Item 2. Management's Discussion and
Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
Certain statements contained herein or
as may otherwise be incorporated by reference herein that are not purely historical constitute “forward-looking statements”
within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include but are not limited
to statements regarding anticipated operating results, future earnings, and the Company’s ability to achieve growth and profitability.
Such forward-looking statements involve known and unknown risks, uncertainties and other factors, including but not limited to
the effect of foreign political unrest; domestic and foreign government policies and economic conditions; future changes in export
laws or regulations; changes in technology; the ability to hire, retain and motivate technical, management and sales personnel;
the risks associated with the technical feasibility and market acceptance of new products; changes in telecommunications protocols;
the effects of changing costs, exchange rates and interest rates; and the Company's ability to secure adequate capital resources.
Such risks, uncertainties and other factors could cause the actual results, performance or achievements of the Company, or industry
results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking
statements. For a more detailed discussion of the risks facing the Company, see the Company’s filings with the SEC, including
its Annual Report on Form 10-K for the fiscal year ended September 30, 2017.
Overview
The Company designs, manufactures, markets
and sells communications security equipment that utilizes various methods of encryption to protect the information being transmitted.
Encryption is a technique for rendering information unintelligible, which information can then be reconstituted if the recipient
possesses the right decryption “key”. The Company manufactures several standard secure communications products and
also provides custom-designed, special-purpose secure communications products for both domestic and international customers. The
Company’s products consist primarily of voice, data and facsimile encryptors. Revenue is generated principally from the sale
of these products, which have traditionally been to foreign governments either through direct sale, pursuant to a U.S. government
contract, or made as a sub-contractor to domestic corporations under contract with the U.S. government. We also sell these products
to commercial entities and U.S. government agencies. We generate additional revenues from contract engineering services performed
for certain government agencies, both domestic and foreign, and commercial entities.
Critical Accounting Policies and Significant
Judgments and Estimates
There have been no material changes in
the Company?s critical accounting policies or critical accounting estimates since September 30, 2017, nor have we adopted any
accounting policy that has or will have a material impact on our consolidated financial statements. For further discussion
of our accounting policies see Note 1,
Summary of Significant Accounting Policies and Significant Judgments and Estimates
in the Notes to Unaudited Consolidated Financial Statements in this Quarterly Report on Form 10-Q and the Notes to Consolidated
Financial Statements in our Annual Report on Form 10-K for the fiscal year ended September 30, 2017 as filed with the SEC.
Results of Operations (dollar amounts
have been rounded to nearest thousandths)
Three Months ended June 30, 2018 compared
to Three Months ended July 1, 2017
Net Sales
Net sales for the quarter ended June 30,
2018 were $1,544,000, compared to $1,068,000 for the quarter ended July 1, 2017, an increase of 45%. Sales for the third quarter
of fiscal 2018 consisted of $1,469,000, or 95%, from domestic sources and $75,000, or 5%, from international customers as compared
to the same period in fiscal 2017, during which sales consisted of $1,057,000, or 99%, from domestic sources and $11,000, or 1%,
from international customers.
Foreign sales consisted of shipments to
two countries during the quarter ended June 30, 2018 and one country during the quarter ended July 1, 2017. A sale is attributed
to a foreign country based on the location of the contracting party. Domestic revenue may include the sale of products shipped
through domestic resellers or manufacturers to international destinations. The table below summarizes our principal foreign sales
by country during the third quarter of fiscal 2018 and 2017:
|
|
|
2018
|
|
2017
|
|
|
Saudi Arabia
|
|
$
|
55,000
|
|
|
$
|
-
|
|
|
|
Philippines
|
|
|
20,000
|
|
|
|
-
|
|
|
|
Bahrain
|
|
|
-
|
|
|
|
11,000
|
|
|
|
|
|
$
|
75,000
|
|
|
$
|
11,000
|
|
|
For
the three months ended June 30, 2018, revenue was derived primarily from
sales of our engineering services amounting to
$1,396,000
. We also sold our internet protocol encryptor to a customer
in Saudi Arabia amounting to $55,000 during the period.
