ITEM 7. MANAGEMENT
’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
This Management
’s Discussion and Analysis of Financial Condition and Results of Operations and other parts of this Annual Report on Form 10-K contain forward-looking statements that involve risks and uncertainties. All forward-looking statements included in this Annual Report on Form 10-K are based on information available to us on the date hereof, and except as required by law, we assume no obligation to update any such forward-looking statements. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth under the caption “Risk Factors” contained in this report and elsewhere herein. The following should be read in conjunction with our annual financial statements contained elsewhere in this report.
Overview
Our primary business focus is to pursue SBIR programs from the DoD, Department of Homeland Security, and other governmental authorities, and to expand this government funded research and development into products and services. Since 2002, we have been awarded several Phase I, II, and III SBIR contracts
, and several IDIQ contracts for our ADEPT and ADSSS products.
Revenues from our government contracts represented
substantially all of our revenues for the years ended December 31, 2017 and 2016. We believe that we can utilize the intellectual property developed under our various SBIR awards to develop proprietary products for both the government and commercial marketplace.
Product Portfolio
Adaptive Diagnostic Electronic Portable Testset (ADEPT)
. ADEPT is an automated maintenance workstation designed to significantly reduce the time required to align the AN/SPY-1 Radar System aboard U.S. Navy Aegis cruisers and destroyers, while optimizing system performance and readiness. ADEPT Systems are currently deploying on all Aegis CG and DDG platforms to support the AN/SPY1 radar system. Since the system uses commercial instrument case and modules, ADEPT units can be modified to support both preventative maintenance and condition-based maintenance of other radars and complex electronic systems in military or commercial applications. In that regard, we have a service contract with the U.S. Navy to extend ADEPT to a second U.S. Navy radar system, the SPS-49. These services are expected to assist in optimizing performance for the Ballistic Missile Defense Mission. As of the date of this report, we have delivered a total of 200 ADEPT units.
A
DEPT
Distance Support Sensor Suite (ADSSS)
. In 2013, we started development of ADSSS for the Navy’s Littoral Combat Ship (“LCS”). ADSSS is a network-enabled system that can be configured to monitor multiple shipboard systems and report maintenance data onshore for further analysis to detect trends and predict failures. ADSSS provides an open architecture approach with industry standard hardware, and cybersecurity compliant software to acquire and process system operational and maintenance data. ADSSS fully automates the capture of system operation, environment and maintenance data to provide unattended operation. The system monitors key parameters and sends alert notifications when parameters move out of tolerance. We expect ADSSS to be used on both variants of the LCS, currently planned to be at least 32 ships. ADSSS, with its remote monitoring and prognostics capabilities, has also generated interest in other ship classes, including Aegis, and we are currently pursuing several related opportunities.
Diagnostic Profiler
. The Diagnostic Profiler is an integrated development environment for developing diagnostic capabilities used in maintenance, embedded diagnostics and troubleshooting applications. The software provides diagnostic services to its host application, including fault call-outs, suggested “next best” test to further isolate faults, and direct maintenance actions. When additional faults are identified, the software prioritizes the fault call-outs by probability. The use of the diagnostic profiler eliminates the need for the development and maintenance of diagnostic flow charts and hard-coded text sequences. This reduces the effort required to correct bugs and design changes and over the life of the system, could result in significant cost savings.
Prognostics Framework
. Prognostics Framework is an analysis software for framework that implements real-time prognostics, diagnostics and status monitoring to support embedded prognostic applications, health management systems and condition-based maintenance applications. The Prognostics Framework software institutes an information framework that organizes relevant data related to: (i) the condition of the system; (ii) the system’s ability to perform required functions over specific time intervals; and (iii) the need for maintenance actions and repair parts. The Prognostics Framework has been used to implement a complete health management system on one of the first radar systems to require prognostics as a key element of its overall solutions. Other potential applications include complex computer networks, power generators, power supply, cooling and environmental systems.
Government Contracts
Please see I
TEM 1 BUSINESS above for a description of our Government Contracts.
