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Item
2.
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Management's
Discussion and Analysis of Financial Condition and Results of Operations
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The
following discussion should be read in conjunction with the Financial Statements and Notes contained herein and with those in
our Form 10-K for the year ended December 31, 2016.
Except
for the historical information contained herein, the matters discussed in this Quarterly Report on Form 10-Q include certain forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. Those statements include, but may
not be limited to, all statements regarding our intent, belief, and expectations, such as statements concerning our future profitability
and operating and growth strategy. Words such as “believe,” “anticipate,” “expect,” “will,”
“may,” “should,” “intend,” “plan,” “estimate,” “predict,”
“potential,” “continue,” “likely” and similar expressions are intended to identify forward-looking
statements. Investors are cautioned that all forward-looking statements contained in this Quarterly Report on Form 10-Q and in
other statements we make involve risks and uncertainties including, without limitation, the factors set forth under the caption
“Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2016, and other factors
detailed from time to time in our other filings with the Securities and Exchange Commission. One or more of these factors have
affected, and in the future could affect our business and financial condition and could cause actual results to differ materially
from plans and projections. Although we believe the assumptions underlying the forward-looking statements contained herein are
reasonable, there can be no assurance that any of the forward-looking statements included in this Quarterly Report on Form 10-Q
will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein,
the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and
plans will be achieved.
Any
forward-looking statement speaks only as of the date on which such statement is made, and we undertake no obligation to update
any forward-looking statement or statements to reflect events or circumstances after the date on which such statements are made
or reflect the occurrence of unanticipated events, unless necessary to prevent such statements from becoming misleading. New factors
emerge from time to time and it is not possible for us to predict all factors, nor can it assess the impact of each such factor
on the business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from
those contained in any forward-looking statements.
Overview
SCI
Engineered Materials, Inc. (“SCI”, “we” or the “Company”), formerly Superconductive Components,
Inc., an Ohio corporation, was incorporated in 1987. We operate in one segment as a global supplier and manufacturer of
advanced materials for Physical Vapor Deposition (“PVD”) Thin Film Applications. We are focused on specific
markets within the PVD industry (Photonics, Thin Film Solar, Glass, Thin Film Battery and Transparent Electronics). Substantially
all of our revenues are generated from customers with multi-national operations. We have made considerable resource investment
in the Thin Film Solar industry and a few customers have adopted our products. Thin Film Battery is a developing market
where manufacturers of batteries use our products to produce very small power supplies with small quantities of stored energy.
Through collaboration with end users and Original Equipment Manufacturers we develop innovative customized solutions enabling
commercial success.
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Item
2.
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Management's
Discussion and Analysis of Financial Condition and Results of Operations (continued)
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Executive
Summary
For
the six months ended June 30, 2017, we had total revenue of $3,283,414. This was an increase of $702,118, or 27.2%, compared to
the six months ended June 30, 2016. Gross profit was $799,832 for the six months ended June 30, 2017 compared to $546,469 for
the same six months in 2016. This was an increase of $253,363 or 46.4%. Gross profit as a percentage of revenue was 24.4% for
the first six months of 2017 compared to 21.2% for the same period in 2016. Pricing and product mix in our photonics market contributed
to the increased revenue and gross profit.
Operating
expenses were $747,807 and $931,775 for the six months ended June 30, 2017 and 2016, respectively. This was a decrease of $183,968
or 19.7%. The decrease was primarily related to the restructuring of our sales department late in 2016 and additional cost cutting
measures which were implemented during the second half of 2016.
We
have new materials under development that may replace the Cadmium Sulfide buffer layer in Copper Indium Gallium Selenide (CIGS)
solar cells. These materials are currently being tested at Case Western Reserve University. We continue to invest in developing
new products for all of our markets including transparent conductive oxide systems for the thin film solar and display markets.
We also have ongoing development efforts with our thin film battery materials and transparent electronic products. These efforts
include accelerating time to market for those products and involve research and development expense.
For
the six months ended June 30, 2017, we had net income after income taxes of $28,873 compared to a net loss of $408,190 for the
six months ended June 30, 2016. This improvement was due to the increased gross profit and the reduction in operating expenses.