For the three months ended July 1, 2017,
product sales revenue was derived primarily from shipments of our narrowband radio encryptors to a domestic customer for deployment
into Afghanistan amounting to $669,000. We also recorded sales under an engineering services contract amounting to $300,000 during
the period.
Gross Profit
Gross profit for the third quarter of fiscal
2018 was $877,000, compared to gross profit of $539,000 for the same period of fiscal 2017, an increase of 63%. Gross profit expressed
as a percentage of sales was 57% for the third quarter of fiscal 2018 compared to 51% for the same period in fiscal 2017, which
was due to the higher margin engineering services sales in fiscal 2018.
Operating Costs and Expenses
Selling, General and Administrative
Expenses
Selling, general and administrative expenses
for the third quarter of fiscal 2018 were $522,000, compared to $479,000 for the same quarter in fiscal 2017. This increase of
$43,000, or 9%, was attributable to an increase in general and administrative expenses of $36,000 and an increase in selling and
marketing expenses of $7,000 during the three months ended June 30, 2018.
The increase in general and administrative
expenses for the three months ended June 30, 2018 was primarily attributable to increases in audit fees and other public company
costs of $19,000, a write-off of collateral of $12,000 and an increase in personnel-related costs of $5,000.
The increase in selling
and marketing expenses for the three months ended June 30, 2018 was attributable to increases in outside sales commissions of $11,000,
bid and proposal costs of $26,000 and outside consulting costs of $14,000. These increases were offset by a decrease in product
evaluation costs of $39,000.
Product Development Costs
Product development costs for the quarter
ended June 30, 2018 were $114,000, compared to $407,000 for the quarter ended July 1, 2017. This decrease of $293,000, or 72%,
was attributable to an increase in billable engineering services contracts during the third quarter of fiscal 2018 that resulted
in decreased product development costs of $347,000 and reduced personnel related costs of $43,000. These decreased costs were partially
offset by an increase in engineering project costs of $97,000 during the period.
Product development costs are charged to
billable engineering services, bid and proposal efforts or business development activities, as appropriate. Product development
costs charged to billable projects are recorded as cost of sales; engineering costs charged to bid and proposal efforts are recorded
as selling expenses; and product development costs charged to business development activities are recorded as marketing expenses.
The Company actively sells its engineering
services in support of funded research and development. The receipt of these orders is sporadic, although such programs can span
over several months. In addition to these programs, the Company also invests in research and development to enhance its existing
products or to develop new products, as it deems appropriate. There was approximately $1,396,000 of billable engineering services
revenue generated during the third quarter of fiscal 2018 and $300,000 in the third quarter of fiscal 2017.
Net Income/Loss
The Company generated net income of $243,000
for the third quarter of fiscal 2018, compared to a net loss of $344,000 for the same period of fiscal 2017. This net income is
primarily attributable to a 63% increase in gross profit and a 28% decrease in operating expenses during the third quarter of fiscal
2018.
Nine Months ended June 30, 2018 compared
to Nine Months ended July 1, 2017
Net Sales
Net sales for the nine months ended June
30, 2018 were $3,590,000, compared to $3,084,000 for the nine months ended July 1, 2017, an increase of 16%. Sales for the first
nine months of fiscal 2018 consisted of $3,387,000, or 94%, from domestic sources and $204,000, or 6%, from international customers
as compared to the same period in fiscal 2017, during which sales consisted of $2,841,000, or 92%, from domestic sources and $243,000,
or 8%, from international customers.
Foreign sales consisted of shipments to
four countries during the nine month period ended June 30, 2018 and five countries during the same period in fiscal 2017. A sale
is attributed to a foreign country based on the location of the contracting party. Domestic revenue may include the sale of products
shipped through domestic resellers or manufacturers to international destinations. The table below summarizes our principal foreign
sales by country during the first nine months of fiscal 2018 and 2017:
|
|
|
2018
|
|
2017
|
|
|
|
|
|
|
|
|
|
Philippines
|
|
$
|
90,000
|
|
|
$
|
10,000
|
|
|
|
Saudi Arabia
|
|
|
89,000
|
|
|
|
101,000
|
|
|
|
Jordan
|
|
|
13,000
|
|
|
|
106,000
|
|
|
|
Other
|
|
|
12,000
|
|
|
|
26,000
|
|
|
|
|
|
$
|
204,000
|
|
|
$
|
243,000
|
|
|
For
the nine months ended June 30, 2018, revenue was derived primarily from
sales of our engineering services amounting to $3,196,000
and
shipments of our narrowband radio encryptors to a customer in the
Far East amounting to $90,000 and to a domestic customer for deployment into Afghanistan amounting to $57,000. We also sold our
internet protocol encryptor to a customer in Saudi Arabia amounting to $89,000 during the period.
For
the nine months ended July 1, 2017, product sales revenue was derived primarily from shipments of our narrowband radio encryptors
to a domestic customer for deployment into Afghanistan amounting to $2,450,000. Additional revenue was generated from
sales
of our engineering services amounting to $300,000.
The Company made shipments
of our secure telephone and fax encryptor to an international customer in Jordan amounting to $106,000. We also sold our internet
protocol encryptor to a customer in Saudi Arabia amounting to $95,000 during the period.
Gross Profit
Gross profit for the first nine months
of fiscal 2018 was $1,800,000, compared to gross profit of $2,129,000 for the same period of fiscal 2017, a decrease of 15%. Gross
profit expressed as a percentage of sales was 50% for the first nine months of fiscal 2018 compared to 69% for the same period
in fiscal 2017, which decrease was due to the lower margin engineering services sales in fiscal 2018. During fiscal 2017 the concentration of sales related to product sales which historically will yield higher
margins.
Operating Costs and Expenses
Selling, General and Administrative
Expenses
Selling, general and administrative expenses
for the first nine months of fiscal 2018 were $1,513,000, compared to $1,669,000 for the same period in fiscal 2017. This decrease
of $156,000, or 9%, was attributable to a decrease in selling and marketing expenses of $231,000, which was partially offset by
an increase in general and administrative expenses of $75,000 during the nine months ended June 30, 2018.
The decrease in selling and marketing expenses
for the nine months ended June 30, 2018 was attributable to decreases in product demonstration costs of $136,000, product evaluation
costs of $99,000 and bid and proposal costs of $17,000. These decreases were partially offset by an increase in personnel-related
costs of $14,000.
The increase in general
and administrative expenses for the nine months ended June 30, 2018 was primarily attributable to increases in audit fees and other
public company costs of $94,000. These increases were partially offset by a decrease in personnel-related costs of $25,000 during
the period.
Product Development Costs
Product development costs for the nine
months ended June 30, 2018 were $415,000, compared to $1,378,000 for the nine months ended July 1, 2017. This decrease of $963,000,
or 70%, was attributable to an increase in billable engineering services contracts during the first nine months of fiscal 2018
that resulted in decreased product development costs of $1,021,000 and reduced personnel related costs of $128,000. These decreased
costs were partially offset by an increase in engineering project costs of $191,000 during the period.
Product development costs are charged to
billable engineering services, bid and proposal efforts or business development activities, as appropriate. Product development
costs charged to billable projects are recorded as cost of sales; engineering costs charged to bid and proposal efforts are recorded
as selling expenses; and product development costs charged to business development activities are recorded as marketing expenses.
