Item 2. Management’s Discussion and Analysis of Financial Position and Results of Operations.
Mikros Systems Corporation (the “Company”, “we” or “us”) designs and manufactures software, hardware and electronic systems used to maintain complex distributed systems. Examples of such systems include defense equipment such as radars and combat systems, and commercial and industrial applications such as printing presses, power distribution, and utility systems, and Federal Aviation Administration (“FAA”) systems.
Over the past decade, our principal customer has been the U.S. Department of Defense (DoD), primarily the U.S. Navy. We provide the following two key systems to the Navy for maintenance of radars and combat systems:
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ADEPT®, the Adaptive Diagnostic Electronic Portable Testset, is a PC-based maintenance automation workstation used to maintain the Navy’s premier AN/SPY-1 phased array radar on Cruisers (CG) and Destroyers (DDG).
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ADSSS®, the ADEPT Distance Support Sensor Suite, is a Condition-Based Maintenance (CBM) system used to monitor Combat System Elements (CSEs) onboard the Littoral Combat Ship (LCS).
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More recently, we have developed and marketed software products to analyze maintenance data collected from target systems, optimize maintenance procedures, and predict failures. Our Prognostics Framework® (PF) and Diagnostic Profiler® (DP) products provide software capabilities which complement our maintenance hardware products (ADEPT and ADSSS) and allow us to provide complete hardware/software solutions for advanced maintenance, particularly of complex distributed systems. Now that we have a complete hardware/software solution for advanced maintenance, we are expanding into commercial and industrial markets.
Product Portfolio
Revenues from our government contracts represented substantially all of our revenues for the six months ended June 30, 2018. 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.
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 203 ADEPT units.
ADEPT 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
In April 2016, we received three contracts to continue logistics support of the ADEPT maintenance automation workstation. A contract valued at approximately $0.3 million to provide ADEPT General Engineering and Support was awarded, along with two other logistics contracts to perform necessary updates, repair and calibration on the ADEPT units, totaling $0.25 million. Along with the contracts received for our ADEPT product, we received a follow on contract in the amount of $0.1 million, for technical support on the USS Fort Worth (LCS3) using the latest version of our ADSSS.
In July 2016, we received two additional contract modifications for our current service contract for LCS systems using the ADSSS, which added an additional $4.65 million for ongoing development. This funding will extend the program until June 2018 and allow us to perform installations and support for the LCS classes.
In September 2016, we were awarded and entered into a multi-year IDIQ contract with the Naval Surface Warfare Center, Port Hueneme Division, relating to our ADSSS product. The contract has a term of five years and provides for the purchase and sale of up to $48 million of ADSSS units and related engineering and logistics support. The IDIQ contract covers the first eight ships of the 28 ship program. The first delivery order in the amount of $3.0 million was awarded on September 15, 2016 to perform installations, support and logistics for the LCS class.
In September 2016, we received multiple contracts totaling approximately $0.4 million to continue logistics support of the ADEPT maintenance workstation. These contracts include general engineering support, repair, calibration and training.
In February 2017, we were awarded a follow-on multi-year Small Business Innovation Research (SBIR) Phase III IDIQ contract with the Naval Surface Warfare Center, Crane Division, for our ADEPT program. The contract provides for the purchase and sale of up to $35.1 million of ADEPT units and related engineering, such as calibration, repair, training and other logistics services. Since the award, we have received multiple delivery orders, some of which are described below.
In March and April 2017, we were awarded the second, third and fourth delivery orders under the ADEPT IDIQ Contract. The second delivery order covers engineering services in the amount of $11.5 million which will be funded incrementally and facilitate the engineering and technical support for the ADEPT program over three years. The third delivery order contract for $0.6 million is to provide sustainment services, such as calibration, repair, evaluations, and screenings of ADEPT units to be performed in our Manufacturing and Depot (M&D) Center in Largo, Florida. The fourth delivery order for $0.1 million is to provide training to sailors in the fleet to operate the ADEPT maintenance automation workstation.
In April 2017, we received contract awards totaling $2.0 million from the U.S. Navy to extend the capabilities of the ADSSS Condition-Based Maintenance (CBM) system to support a fourth Navy radar system, the MK 99. The Small Business Innovation Research (SBIR) office in Dahlgren, VA provided $0.5 million of the total funding to support this effort.
In July 2017 and November 2017, we received modifications which added funding to our ADEPT IDIQ Contract, for engineering services in the amounts of $0.4 million and $0.1 million, respectively. These awards will allow us to continue to support the ADEPT product line in the fleet, implement necessary software enhancements, and provide general support of the program.
In August 2017, we received a modification to our ADEPT sustainment delivery order, adding $0.5 million to allow our M&D Center in Largo, Florida, to continue to provide bi-annual sustainment services for units from the fleet cycling through our M&D Center.
In September 2017, we received a delivery order in the amount of $2.4 million for the production and delivery of additional ADEPT units. These new units will continue our fleet support on Aegis cruisers and destroyers in the U.S. Navy. In 2018, we received additional modifications to our ADEPT IDIQ Contract and incremental awards for continued engineering services in the aggregate amount of $0.42 million. This funding will support necessary software enhancements to sustainment services for the ADEPT product out of our M&D Center.
In February and March 2018, we received modifications to our ADEPT sustainment delivery orders, adding $0.25 million to allow us to continue to provide bi-annual sustainment services for units from the fleet cycling through the M&D Center. In addition to those sustainment services, it allows our team at the M&D Center to provide training to sailors in the fleet to operate the ADEPT maintenance automation workstation.