Key Performance Indicator
As substantially all of our revenue is derived from contracts with the Federal government, our key performance indicator is the dollar volume of contracts
and task orders awarded to us under our IDIQ contracts. Increases in the number and value of contracts and task orders awarded will generally result in increased revenues in future periods and, assuming relatively stable variable costs associated with our fulfilling such awards, increased profits in future periods. The timing of such awards is uncertain as we sell to Federal government agencies where the process of obtaining such awards can be lengthy and at times uncertain. As the substantial majority of our revenue in 2017, and expected revenue in 2018, is or will be from sales of ADEPT units and ADSSS systems under our IDIQ contracts, continued generation of task orders and our ability to expand the market and potential customer base for ADEPT units will be a key indicator of future revenue. ADEPT units must be serviced and calibrated every two years. Accordingly, as we continue to increase the installed base of ADEPT units and expand the units to other radar systems, we expect to generate future recurring maintenance and service revenue.
Outlook
Our strategy for continued growth is based on continuing expansion of our defense business
and executing new initiatives to apply our advanced maintenance technology in commercial markets. With regard to the defense industry, we expect to continue expanding our technology base, backlog and revenue by continuing our active participation in the DoD SBIR program and bidding on projects that fall within our areas of expertise. These areas include electronic systems engineering and integration, radar systems engineering, combat/C4I (Command, Control, Communications, Computers & Intelligence) systems engineering, and communications engineering. We believe that we can utilize the intellectual property developed under our various SBIR awards to develop proprietary products, such as ADEPT and ADSSS, with broad appeal in both the government and commercial marketplace. Our state-of-the-art test equipment can be used by many commercial and governmental customers such as the FAA, radio and television stations, cell phone stations, and airlines. Second, we will continue to pursue SBIR projects with the Department of Homeland Security, the U.S. Navy, and other government agencies. Third, we believe that through our marketing of products, such as ADEPT, we will develop key relationships with prime defense contractors. Our strategy is to develop these relationships into long-term, key subcontractor roles on future major defense programs awarded to these prime contractors.
With regard to commercial markets, our Diagnostics Profiler and Prognostics Framework software offerings complement our hardware products and allow us to provide complete hardware/software solutions for advanced maintenance applications. Current customers for these systems include major multinational corporations such as HP, which recently extended our Diagnostic Profiler software support with for a fifth year. We continue to receive repeat orders from these customers to support their applications.
We plan to provide “condition-based maintenance” systems for applications such as FAA radar surveillance and support systems, power distribution and utilities infrastructure, commercial shipping, cooling and environmental systems, and other “complex distributed systems” to commercial customers. In that regard, we are currently developing a condition-based maintenance solution for heating ventilation, air conditioning and refrigeration (HVAC) equipment based on our proprietary Prognostics Framework solution. We have deployed two active pilot systems that are providing key maintenance data on a daily basis to service technicians.
In 201
8, our primary strategic focus is to continue as a premium provider of R&D and product development services to the defense industry, generate multiple task orders under our two IDIQ contracts, and expand our commercial business through marketing and sales of our Prognostics Framework and Diagnostic Profiler software products. We will also seek to generate incremental revenue through providing light assembly and production services to commercial customers at our manufacturing and depot center in Largo, Florida.
Over the longer term, we intend to further develop advanced maintenance technologies and implement these technologies in products for deployment in defense applications and to expand into more commercial applications. We believe that many of our core capabilities, remote monitoring, rugged systems, predictive maintenance and communications expertise, are applicable to other industries that work with complex distributed systems, such as utilities, communications and transportation systems. We are currently in discussions with certain industry participants regarding this initiative.
During
recent years, the combination of spending caps, discretionary spending cuts, sequestration and further changes in defense spending and priorities have caused, and may in the future continue to cause, delays in funding certain projects. This may negatively impact our revenues and profits.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, warranty costs, recoverability of long-lived assets, income taxes, stock-based compensation, backlog and commitments. We base our estimates on historical experience and on various other assumptions that we believe 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 under different assumptions or conditions. The accounting estimates and assumptions discussed in this section are those that we consider to be the most critical to an understanding of our financial statements because they inherently involve significant judgments and uncertainties.
