Form 10-Q for MIKROS SYSTEMS CORP
14-Aug-2013
Quarterly Report
Item 2. Management's Discussion and Analysis of Financial Position and Results of Operations
Mikros Systems Corporation ("Mikros," the "Company," "we" or "us") is an advanced technology company specializing in the research and development of electronic systems technology primarily for military applications. Classified by the Department of Defense ("DoD") as a small business, our capabilities include technology management, electronic systems engineering and integration, radar systems engineering, combat/command, control, communications, computers and intelligence ("C4I") systems engineering, and communications engineering.
Overview
Our primary business focus is to pursue Small Business Innovative Research ("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.
Revenues from our government contracts represented 100% of our revenues for the three and six months ended June 30, 2013 and 2012. 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.
ADEPT?
Originally designated as the Multiple Function Distributed Test and Analysis Tool, the ADEPT began as an SBIR investigation in 2002. Additional ADEPT development was completed through a series of SBIR grants and contracts. ADEPT is an automated maintenance workstation designed to significantly reduce the man-hours required to align the AN/SPY-1 Radar System aboard U.S. Navy AEGIS cruisers and destroyers, while optimizing system performance and readiness. ADEPT represents a new approach to Navy shipboard maintenance, integrating modular instrumentation cards in a rugged enclosure with an onboard computer, input and output devices, networking hardware, removable hard drives, and a touch screen display. A custom software application provides the user interface and integrates the hardware with a database that stores user information, instrument readings, maintenance requirements, and training aids. ADEPT is designed to be adapted to other complex shipboard systems, and to provide integrated distance support capabilities for remote diagnostics and troubleshooting by shore-based Navy experts.
Key benefits of ADEPT include:
? Distance support capability enabling "expert" remote (shore-based) system support and fleet-wide system analysis;
? Reduction in the amount of electronic test equipment required for organizational level support; and
? Modularity and programmability which aims to overcome obsolescence issues encountered with current test equipment and support capability enhancements in future systems.
The goal for ADEPT has been to obtain a multi-year Indefinite-Delivery, Indefinite-Quantity ("IDIQ") contract for production, engineering, and logistics support. On March 19, 2010, we were awarded and entered into an IDIQ contract with the Naval Surface Warfare Center. The contract is for a term of five years and provides for the purchase and sale of up to $26 million of ADEPT units and related support.
From 2010 through 2012, we received orders to design, produce, deliver, and further enhance An initial delivery order for 27 ADEPT units valued at $2.3 million was awarded on March 22, 2010. In September 2010, we were awarded a new production order from the U.S. Navy to build additional ADEPT equipment for deployment on U.S. AEGIS Cruisers and Destroyers, as well as the Navy's new Littoral Combat Ship. Under this order, we delivered an additional 18 ADEPT units and upgraded to the Low-Rate Initial Production Units manufactured under previous contracts. Some of the funding associated with this award allowed our engineers to enhance the distance support capabilities of ADEPT and incorporate new design features to enable ADEPT to be used on other U.S. Navy systems. In July 2011, we received $3.1 million in orders to produce and deliver an additional 36 ADEPT units and related support services, and in September, 2011 we received a $2.1 million delivery order from the U.S. Navy for additional research, development, and support of ADEPT units. In April, June, and July 2012, we received commitments of $385,000, $852,000 and $88,000, respectively, under the IDIQ to provide additional engineering and logistics support. Finally, in August and September 2012, we received new task orders to produce and deliver 35 ADEPT units.
Wireless Local Area Network Systems
Since June 2004, we have been working with the Office of Naval Research regarding emerging Wireless Local Area Network systems ("WLANs") and DoD radar systems to, among other things, evaluate and quantify the potential improvements which may be afforded by selected mitigation techniques. We continue to perform contracts in connection with this project and have worked closely with engineers from the Naval Air Warfare Center, Weapons Division. Specifically, in April 2010, we were awarded a $250,000 subcontract with a major defense prime contractor to perform design of shipboard wireless networks for a new U.S. Navy communications program.
Recent Developments
In June 2013, we were awarded a $2,803,845 service contract with Condition-Based Maintenance ("CBM") for Littoral Combat Ship Systems using the ADEPT Distance Support Sensor Suite. This project will extend the development of the ADEPT to better facilitate the integration of multiple distributed sensors and portable data collection units; provide enhanced automated data collection and processing capabilities; and support hosting of prognostics modeling tools that use the collected data to predict remaining end of life for equipment under test components. Specific objectives of this project will be realized using a phased approach and will contain specific milestones.
In June 2013, we were also awarded $667,000 in new task orders under the ADEPT contract to produce and deliver 6 ADEPT units and related support services.
In May 2013, we were awarded a $24,000 contract by the Naval Surface Warfare Center to produce and deliver 25 hard drive assemblies.
