CPSH CPS Technologies Corp

ITEM 2       MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of financial condition and results of operations is based upon and should be read in conjunction with the financial statements of the Company and notes thereto included in this report and the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements that involve a number of risks and uncertainties. There are a number of factors that could cause the Company’s actual results to differ materially from those forecasted or projected in such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements which speak only as of the date hereof.  The Company undertakes no obligation to publicly release the results of any revisions to these forward-looking statements which may be made to reflect events or changed circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Critical Accounting Policies

The critical accounting policies utilized by the Company in preparation of the accompanying financial statements are set forth in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.  There have been no material changes to these policies since December 31, 2016.

Overview

CPS Technologies Corporation (the ‘Company’ or ‘CPS’) provides advanced material solutions to the electronics, power generation, automotive and other industries .  

The Company’s products are generally used in high-power, high-reliability applications. These applications always involve energy use or energy generation and the Company’s products allow higher performance and improved energy efficiency. The Company is an important participant in the growing movement towards alternative energy and "green" lifestyles. For example, the Company’s products are used in mass transit, hybrid and electric cars, wind-turbines for electricity generation as well as routers and switches for the internet which in turn allows telecommuting.

The Company’s primary advanced material solution is metal matrix composites (MMCs), a new class of materials which are a combination of metal and ceramic. CPS has a leading, proprietary position in metal m atrix composites. Metal matrix composites have several superior properties compared to conventional materials including improved thermal conductivity, thermal expansion matching, stiffness and light weight which enable higher performance and higher reliability in our customers’ products.

Like plastics several decades ago, we believe metal-matrix composites will penetrate many end markets over many years. CPS management believes our business model of providing advanced material solutions to a portfolio of high growth end markets which are, at any point in time, in various stages of the technology adoption lifecycle, provides CPS with the opportunity for sustained growth and a diversified customer base. We believe we have validated this model as we are now supplying customers at all stages of the technology adoption lifecycle.

CPS is the leader in supplying metal matrix composites to certain high growth electronics end markets which are well along in the adoption lifecycle and therefore generating significant demand. These end markets include high-performance integrated circuits and circuit boards used in internet switches and routers, as well as motor controllers used in high-speed electric trains, subway cars and wind turbines.   CPS supplies heat spreaders, lids and baseplates to customers in these end markets. CPS is a fully qualified manufacturer for many of the world’s largest electronics OEMs.

CPS also assembles housings and packages for hybrid circuits. These housings and packages may include components made of metal-matrix composites; they may include components made of more traditional materials such as aluminum, copper-tungsten, etc.

A market at an earlier stage of the adoption lifecycle is the market for hybrid and electric automobiles.  In 2012 the Company announced a multi-year supply agreement with a major tier one automotive supplier for the supply of AlSiC pin fin baseplates for use in motor controllers for hybrid and electric automobiles.

We are also actively working with customers in end markets at the beginning stages of the adoption lifecycle. An example of such a market is the market for armor. In 2008 the Company entered into a cooperative agreement with the Army Research Laboratory to further develop large hybrid metal matrix composite modules which integrally combine metal matrix composites and ceramics by enveloping ceramic tiles with MMCs. This system offers a lighter weight, durable, multi-hit capable and cost competitive alternative to conventional steel, aluminum and ceramic based armor systems. CPS hybrid hard face armor modules are comprised of multiple materials completely enveloped within and mechanically and chemically bonded to lightweight and stiff aluminum metal matrix composites.

The Company believes that its hybrid hard face armor tiles will find application in many military vehicles as well as armored commercial vehicles.

Our products are manufactured by proprietary processes we have developed including the QuicksetTM Injection Molding Process (‘Quickset Process’) and the QuickCastTM Pressure Infiltration Process (‘QuickCast Process’).

CPS was incorporated in Massachusetts in 1984 as Ceramics Process Systems Corporation and reincorporated in Delaware in April 1987 through a merger into a wholly-owned Delaware subsidiary organized for purposes of the reincorporation. In July 1987, CPS completed our initial public offering of 1.5 million shares of our Common Stock. In March 2007, we changed our name from Ceramics Process Systems Corporation to CPS Technologies Corporation.

Results of Operations for the Second Fiscal Quarter of 2017 (Q2 2017) Compared to the Second Fiscal Quarter of 2016 (Q2 2016); (all $ in 000s)

Total revenue was $3,724 in Q2, 2017, a 5% decrease compared with total revenue of $3,935 in Q2, 2016. This decrease was due to lower sales of hermetic packages and lower armor revenue. There were no significant price changes in Q2, 2017 compared with Q2, 2016.

Gross margin in Q2 2017, totaled $414 or 11% of sales. In Q2 2016, gross margin was $561 or 14% of sales.   This decrease in margin was primarily due to lower sales volume.

Selling, general and administrative expenses (SG&A) were $933 in Q2, 2017, up 5% compared with SG&A expenses of $ 892 in Q2, 2016.  During Q1, 2017 the Company incurred an additional $100 in legal and other costs associated with preparing for the annual proxy process.   If it had not been for this one-time expenditure, the total SG&A spending would have been down 7% versus the same period last year, primarily as a result of decreased professional fees and sales commissions.

Primarily as a result of the decline in sales volume, the Company experienced an operating loss of $519 compared with an operating loss of $332 in the same quarter last year. The net loss for Q2, 2017 totaled $333 versus a net loss of $259 in Q2, 2016.  In both cases the drop in sales volume, and to a lesser degree one-time proxy related costs, were the primary reasons for the variance.