Between January 2018 through April 2018, we received multiple contract awards which increased funding on our ADEPT IDIQ Contract for Engineering Services. The total amount awarded in the first quarter of 2018 was $0.5 million and an additional $1.6 million was awarded in April 2018. This funding will allow us to continue supporting the ADEPT product line in the fleet and implementing necessary software enhancements to increase readiness.
In June 2018, we received the second delivery order on our current multi-year IDIQ contract with the Naval Surface Warfare Center, Port Hueneme Division, relating to our ADSSS product. The award totaling $2.5 million will support the MK 99 FCS development, test and installation.
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 trade 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 IDIQs contract, 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 Diagnostic 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 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 2018, 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 M&D Center.
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.
Changes to Critical Accounting Policies and Estimates
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, as amended (commonly referred to as ASC 606), which replaces numerous requirements in U.S. GAAP, including industry-specific requirements, and provides companies with a single revenue recognition model for recognizing revenue from contracts with customers and significantly expanded the disclosure requirements for revenue arrangements. The new standard, as amended, was effective for the Company for interim and annual reporting periods beginning on January 1, 2018.
We adopted ASC 606 using the modified retrospective transition method. Results for reporting periods beginning after December 31, 2017 are presented under ASC 606, while prior period comparative information has not been restated and continues to be reported in accordance with ASC 605, Revenue Recognition, the accounting standard in effect for periods ending prior to January 1, 2018.
Results of Operations
Three
Months
Ended
June 30
, 201
8
and
201
7
We generated revenues of $2,242,111 during the three months ended June 30, 2018 compared to $1,740,863 during the three months ended June 30, 2017, an increase of $501,248, or 29%. The increase was due primarily to the receipt of production order of 26 ADEPT units in September 2017, increase in revenue from engineering contracts, and the receipt of additional contracts for engineering services, support and 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. Cost of sales during the three months ended June 30, 2018 was $1,102,407 compared to $621,582 for the three months ended June 30, 2017, an increase of $480,825 or 77%. The increase was due primarily to the receipt of a production order for 26 ADEPT units in September 2017, increase in revenues from engineering contracts received in 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 49% and 36% of revenues for the three months ended June 30, 2018 and 2017, respectively.
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 for the three months ended June 30, 2018 were $593,797 compared to $539,412 for the three months ended June 30, 2017, an increase of $54,385, or 10%. The increase in 2018 was due to increases in engineering salaries and fringe benefits for additional employees hired in the second half of 2017, incentive compensation and engineering consulting fees.
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 (representing those expenses for which the government will not reimburse us, including independent research and development (IR&D) which consists of research and development expenses unrelated to our defense contracts). General and administrative costs for the three months ended June 30, 2018 were $422,259 compared to $430,384 for the three months ended June 30, 2017, a decrease of $8,125, or 2%.
At June 30, 2018, we estimated our annual effective tax rate for 2017 to be 32%. We recognized a tax expense of $40,277 for the three months ended June 30, 2018 primarily due to expected net income for the remainder of 2018. At June 30, 2018, the difference from the expected federal statutory income tax rate is attributable to state income taxes and certain permanent book-tax differences. In December 2017, new legislation was signed into law reducing the corporate U.S. tax rate from 35% to 21% for tax years beginning after December 31, 2017. Tax expense for the period was $19,000 less under the lower 2018 rate than it would have been using the prior statutory tax rate.
Six
Months
Ended
June 30, 201
8
and
201
7
We generated revenues of $4,732,771 during the six months ended June 30, 2018 compared to $3,495,836 during the six months ended June 30, 2017, an increase of $1,236,935, or 35%. The increase was due primarily to a production order for 26 ADEPT units in September 2017, increase in revenue from engineering contracts, and the receipt of additional contracts for engineering services, support and repairs and calibration services.
Cost of sales for the six months ended June 30, 2018 was $2,279,439 compared to $1,273,118 for the six months ended June 30, 2017, an increase of $1,006,321 or 79%. The increase was due primarily to the receipt of a production order for 26 ADEPT units in September 2017, increase in revenues from engineering contracts received in 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 48% for the six months ended June 30, 2018 as compared to 36% of revenues for the six months ended June 30, 2017. The increase is due to an increase in production costs and other direct costs.
Engineering costs for the six months ended June 30, 2018 were $1,234,090 compared to $1,056,592 for the six months ended June 30, 2017, an increase of $177,498, or 17%. The increase in 2018 was due to increases in engineering salaries and fringe benefits for additional employees hired in the second half of 2017, incentive compensation and engineering consulting fees.
General and administrative costs for the six months ended June 30, 2018 were $873,937 compared to $839,287 for the six months ended June 30, 2017, an increase of $34,650, or 4%.
At June 30, 2018, we estimated our annual effective tax rate for 2018 to be 32%. We recognized a tax expense of $109,089 for the six months ended June 30, 2018 primarily due to expected net income for the remainder of 2018. At June 30, 2018, the difference from the expected federal statutory income tax rate is attributable to state income taxes and certain permanent book-tax differences. In December 2017, new legislation was signed into law reducing the corporate U.S. tax rate from 35% to 21% for tax years beginning after December 31, 2017. Tax expense for the period was $53,000 less under the lower 2018 rate than it would have been using the prior statutory tax rate.
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.
During the six months ended June 30, 2018, net cash used in operations was $51,819 compared to net cash provided by operations of $188,986 during the six months ended June 30, 2017. The decrease was primarily due to the timing of receipts and payments related to our operating assets and liabilities.
Net cash used in investing activities was $40,506 in the six months ended June 30, 2018 as compared to $66,744 in the six months ended June 30, 2017, a decrease of $26,238. The decrease was due to the decrease in purchases of equipment and furniture and fixtures related to an expansion of our offices in Pennsylvania.
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.
Off-Balance
Sheet
Arrangements
As of June 30, 2018, 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.