Revenue Recognition
. We are engaged in research and development contracts with the federal government to develop certain technology to be utilized by the U.S. Department of Defense (“DoD”). The contracts are cost plus fixed fee and firm fixed price contracts and revenue is recognized on the basis of such measurement of partial performance as will reflect reasonably assured realization or delivery of completed articles. Fees earned under our contracts may also be accrued as they are billable, under the terms of the agreements, unless such accrual is not reasonably related to the proportionate performance of the total work or services to be performed by us from inception to completion. Under the terms of certain contracts, fixed fees are not recognized until the receipt of full payment has become unconditional, that is, when the product has been delivered and accepted by the federal government. Backlog represents the estimated amount of future revenues to be recognized under negotiated contracts as work is performed. Our backlog includes future ADEPT units and ADSSS systems to be developed and delivered to the federal government.
We
recognize revenue as it relates to the license of software when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable, and collection is probable. The sale and/or license of software products and technology is deemed to have occurred when a customer either has taken possession of or has access to take immediate possession of the software or technology. Software license agreements include post-contract customer support ("PCS"). For our software and software-related multiple element arrangements, where customers purchase both software related products and software related services, we use vendor-specific objective evidence (“VSOE”) of fair value for software and software-related services to separate the elements and account for them separately. VSOE exists when a company can support what the fair value of its software and/or software-related services is based on evidence of the prices charged when the same elements are sold separately. VSOE of fair value is required, generally, in order to separate the accounting for various elements in a software and related services arrangement. We established VSOE of fair value for the majority of the PCS, professional services, and training. Given the limited number of sales related to this software, and the fact that we do not sell the PCS element separately, there is no VSOE currently available to bifurcate the PCS element from the contract. In accordance with Accounting Standards Codification Topic 985-605-25-10a, the fees earned from sale of licenses to which the only undelivered element is the PCS, are recognized ratably over the life of the contract. Revenues from the sale of software licenses and maintenance for the year ended December 31, 2017 and 2016 were $33,750 and $84,001, respectively. At December 31, 2017 and 2016, deferred revenues amounted to $18,750 and $7,500, respectively.
Unbilled revenue reflects work performed, but not billed at the time, per contractual requirements. As of December 31, 2017 and 2016,
we had unbilled revenues of $139,235 and $235,421, respectively which are recorded within receivables on government contracts in the Company’s balance sheet. Billings to customers in excess of revenue earned are classified as advanced billings, and shown as a liability. As of December 31, 2017 and 2016, there were no advanced billings.
Accounts Receivable
. Accounts receivable from government contracts are stated at outstanding balances. When necessary, an allowance for doubtful accounts is established through provisions charged against operations. Receivables deemed to be uncollectible are charged against the allowance and subsequent recoveries, if any, are credited to the allowance.
Management
’s periodic evaluation of the adequacy of the allowance is based on past experience, aging of the receivables, adverse situations that may affect a customer's ability to pay, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires estimates that may be susceptible to significant change. Unpaid balances remaining after the stated payment terms are considered past due. All of our business is conducted with the federal government in which nonpayment for awarded contracts is unlikely. No allowance for doubtful accounts was deemed necessary by management at December 31, 2017 and 2016.