Results of Operations for the First Six Months of 2017 Compared to the First Six Months of 2016 (all $ in 000s)

Total revenue was $6,569 in the first half of 2017, a 28% decrease compared with total revenue of $9,151 in the first six months of 2016. This decrease was due primarily to a reduction in the sales of baseplates and, to a lesser degree, lower armor sales. There were no significant price changes during the first half of 2017 compared with the first half of 2016.

Gross margin in the first six months of 2017 totaled $334 or 5% of sales.  In the first six months of 2016 gross margin totaled $1,692 or 18% of sales.  This decrease was almost entirely due to the reduction in revenues.

Selling, general and administrative (SG&A) expenses were $1,907 during the first six months of 2017, up 6% compared with SG&A expenses of $1,801 in the first six months of 2016  During the first half of 2017, the Company incurred approximately an additional $200 in legal and other costs associated with preparing for this years annual proxy process.  If it had not been for this one-time additional costs, the total SG&A spending would have been down 5% versus the same period last year, primarily due to lower sales commissions which were due to lower sales volume.

In the first six months of 2017 the Company incurred an operating loss of $1,573 compared with an operating loss of $108 in the same period last year.  The net loss for the first six months of 2017 totaled $937 versus a net loss of $62 in the first six months of 2016.  In both cases, as cited earlier, the primary reason for these variances was the drop in sales volume.

The Company continues to sell to a limited number of customers and the loss of any one of these customers could cause the Company to require additional external financing. Failure to generate sufficient revenues, raise additional capital or reduce certain discretionary spending could have a material adverse effect on the Company’s ability to achieve its business objectives.

Liquidity and Capital Resources (all $ in 000s unless noted)

The Company’s cash and cash equivalents at July 1, 2017 totaled $1,942.  This compares to cash and cash equivalents at December 31, 2016 of $3,408. The decrease in cash was due primarily to losses from operations.

Accounts receivable at July 1, 2017 totaled $2,706 compared with $1,960 at December 31, 2016. Days Sales Outstanding (DSOs) increased slightly from 61 days at the end of 2016 to 65 days at the end of Q2, 2017. The accounts receivable balances at December 31, 2016, and July 1, 2017 were both net of an allowance for doubtful accounts of $10.

Inventories totaled $1,946 at July 1, 2017, flat when compared with inventories of $1,971 at December 31, 2016. Inventory turnover for the four quarters in 2016 was 5.6 times (based on a 5 point average) and 5.7 times for the most recent four quarters ending Q2, 2017.

All consigned inventory is shipped under existing purchase orders and per customers’ requests. Of the inventory at July 1, 2017, $543 was located at customers’ locations pursuant to consigned inventory agreements. Of the total inventory at December 31, 2016, $848 was located at customers’ locations pursuant to consigned inventory agreements.

The Company used its cash balance to finance operations during the first half of 2017. The Company expects it will continue to be able to fund its operating requirements for the remainder of 2017 from a combination of existing cash balances and borrowings under its line of credit, if necessary.

Contractual Obligatiions 

In June 2017, the Company renewed its revolving line of credit line with Santander Bank for $1.5 million.  The agreement matures at the end of May 2018.  The LOC is secured by the accounts receivable and other assets of the Company, has an interest rate of prime plus 100 basis points. Under the terms of the agreement, the Company is required to maintain its operating accounts with Santander Bank. The Company is also subject to certain financial covenants.  These include a minimum cash balance of $1.5 million at July 1, 2017 and specific earnings levels, targeted current ratios and targeted debt to tangible net worth ratios at the end of subsequent quarters.  At July 1, 2017, the Company was in compliance with all existing covenants.  Also, at July 1, 2017 the Company had no borrowings under this LOC and its borrowing base at the time would have permitted $1.456 million to have been borrowed.

 The financial covenant requirement at the end of Q2, 2017 are shown below, together with the actual ratios achieved:

Management believes that cash flows from operations, existing cash balances and the leasing and credit line in place with Santander Bank will be sufficient to fund our cash requirements for the foreseeable future. However, there is no assurance that we will be able to generate sufficient revenues or reduce certain discretionary spending in the event that planned operational goals are not met such that we will be able to meet our obligations as they become due.

As of July 1, 2017 the Company had $138 of construction in progress.   The Company intends to finance production equipment in construction in progress and outstanding commitments under the lease agreement, with existing cash balances and funds generated by operations.

The Company entered into a 10-year lease for the Norton facilities effective on March 1, 2006. The leased facilities comprise approximately 38 thousand square feet. In January 2016 this lease was amended to extend the lease to February 28, 2017.  As part of the agreement the Company obtained two, one-year options which enabled it to continue to lease through February 28, 2019. In June 2016 the Company exercised the option to extend the lease through February 28, 2018 The lease is a triple net lease wherein the Company is responsible for payment of all real estate taxes, operating costs and utilities.  The Company also has an option to buy the property and a first right of refusal during the term of the lease.  Annual rental payments are $100 thousand in year one increasing to $152 thousand at the end of the extended term.

In February 2011, the Company entered into a lease for an additional 13.8 thousand square feet in Attleboro, MA. Monthly rent, which includes utilities, is $6,900. In Q4, 2016, the Company exercised its option to extend the lease through the end of February 2018. Annual rental payments in 2017 are expected to be $83 thousand.

The Company’s contractual obligations at July 1, 2017 consist of the following: