 million revolving loan with MBT, which
we anticipate renewing (See Note 6 of notes to consolidated financial statements contained elsewhere in this report).

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

Surplus Capital Investment Policy

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

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

The Investment Committee approved
each of the investments comprising the $3.0 million of marketable public equity securities held at June 30, 2021, which amount includes
unrealized holding losses in the amount of $215,000 at June 30, 2021.

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

During the fiscal year ended
June 30, 2021, we repurchased 216,171 shares at an aggregate cost, inclusive of fees under the Plan, of $5.5 million. During the fiscal
year ended June 30, 2020, we repurchased 231,274 shares at an aggregate cost, inclusive of fees under the Plan, of $3.4 million. On a
cumulative basis, we have repurchased a total of 1,035,496 shares under the share repurchase programs at an aggregate cost, inclusive
of fess under the Plan, of $14.0 million. All repurchases under the 10b5-1 Plans were administered through an independent broker.

Recent Accounting Pronouncements

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

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

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