Warranty Expense
. We provide a limited warranty, as defined by the related warranty agreements, for our production units. Our warranties require us to repair or replace defective products during the 12 month period following delivery and acceptance of production units by the government. We estimate the costs that may be incurred under our warranty and record a liability in the amount of such costs at the time product revenue is recognized. Factors that affect our warranty liability include the number of units sold, anticipated rates of warranty claims, and cost per claim. We periodically assesses the adequacy of our recorded warranty liability and adjusts the amount as necessary. We had net warranty recoveries, which are a component of our cost of sales of $198,967 and $84,501 for the years ended December 31, 2017 and 2016, respectively. Since the inception of the IDIQ contract awarded to us in March 2010, we have delivered 200 ADEPT units. As of December 31, 2017, there are 11 ADEPT units that remain under the limited warranty coverage. The warranty recovery is attributable to the warranty product expirations outpacing warranty product expenses for units produced and sold under the IDIQ contract. We had an accrued warranty expense liability of $40,000 and $240,980 at December 31, 2017 and 2016, respectively.
Income Taxes
. Deferred tax assets and liabilities are determined based on the differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities, and are measured at the prevailing enacted tax rates that will be in effect when these differences are settled or realized. Deferred tax assets, including tax loss and credit carryforwards, and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We had $112,871 of state net operating loss carry forwards at December 31, 2017 which begin to expire in 2023.
We recognize liabilities for uncertain tax positions. If we ultimately determine that the payment of such a liability is not necessary, then we reverse the liability and recognize a tax benefit during the period in which the determination is made that the liability is no longer necessary. As of December 31,
2017 and 2016, there were no tax contingencies or unrecognized tax positions recorded.
On December 22, 2017, the
“
Tax Cuts and Jobs Act
”
(the
“
2017 Tax Act
”
), which enacts a broad range of changes to the Code, was signed into law. The 2017 Tax Act, among other things, includes changes to U.S. federal tax rates, imposes significant additional limitations on the deductibility of interest and net operating losses, allows for the expensing of certain capital expenditures, and puts into effect a number of changes impacting operations outside of the United States including, but not limited to, the imposition of a one-time tax on accumulated post-1986 deferred foreign income that has not previously been subject to tax and modifications to the treatment of certain intercompany transactions. Our
net deferred tax assets and liabilities have been revalued at the newly enacted U.S. corporate rate, and the impact which was not significant was recognized in tax expense for the year ended December 31, 2017, the year of enactment. The Company continues to examine the impact this tax legislation may have on its business.
Share-based Compensation
. We record compensation expense associated with stock options and other forms of equity compensation based on the estimated fair value at the grant date. There were no stock options issued during the years ended December 31, 2017 and 2016. In 2017, we granted 70,000 restricted stock awards. The fair value of the restricted stock awards amounted to $32,400 was determined on the date of grant using our closing stock price. The fair value of the restricted stock awards will be amortized over the vesting period of three to five years utilizing the straight-line method.
Recently Issued Accounting Pronouncements
In February 2018, the
Financial Accounting Standards Board (“
FASB”) issued ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, to address specific consequences of the Tax Reform Act. The update allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Reform Act. The accounting update is effective January 1, 2019, with early adoption permitted, and is to be applied either in the period of adoption or retrospectively to each period in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Act is recognized. The Company is currently evaluating the impact of the new standard on the Company's Consolidated Financial Statements.
In May 2017, the FASB issued ASU No. 2017-09, Scope of Modification Accounting (Topic 718) ("ASU 2017-09"), which amends the scope of modification accounting for share-based payment arrangements. The amendment provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. ASU 2017-09 is effective for fiscal years beginning after December 15, 2017, with early adoption permitted. The Company anticipates this standard will have no impact on its Consolidated Financial Statements.
In February 2017, the FASB issued ASU No. 2017-02, “Leases (Topic 842)”. ASU 2017-02 requires the recognition of lease rights and obligations as assets and liabilities on the balance sheet. Previously, lessees were not required to recognize on the balance sheet assets and liabilities arising from operating leases. The ASU also requires disclosure of key information about leasing arrangements. ASU 2017-02 is effective on January 1, 2019, using the modified retrospective method of adoption, with early adoption permitted. While the Company is currently evaluating the effect ASU 2017-02 will have on the financial statements and disclosures, the adoption of this ASU will result in an increase to the Company
’s stated assets and liabilities.