The Company actively sells its engineering
services in support of funded research and development. The receipt of these orders is sporadic, although such programs can span
over several months. In addition to these programs, the Company also invests in research and development to enhance its existing
products or to develop new products, as it deems appropriate. There was approximately $3,196,000 of billable engineering services
revenue generated during the first nine months of fiscal 2018 and $300,000 in the first nine months of fiscal 2017.
Net Loss
The Company incurred a net loss of $122,000
for the first nine months of fiscal 2018, compared to a net loss of $911,000 for the same period of fiscal 2017. This decrease
in net loss is primarily attributable to a 37% decrease in operating expenses and partially offset by a 15% decrease in gross profit
during the first nine months of fiscal 2018.
The effects of inflation and changing costs
have not had a significant impact on sales or earnings in recent years. As of June 30, 2018, none of the Company’s monetary
assets or liabilities was subject to foreign exchange risks. The Company usually includes an inflation factor in its pricing when
negotiating multi-year contracts with customers.
Liquidity and Capital Resources
(dollar
amounts have been rounded to nearest thousandths)
Our cash and cash
equivalents at June 30, 2018 totaled $1,460,000 and we continue to have no debt.
Liquidity
and Ability to Continue as a Going Concern
The
Company has suffered recurring losses from operations and had an accumulated deficit of $945,000 at June 30, 2018. These factors
raise substantial doubt about the Company's ability to continue as a going concern within one year from the issuance date of the
unaudited consolidated financial statements included in this Quarterly Report on Form 10-Q. The unaudited consolidated financial
statements included herein do not include any adjustments to reflect the uncertainty about the Company’s ability to continue
as a going concern.
We
anticipate that our principal sources of liquidity will only be sufficient to fund our activities through June 30, 2019. In order
to have sufficient cash to fund our operations beyond June 30, 2019, we will need to secure new customer contracts, raise additional
equity or debt capital, and reduce expenses, including payroll and payroll-related expenses.
In
order to have sufficient capital resources to fund operations, the Company has been working diligently to secure several large
orders with new and existing customers. In addition, we are pursuing raising capital through equity or debt arrangements. Although
we believe our ability to secure such new business and raise new capital is likely, we cannot provide assurances we will be able
to do so.
Should
we be unsuccessful in these efforts, we would then be forced to implement headcount reductions, employee furloughs and/or reduced
hours for certain employees.
Sources and Uses of Cash
The following table
presents our abbreviated cash flows for the nine month periods ended (unaudited):
|
|
June 30,
2018
|
|
July 1,
2017
|
|
|
|
|
|
Net loss
|
|
$
|
(122,000
|
)
|
|
$
|
(911,000
|
)
|
Changes not affecting cash
|
|
|
33,000
|
|
|
|
114,000
|
|
Changes in assets and liabilities
|
|
|
(54,000
|
)
|
|
|
(649,000
|
)
|
|
|
|
|
|
|
|
|
|
Cash used in operating activities
|
|
|
(143,000
|
)
|
|
|
(1,446,000
|
)
|
Cash provided by investing activities
|
|
|
306,000
|
|
|
|
372,000
|
|
|
|
|
|
|
|
|
|
|
Net change in cash, cash equivalents and restricted cash
|
|
|
163,000
|
|
|
|
(1,074,000
|
)
|
Cash, cash equivalents and restricted cash - beginning of period
|
|
|
1,297,000
|
|
|
|
2,617,000
|
|
|
|
|
|
|
|
|
|
|
Cash, cash equivalents and restricted cash - end of period
|
|
$
|
1,460,000
|
|
|
$
|
1,543,000
|
|
Operating Activities
The Company used approximately $1,303,000
less cash for operating activities in the first nine months of fiscal 2018 compared to the same period in fiscal 2017. This decrease
was primarily attributable to a decrease in the net loss for the nine month period ended June 30, 2018.