RESULTS
OF OPERATIONS
Three
and six months ended June 30, 2017 (unaudited) compared to three and six months ended June 30, 2016 (unaudited):
Revenue
For
the three months ended June 30, 2017, we had total revenue of $1,911,498. This was an increase of $705,014, or 58.4%, compared
to the three months ended June 30, 2016. For the six months ended June 30, 2017, we had total revenue of $3,283,414 compared to
$2,581,296 for the same period in 2016. This was an increase of $702,118, or 27.2%. Pricing and product mix in our photonics market
contributed to the increased revenue and gross profit.
Revenue
from product sales is recognized based on shipping terms or upon shipment to customers. Provisions for discounts and rework costs
for returns are established when products are shipped based on historical experience. Customer deposits represent cash received
in advance of revenue earned.
Gross
Profit
Gross
profit was $462,847 for the three months ended June 30, 2017 compared to $286,859 for the same three months in 2016. This was
an increase of $175,988 or 61.4%. Gross profit as a percentage of revenue (gross margin) was 24.2% for the second quarter of 2017
compared to 23.8% for the same period in 2016. Gross profit was $799,832 for the six months ended June 30, 2017 compared to $546,469
for the first six months of 2016. This was an increase of $253,363 or 46.4%. Gross margin was 24.4% for the first six months of
2017 compared to 21.2% for the same period in 2016. The increase in gross profit and gross margin was attributed to pricing and
improved product mix.
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Item
2.
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Management's
Discussion and Analysis of Financial Condition and Results of Operations (continued)
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General
and Administrative Expense
General
and administrative expense for the three months ended June 30, 2017 decreased to $256,112 from $273,712 for the three months ended
June 30, 2016, or 6.4%. This decrease was primarily related to lower compensation due to cost cutting measures.
General
and administrative expense for the six months ended June 30, 2017 decreased to $510,550 from $563,440 for the six months ended
June 30, 2016, or 9.4%. The first six months of 2017 included lower compensation of approximately $35,000 related to the previously
mentioned cost cutting measures and also lower professional fees of approximately $7,000.
We
reclassified a portion of rent expense from operating expenses (general and administrative) to cost of goods sold to
accurately reflect an amount assigned to the manufacturing area of our facility. This was retroactively reclassified
beginning January 1, 2016.
Professional
Fees
Included
in general and administrative expense was $41,688, and $43,491 for professional fees for the three months ended June 30, 2017
and 2016, respectively and $97,232 and $104,528 for professional fees for the six months ended June 30, 2017 and 2016, respectively.
These continued expenses are primarily related to SEC compliance costs for legal, accounting and stockholder relations fees.
Research
and Development Expense
Research
and development expense for the three months ended June 30, 2017 was $79,175 compared to $74,417 for the same period in 2016,
an increase of 6.4%. Research and development expense for the six months ended June 30, 2017 was $161,787 compared to $154,493
for the same period in 2016, an increase of 4.7%. We continue to invest in developing new products for all of our markets including
the buffer layer in CIGS solar cell, transparent conductive oxide systems for applications in transparent electronics, thin film
solar markets and ongoing development of thin film battery materials. These efforts include accelerating time to market for those
products and involve ongoing research and development expense.
Marketing
and Sales Expense
Marketing
and sales expense was $46,581 and $104,832 for the three months ended June 30, 2017 and 2016, respectively. This was a decrease
of $58,251 or 55.6%. We restructured our sales department during the fourth quarter of 2016 for improved efficiency. This action
resulted in lower stock compensation expense of approximately $10,000, consulting expense of approximately $24,000 as well as
lower wages and compensation of approximately $35,000.
Marketing
and sales expense was $75,470 and $213,842 for the six months ended June 30, 2017 and 2016, respectively. This was a decrease
of $138,372 or 64.7%. The first six months of 2017 resulted in lower stock compensation expense of approximately $21,000, consulting
expense of approximately $50,000 as well as lower wages and compensation of approximately $74,000.
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Item
2.
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Management's
Discussion and Analysis of Financial Condition and Results of Operations (continued)
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Stock
Compensation Expense
Included
in operating expenses were non-cash stock based compensation costs of $50,187 and $51,049 for the three months ended June 30,
2017 and 2016, respectively and $96,565 and $104,138 for the six months ended June 30, 2017 and 2016, respectively. Compensation
cost for all stock-based awards is based on the grant date fair value and recognized over the required service (vesting) period.
Unrecognized non-cash stock based compensation expense related to operating expense was $75,614 as of June 30, 2017 and will be
recognized through 2019.