In May 2014, the FASB issued an Accounting Standards Update (“ASU”) for revenue recognition for contracts, superseding the previous revenue recognition requirements, along with most existing industry-specific guidance. The guidance requires an entity to review contracts in five steps: 1) identify the contract, 2) identify performance obligations, 3) determine the transaction price, 4) allocate the transaction price, and 5) recognize revenue. The new standard will result in enhanced disclosures regarding the nature, amount, timing, and uncertainty of revenue arising from contracts with customers. In August 2015, the FASB issued guidance approving a one-year deferral, making the standard effective for reporting periods beginning after December 15, 2017, with early adoption permitted only for reporting periods beginning after December 15, 2016. In March 2016, the FASB issued guidance to clarify the implementation guidance on principal versus agent considerations for reporting revenue gross rather than net, with the same deferred effective date. In April 2016, the FASB issued guidance to clarify the identification of performance obligations and licensing arrangements. In May 2016, the FASB issued guidance addressing the presentation of sales and other similar taxes collected from customers, providing clarification of the collectability criterion assessment, as well as clarifying certain transition requirements.
We have
a team in place to analyze the new standard and the related ASU's across all revenue streams to evaluate the impact of the new standard on revenue contracts. This includes reviewing current accounting policies and practices to identify potential differences that would result from applying the requirements under the new standard. We are completing contract evaluations and validating the results of applying the new revenue guidance and is in the process of finalizing its accounting policies, drafting the new disclosures, quantifying the potential financial adjustment and completing its evaluation of the impact of the accounting and disclosure requirements on business processes, controls and systems. Full implementation will be completed by April 2018. We expect to adopt the new standard using the modified retrospective approach, under which the cumulative effect of initially applying the new guidance is recognized as an adjustment to the opening balance of retained earnings in the first quarter of 2018.
Results of Operations
Years en
ded December 31,
2017
and
2016
We generated revenues of $
7,196,131 in the year ended December 31, 2017 compared to $5,067,365 in 2016, an increase of $2,128,766, or 42%. The increase was due primarily to a production order for 11 ADEPT units in February 2017, a production order for 26 ADEPT units in September 2017, and the receipt of additional contracts for engineering services, support, repairs and calibration services.
Cost of sales consists of direct contract costs including labor, material, subcontracts, warranty expense for ADEPT units that have been delivered, travel, and other direct costs. Costs of sales were $
2,994,087 in 2017 compared to $2,047,002 in 2016, an increase of $947,085, or 46%. The increase was due primarily to a production order for 11 ADEPT units in February 2017, a production order for 26 ADEPT units in September 2017, and the receipt of additional contracts for engineering services, support and repairs and calibration services.
As a percentage of revenue, cost of sales was 42% for 2017 as compared to 40% of revenues for 2016. The increase is due to an increase in production costs and other direct costs.
The majority of our engineering costs consist of (i) salary, wages and related fringe benefits paid to engineering employees, (ii) rent-related costs, and (iii) consulting fees paid to engineering consultants. As the nature of these costs benefit the entire organization and all research and development efforts, and their benefit cannot be identified with a specific project or contract, these engineering costs are classified as part of “engineering overhead” and included in operating expenses. Engineering costs were $
2,180,083 in 2017 as compared to $1,632,228 in 2016, an increase of $547,775, or 34%. The increase was due to significant increases in fringe benefits and engineering salaries due to the hiring of six additional employees, recruiting costs, travel and subsistence expenses, engineering consulting costs and incentive compensation.
General and administrative expenses consist primarily of salary, intellectual property, consulting fees and related costs, professional fees, business insurance, franchise tax, SEC compliance costs, travel, and unallowable expenses
(consisting of those expenses for which the government will not reimburse us). General and administrative expenses were $1,565,240 in 2017 as compared to $1,213,718 in 2016, a increase of $351,522, or 29%. The increase was due primarily to increases in salaries, incentive compensation, research and development costs and professional fees offset by a reduction in accrued expenses as a result of a change in the estimate of the amount to be paid.