Investing Activities
Cash provided by investing activities during
the first nine months of fiscal 2018 decreased by approximately $66,000 compared to the same period in fiscal 2017. This change
is primarily attributable to a decrease in proceeds from the sale of cost method investment of $76,000 and an increase in additions
to equipment and leasehold improvements of $40,000, partially offset by the difference in the maturity of short-term investments
in marketable securities of $50,000 during the first nine months of 2018 compared to the same period in fiscal 2017.
Company Facilities
On July 1, 2014,
the Company entered into a lease for its current facilities. This lease is for 22,800 square feet located at 100 Domino Drive,
Concord, MA. The Company has been a tenant in this space since 1983. This is the Company’s only facility and houses all manufacturing,
research and development, and corporate operations. The initial term of the lease is for five years through June 30, 2019 at an
annual rate of $171,000. In addition, the lease contains options to extend the lease for two and one half years through September
30, 2021 and another two and one half years through June 30, 2024 at an annual rate of $171,000. Rent expense for each of the nine
month periods ended June 30, 2018 and July 1, 2017 was $128,000.
Backlog
Backlog at June 30, 2018 and September
30, 2017 amounted to $2,750,000 and $2,675,000, respectively. The orders in backlog at June 30, 2018 are expected to ship and/or
services are expected to be performed over the next nine months depending on customer requirements and product availability.
Performance guaranties
Certain foreign customers
require the Company to guarantee bid bonds and performance of products sold. These guaranties typically take the form of standby
letters of credit. Guaranties are generally required in amounts of 5% to 10% of the purchase price and last in duration from three
months to one year. At June 30, 2018, the Company had no outstanding letters of credit. At September 30, 2017, the Company had
two outstanding letters of credit in the amounts of $12,000 and $1,000. These collateralized bank accounts represented cash which
had restrictions on its use.
Research and development
Research and development efforts are undertaken
by the Company primarily on its own initiative. In order to compete successfully, the Company must improve existing products and
develop new products, as well as attract and retain qualified personnel. No assurances can be given that the Company will be able
to hire and train such technical, management and sales personnel or successfully improve and develop its products.
During the nine months ended June 30, 2018
and July 1, 2017, the Company spent $415,000 and $1,378,000, respectively, on internal product development. The Company also spent
$1,410,000 on billable development efforts during the first nine months of fiscal 2018 and $152,000 during the same period of fiscal
2017. The Company’s total product development costs during the first nine months of fiscal 2018 were 19% higher than the
same period in fiscal 2017 but in line with its planned commitment to research and development, and reflected the costs of custom
development, product capability enhancements and production readiness. It is expected that development expenses for fiscal 2018
will be approximately 20% higher compared to fiscal 2017 levels.
It is anticipated
that cash from operations will fund our near-term research and development and marketing activities through at least the end of
June 2019. We also believe that, in the long term, based on current billable activities, cash from operations will be sufficient
to meet the product development goals of the Company, although we can give no assurances. Any increase in development activities
- either billable or new product related - will require additional resources, which we may not be able to fund through cash from
operations. In circumstances where resources will be insufficient, the Company will look to other sources of financing, including
debt and/or equity investments; however, we can provide no guarantees that we will be successful in securing such additional financing.
Other than those
stated above, there are no plans for significant internal product development or material commitments for capital expenditures
during the remainder of fiscal 2018.
New Accounting Pronouncements
ASU 2014-09, Revenue from Contracts
with Customers, amended by ASU 2015-14 (Topic 606), ASU 2016-10, ASU 2016-11 and ASU 2016-12
In May 2014, the FASB issued ASU No. 2014-9: “Revenue from
Contracts with Customers” (ASC 606). The standard provides that revenue should be recognized when an entity transfers promised
goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange
for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing and uncertainty of revenues
and cash flow arising from contracts with customers. The FASB has issued several amendments and updates to the new revenue standard,
including how an entity should identify performance obligations. As amended, the new guidance is effective for us beginning October
1, 2018. We have elected to adopt ASC 606 using the modified retrospective method approach as of October 1, 2018. This approach
will be applied to all contracts not completed as of October 1, 2018.