In January and April 2013, we were awarded an additional $185,000 and $187,238, respectively, under the IDIQ to provide additional engineering and logistics support related to ADEPT.
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 awarded to us. Increases in the number and value of contracts awarded will generally result in increased revenues in future periods and, assuming relatively stable variable costs associated with our fulfilling such contracts, 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 majority of our revenue during the first and second quarters of 2013, and expected revenue over the next six months, is or will be from sales of ADEPT units under our IDIQ 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.
Outlook
Our strategy for continued growth is three-fold. First, 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 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 the ADEPT, with broad appeal in both the government and commercial marketplace. This state-of-the-art test equipment can be used by many commercial and governmental customers such as the FAA, radio and television stations, cellular service providers, 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 system contractors. Our strategy is to develop these relationships into longer-term, key subcontractor roles on future major defense programs awarded to these prime contractors.
For the remainder of 2013, our primary strategic focus is to continue to: (i) establish ourselves as a premium provider of research and development and product development services to the defense industry; and (ii) grow our business, generate profits and increase our cash reserves through obtaining additional SBIR contracts and positioning ourselves to obtain future SBIR contracts. From an operational perspective, we expect to focus substantial resources on generating purchase orders under the IDIQ contract for ADEPT units and exploring commercialization opportunities. We intend to capitalize on the Navy modernization program, which could result in two or three ADEPT units being placed on each destroyer and cruiser in the U.S. Navy, with the potential to install multiple units on additional U.S. Navy ships and submarines.
Over the longer term, we expect to further develop technology based on existing and additional SBIR contracts and to develop these technologies into products for wide deployment to DoD customers and contractors, as well as developing potential commercial applications.
Changes to Critical Accounting Policies and Estimates
Our critical accounting policies and estimates are set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. As of June 30, 2013, there have been no changes to such critical accounting policies and estimates.
Results of Operations
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") and the requirements of the SEC. The preparation of these 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, recoverability of long-lived assets, income taxes 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 the notes to our condensed financial statements included herein 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.
Three Months Ended June 30, 2013 and 2012
We generated revenues of $367,558 during the three months ended June 30, 2013 compared to $479,369 during the three months ended June 30, 2012, a decrease of $111,811, or 23%. The decrease was primarily due to the delay in receiving orders for additional ADEPT units in 2013 as well as the change in our revenue
mix. Revenues earned are based upon the labor, subcontracting services, materials, and other direct costs that we incur. Generally labor and other direct costs generate higher revenues while subcontracting services and material costs are less. During the three months ended June 30, 2013, revenues derived from subcontracting services and materials outpaced revenues derived from labor hours completed. During the three months ended June 30, 2012, revenues derived from labor hours completed outpaced subcontracting services and materials, resulting in higher revenues earned in 2012.
Cost of sales consists of direct contract costs including labor, material, subcontracts, and warranty expense for ADEPT units that have been delivered, travel, and other direct costs. Cost of sales for the three months ended June 30, 2013 was $215,442 compared to $204,852 for the three months ended June 30, 2012, an increase of $10,590, or 5%. The increase was primarily attributable to the change in the mix of costs incurred and an increase in our warranty reserve. Our cost of sales during the three months ended June 30, 2013 was comprised of more subcontracting services and material purchases and less direct labor hours. Labor costs were significantly higher during the comparable period in 2012. Our warranty reserve increased during the three months ended June 30, 2013 while the reserve remained unchanged during the comparable period in 2012. The change is due to the timing of units shipped during 2013.
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 benefits 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, 2013 were $203,109 compared to $146,455 for the three months ended June 30, 2012, an increase of $56,654, or 39%. The increase was primarily due to the increase in engineering salaries and an increase in the allocation of engineering overhead due to the delay in receiving new task orders.
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). General and administrative costs for the three months ended June 30, 2013 were $285,006 compared to $273,701 for the three months ended June 30, 2012, an increase of $11,305, or 4%. The increase was primarily due to an increase in research and development related expenses and director fees, offset by a reduction in administrative salaries and professional fees.
At June 30, 2013, we estimate our annual effective tax rate for 2013 to be 33.4%. We recognized a tax benefit of $154,814 for the quarter ended June 30, 2013 primarily due to state income taxes and the expected change in the valuation allowance established for net deferred tax assets. The tax benefit for the quarter includes a discrete benefit of $47,600 related to the expected future use of federal net operating losses. The expected change in our valuation allowance during 2013 is based on ADEPT and ADSS contracts awarded to us during the three months ended June 30, 2013, and the determination by management that the future realization of the net deferred tax assets was judged to be more-likely-than-not. At June 30, 2013, the difference from the expected federal income tax rate is attributable to state income taxes, certain permanent book-tax differences and the income tax impact of the change in the valuation allowance established for net deferred tax assets.