We reported a net income of $
235,805 in 2017 as compared to $82,490 in 2016. The increase was attributable primarily to the increase in revenues during 2017 with proportional increases in our selling, general and administrative expenses and engineering expenses.
At December 3
1, 2017, we estimated our annual effective tax rate for 2017 to be 48.7%. At December 31, 2017, the difference from the expected federal income tax rate is attributable to state income taxes and certain permanent book-tax differences. The income tax expense was $223,830 in 2017 and $96,425 in 2016, representing an effective income tax rate of 48.7% and 53
.
9%, respectively.
Liquidity and Capital Resources
Since our inception, we have financed our operations through debt, private and public offerings of equity securities and cash generated by operations.
At December 31,
2017, we had cash and cash equivalents of $1,173,177 and net working capital of $1,826,167. During the year ended December 31, 2017, net cash provided by operating activities was $432,377 compared to net cash used in operating activities of $1,398,511 in 2016. The increase in operating cash flows was due primarily to the timing of our billings and collections, an increase in net income, and increases in accounts payable and other current liabilities as a result of timing of payments to vendors and employees.
Net cash used in investing activities was $130,418 in 2017 as
compared to $1,534 in 2016, an increase of $128,884. The increase was due to the purchase of additional equipment, software, furniture and fixtures, and leasehold improvements related to an expansion of our offices in Pennsylvania. We also spent an additional $8,767 on new patents.
During
2017, cash provided by financing activities was $12,350, as compared to cash used in financing activities of $599,742 in 2016. In 2016, this amount was used to complete a recapitalization transaction (the “
Recapitalization Transaction
”) pursuant to which all issued and outstanding shares of our preferred stock were exchanged or redeemed for a combination of cash and shares of our common stock in the amounts set forth in the table below.
Series of
Preferred Stock
|
|
Amount
of Cash
per Share
|
|
|
Number of
Shares of
Common Stock
Per Share
|
|
|
|
|
|
|
|
|
|
|
Convertible Preferred Shares
|
|
$
|
0.165
|
|
|
|
1.95
|
|
|
|
|
|
|
|
|
|
|
Series B Shares
|
|
$
|
0.0825
|
|
|
|
2.43
|
|
|
|
|
|
|
|
|
|
|
Series C Shares
|
|
$
|
2.708
|
|
|
|
31.27
|
|
|
|
|
|
|
|
|
|
|
Series D Shares
|
|
$
|
0.36232
|
|
|
|
5.072464
|
|
As part of the Recapitalization Transaction, we also repurchased 2,084,167 shares of common stock owned by the United States Small Business Administration. Pursuant to the Recapitalization Transaction, we made aggregate cash payments of $540,892
and issued 5,089,189 shares of common stock, which resulted in the net issuance of 3,005,022 additional shares of common stock, and eliminated $2,955,433 of aggregate liquidation preferences applicable to our previously outstanding shares of preferred stock.
On January
31, 2018, we entered into a $550,000 credit facility with PNC Bank. The facility matures on January 31, 2019 and accrues interest at a variable rate equal to the Daily LIBOR Rate plus 250 basis points. Interest is paid monthly. Principal borrowings may be prepaid at any time without penalty and the facility is secured by substantially all of our assets. The facility contains customary affirmative and negative nonfinancial covenants. As of the date of this report, no amounts were outstanding under the facility.
In order to pursue strategic opportunities, obtain additional SBIR contracts, or acquire strategic assets or businesses, we may need to obtain additional financing or seek strategic alliances or other partnership agreements with other entities. In order to raise any such financing, we anticipate considering the sale of additional debt or equity securities under appropriate market conditions. There can be no assurance, assuming we successfully raise additional funds or enter into business alliances, that we will remain profitable or continue to generate positive cash flow.
We believe our available cash resources and expected cash flows from operations will be sufficient to fund operations for the next twelve months. We do not expect to incur any material capital expenditures during the next twelve months.
Off-Balance Sheet Arrangements
As of December 31,
2017, we did not have any relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.