The qualitative assessments of the standard
provided below are estimates of the expected effects of the adoption of ASC 606. This represents our best estimate of the effects
of adopting ASC 606 at the time of the preparation of this Quarterly Report on Form 10-Q. The actual impact of ASC 606 is subject
to change from these estimates and such change may be significant, pending the completion of our assessment in the first quarter
of fiscal 2019.
Engineering Services Revenue
We expect that the deliverables
under the current guidance will be consistent with performance obligations identified under ASC 606. The adoption of ASC 606 will
not result in a change to the timing of revenue recognition for this segment as the standard requires revenues to be estimated
and recognized upon transfer of the promised goods and services. As such, we do not expect the adoption of ASC 606 will result
in a material impact to revenue recognition.
Engineering Services Revenue
We
expect that the deliverables under the current guidance will be consistent with performance obligations identified under ASC 606.
The adoption of ASC 606 will not result in a change to the timing of revenue recognition for this segment as the standard requires
revenues to be estimated and recognized upon transfer of the promised goods and services. As such, we do not expect the adoption
of ASC 606 will result in a material impact to revenue recognition.
ASU
No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory
In
July 2015, the FASB issued guidance with respect to inventory measurement. This ASU requires inventory to be measured at the lower
of cost and net realizable value. The provisions of this ASU became effective for fiscal years beginning after December 15, 2016,
including interim periods within those fiscal years. The amendment is required to be applied prospectively, and early adoption
is permitted. This guidance was adopted by the Company in the first quarter of its 2018 fiscal year; the adoption of this standard
did not have a material impact on our financial statements.
ASU
No. 2016-02, Leases
In
February 2016, the FASB issued guidance with respect to leases. This ASU requires entities
to recognize right-of-use assets
and lease liabilities on its balance sheet and disclose key information about leasing arrangements. This guidance offers specific
accounting guidance for a lessee, a lessor and sale and leaseback transactions. Lessees and lessors are required to disclose qualitative
and quantitative information about leasing arrangements to enable a user of the financial statements to assess the amount, timing
and uncertainty of cash flows arising from leases. This guidance is effective for annual reporting periods beginning after December
15, 2018, including interim periods within that reporting period, and requires a modified retrospective adoption, with early adoption
permitted. We are currently evaluating the potential impact this standard will have on our financial statements and related disclosure.
The Company currently has one operating lease on its facility in Concord, MA. The Company expects to adopt this standard during
its fiscal year 2020.
ASU No. 2016-09,
Improvements to Employee Share-Based Payment Accounting,
In March 2016, the
FASB issued guidance that simplifies several aspects of the accounting for employee share-based payment transactions for both public
and nonpublic entities, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as
well as classification in the statement of cash flows. The new guidance is effective for annual periods beginning after December
15, 2016, including interim periods within those fiscal years.
This guidance was adopted
by the Company in the first quarter of its 2018 fiscal year; the adoption of this standard did not have a material impact on our
financial statements.
ASU No. 2016-18, Restricted Cash Presentation
on Statement of Cash Flows,
In November 2016, the FASB issued guidance in regards to additional
disclosure surrounding restricted cash activity. The amendments in this update require that a statement of cash flows explain
the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted
cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included
with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement
of cash flows. The new guidance is effective for annual periods beginning after December 15, 2017, including interim periods within
those fiscal years. Accordingly, restricted cash has been grouped
with cash and cash equivalents on the statements of cash flows and results for the nine month period ended July 1, 2017 have
been retrospectively reclassified.
Other
recent accounting pronouncements were issued by the FASB (including its Emerging Issues Task Force), the AICPA and the SEC during
the first nine months of our 2018 fiscal year but such pronouncements are not believed by management to have a material impact
on the Company’s present or future financial statements
.
Off-Balance Sheet Arrangements
The Company does not have any off-balance
sheet arrangements.