Interest
Interest
was $10,710 and $11,156 for the three months ended June 30, 2017 and 2016, respectively. Interest was $22,204 and $22,841 for the
six months ended June 30, 2017 and 2016, respectively.
Income
(loss) Applicable to Common Stock
Income
applicable to common stock for the three months ended June 30, 2017 was $63,283 compared to a loss applicable to common stock
of $183,339 for the three months ended June 30, 2016. Income applicable to common stock for the six months ended June 30, 2017
was $16,797 compared to a loss applicable to common stock of $420,266 for the six months ended June 30, 2016. The improvement
was due to higher revenue and gross profit as well as lower operating expenses.
Common
Stock
The
following schedule represents our outstanding common stock during the period of 2017 through 2024 assuming all outstanding stock
options are exercised during the year of expiration. Based on outstanding shares at June 30, 2017, if each shareholder exercises
his or her options, it would increase our common shares by 397,671 to 4,533,098 by December 31, 2024. Assuming all such options
are exercised in the year of expiration, the effect on shares outstanding is illustrated as follows:
|
|
Options
due to
expire
|
|
|
Potential
shares
outstanding
|
|
|
Weighted
average
exercise price
|
|
2018
|
|
|
5,000
|
|
|
|
4,140,427
|
|
|
$
|
3.10
|
|
2019
|
|
|
271,500
|
|
|
|
4,411,927
|
|
|
$
|
6.00
|
|
2024
|
|
|
121,171
|
|
|
|
4,533,098
|
|
|
$
|
0.84
|
|
Liquidity
and Capital Resources
Cash
As
of June 30, 2017 cash on hand was $983,621. Cash on-hand was $730,352 at December 31, 2016. We believe, based on forecasted
sales and expenses that cash flow from operations will be adequate to sustain operations at least through August 2,
2018.
Working
Capital
At
June 30, 2017 working capital was $651,371 compared to $531,654 at December 31, 2016, an increase of $119,717 or 22.5%. As discussed
below, cash increased approximately $253,000. Inventories increased approximately $1,346,000 and customer deposits increased approximately
$1,471,000 due to orders received during the first half of 2017. Accounts receivable and accounts payable increased approximately
$203,000 and $201,000 respectively. Current debt obligations increased approximately $38,000 from $293,791 to $331,589.
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Item
2.
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Management's
Discussion and Analysis of Financial Condition and Results of Operations (continued)
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Cash
from Operations
Net
cash provided by operating activities was approximately $457,000 for the six months ended June 30, 2017 and approximately $135,000
for the six months ended June 30, 2016. Included in expenses were non cash stock based compensation costs of approximately $98,000
and $105,000 for the six months ended June 30, 2017 and 2016, respectively.
Cash
from Investing Activities
Cash
of approximately $44,000 was used in investing activities during the six months ended June 30, 2017, compared to approximately
$59,000 during the six months ended June 30, 2016.
Cash
from Financing Activities
Cash
of approximately $160,000 and $190,000 was used in financing activities for principal payments to third parties for capital lease
obligations and notes payable during the six months ended June 30, 2017 and 2016, respectively. During the second quarter of 2016,
proceeds of $4,200 were received from the exercise of stock options.
Debt
Outstanding
Total
debt outstanding decreased to approximately $689,000 at June 30, 2017, from approximately $741,000 at December 31, 2016, or 7.0%.
Debt issuance costs of $5,506 at June 30, 2017, and $10,226 at December 31, 2016, are netted for financial statement presentation.
During the first quarter of 2017 we closed on a new capital lease obligation of approximately $104,000. During the second quarter
of 2016 we closed on a new capital lease obligation of approximately $145,000.
Liquidity
We
have forecasted revenues and related costs as well as investing plans and financing needs to determine liquidity to meet
cash flow requirements and believe we will have sufficient liquidity at least through August 2, 2018. This forecast was
based on current cash levels and debt obligations, and the best estimates of revenues primarily from existing customers and gave
consideration to the continued and possible increased levels of uncertainty in demand in the markets in which we operate. Our
ability to maintain current operations is dependent upon our ability to achieve these forecasted results, which we believe will
occur.
Off
Balance Sheet Arrangements
We
have no off balance sheet arrangements including special purpose entities.
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Item
2.
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Management's
Discussion and Analysis of Financial Condition and Results of Operations (continued)
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Critical
Accounting Policies
The
preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the
United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Financial
Statements and accompanying notes
.
Note 2 to the Financial Statements in our Annual Report on Form 10-K for the year ended
December 31, 2016, describes the significant accounting policies and methods used in the preparation of the Financial Statements.
Estimates are used for, but not limited to, accounting for the allowance for doubtful accounts, inventory allowances, property
and equipment depreciable lives, patents and licenses useful lives, revenue recognition, tax valuation allowance, stock based
compensation and assessing changes in which impairment of certain long-lived assets may occur. Actual results could differ from
these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates
used in the preparation of the Financial Statements. The allowance for doubtful accounts is based on our assessment of the collectability
of specific customer accounts and the aging of the accounts receivable. If there is a deterioration of a major customer’s
credit worthiness or actual defaults are higher than our historical experience, our estimates of the recoverability of amounts
due us could be adversely affected. Inventory purchases and commitments are based upon future demand forecasts. If there is a
sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly
changing technology and customer requirements, we may be required to increase our inventory allowances and our gross margin could
be adversely affected. Depreciable and useful lives estimated for property and equipment, licenses and patents are based on initial
expectations of the period of time these assets and intangibles will benefit us. Changes in circumstances related to a change
in our business, change in technology or other factors could result in these assets becoming impaired, which could adversely affect
the value of these assets.
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Item
4.
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Controls
and Procedures
|
Evaluation
of Disclosure Controls and Procedures
Our
management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the
effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by
this report. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures,
no matter how well designed and operated, can only provide reasonable assurance of achieving the desired control objectives and
management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Due to a segregation of duties material weakness described below, and based on this evaluation, the Company’s Chief Executive
Officer and Chief Financial Officer have concluded that as of June 30, 2017, the Company’s disclosure controls and procedures
were not effective, at the reasonable assurance level, in recording, processing, summarizing and reporting, on a timely basis,
information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act and in ensuring
that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated
and communicated to the Company’s management, including the Chief Executive Officer and Chief Accounting Officer, as appropriate
to allow timely discussions regarding required disclosure. Until we are able to hire additional employees, we will continue to
report to the Audit Committee and the Board of Directors at least monthly (and more often as necessary). We believe this will
continue to mitigate this weakness. This reporting includes balance sheets, statements of operations, statements of cash flows,
and other detail supporting these statements. Accordingly, we believe that the financial statements included in this report fairly
present, in all material respects, our financial condition, results of operation, changes in shareholder’s equity and cash
flows for all periods presented.
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Item
4.
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Controls
and Procedures (continued)
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Inherent
Limitations over Internal Controls
Our
internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Our internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records
that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable
assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally
accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management
and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use,
or disposition of assets that could have a material effect on the financial statements.
Management,
including our Chief Executive Officer and Chief Financial Officer, does not expect that our internal controls will prevent or
detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not
absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the
fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of
the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control
issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods
is subject to the risk that those internal controls may become inadequate because of changes in business conditions or that the
degree of compliance with the policies or procedures may deteriorate.
Management
previously disclosed a material weakness in internal control over financial reporting in its annual report on Form 10-K, filed
on February 27, 2017, for the year ended December 31, 2016, relating to insufficient segregation of duties consistent with control
objectives. Management is aware of the risks associated with the lack of segregation of duties due to the small number of employees
currently working with general administrative and financial matters. Due to our size and nature, segregation of all conflicting
duties may not always be possible and may not be economically feasible. However, to the extent possible, the initiation of transactions,
the custody of assets and the recording of transactions shall be performed by separate individuals. In order to remediate this
weakness, we will need to hire additional employees. Although we will periodically reevaluate this situation, at this point we
consider that the risks associated with such lack of segregation of duties and the potential benefits of adding employees to segregate
such duties are not cost justified. Until we are able to hire additional employees, we will continue to report to the Audit Committee
and the Board of Directors at least monthly (and more often as necessary). We believe this will continue to mitigate this weakness.
This reporting includes balance sheets, statements of operations, statements of cash flows, and other detail supporting these
statements.
Changes
in Internal Controls over Financial Reporting
There
were no changes in our internal controls over financial reporting for the three months ended June 30, 2017, that materially affected
or were reasonably likely to materially affect our disclosure controls and procedures. Additionally, there were no changes in
our internal controls that could materially affect our disclosure controls and procedures subsequent to the date of their evaluation.