We incurred a net loss of $181,185 during the three months ended June 30, 2013 as compared to $119,745 during the three months ended June 30, 2012. The increase in net loss was primarily due to the change in the mix of costs and services we provided in 2013 compared to 2012 that limited the amount of revenue we were eligible to recognize. The increase in net loss was also due to the timing in which we completed delivery order contracts for ADEPT units. Lastly, the increase in net loss was attributable to the increase in our warranty expense and the decrease in the income tax benefit when compared to recoveries and benefits, respectively, during the comparable period in 2012.
Six Months Ended June 30, 2013 and 2012
We generated revenues of $1,269,754 during the six months ended June 30, 2013 compared to $1,238,492 during the six months ended June 30, 2012, an increase of $31,262, or 3%. The increase was primarily due to the timing of the production and delivery of ADEPT units offset by the change in the revenue mix between 2013 and 2012. We experienced a delay in new delivery orders for ADEPT units during the six months ended June 30, 2012. Revenues for subcontracting and materials outpaced direct labor hours and costs during the six months ended June 30, 2013 compared to a higher mix of labor hours and direct costs during the comparable period in 2012.
Cost of sales for the six months ended June 30, 2013 was $677,393 compared to $465,082 for the six months ended June 30, 2012, an increase of $212,311, or 46%. The increase was primarily attributable to the change in the mix of costs incurred and an increase in our warranty reserve. Our cost of sales during the six months ended June 30, 2013 was comprised of more subcontracting services and material purchases and less direct labor hours. Labor costs were significantly higher during the comparable period in 2012. Our warranty reserve increased during the six months ended June 30, 2013 while the reserve decreased during the comparable period in 2012. The change is a direct result in the timing of units shipped during 2013 while the expiration of warranty coverage outpaced shipped units for the comparable period in 2012.
Engineering costs for the six months ended June 30, 2013 were $405,007 compared to $306,753 for the six months ended June 30, 2012, an increase of $98,254, or 32%. The increase was primarily due to the increase in engineering salaries and an increase in the allocation of engineering overhead due to the delay in receiving new task orders.
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). General and administrative costs for the six months ended June 30, 2013 were $548,396 compared to $594,488 for the six months ended June 30, 2012, a decrease of $46,092, or 8%. The decrease was primarily due to a reduction in administrative salaries and professional fees that were offset by an increase in research and development related expenses.
We recognized a tax benefit of $160,214 for the six months ended June 30, 2013 primarily due to state income taxes and the expected change in the valuation allowance established for net deferred tax assets. The tax benefit for the quarter includes a discrete benefit of $47,600 related to the expected future use of federal net operating losses. The expected change in our valuation allowance during 2013 was based on the ADEPT and ADSS contracts awarded to us during six months ended June 30, 2013, and the determination by management that the future realization of the net deferred tax assets was judged to be more-likely-than-not. At June 30, 2013, the difference from the expected federal income tax rate is attributable to state income taxes, certain permanent book-tax differences and the income tax impact of the change in the valuation allowance established for net deferred tax assets.
We incurred a net loss of $200,811 during the six months ended June 30, 2013 as compared to $105,733 during the six months ended June 30, 2012. The increase in net loss is primarily attributable to the change in the mix of costs and services we provided in 2013 compared to 2012 that limited the amount of revenue we were eligible to recognize. The decrease was also due to the timing in which we completed delivery order contracts for ADEPT units, the related warranty expense for ADEPT units. Lastly, the decrease was also attributable to the increases in our warranty expense and decreases in our income tax benefits when compared to recoveries and benefits, respectively, during the comparable period in 2012.
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, 2013, net cash provided by operations was $166,823 compared to $35,155 during the six months ended June 30, 2012. The increase was due primarily to timing of payments related to our operating assets and liabilities. We had a decrease in accounts receivable as a result of receiving payments and decreases in accounts payable and accrued expenses, including accrued payroll and payroll taxes due to the timing of our vendor payments and payroll processing. We had working capital of $1,070,083 as of June 30, 2013 as compared to $1,379,678 as of December 31, 2012.
During the six months ended June 30, 2013, net cash used in investing activities was $1,500 compared to $1,102 during the six months ended June 30, 2012. The increase was due to capital expenditures.
In June 2013, we renewed our line of credit agreement. The facility matures on June 30, 2014 and accrues interest at a variable rate equal to the bank's prime rate plus 250 basis points with a minimum annual interest rate of 4.500%. We increased the facility's borrowing capacity to $500,000. Principal borrowings may be prepaid at any time without penalty, and the facility is secured by substantially all of our assets. Borrowings under the facility are limited to a percentage of aggregate outstanding receivables that are due within 90 days. The facility contains customary affirmative and negative covenants and a net worth financial covenant. As of the date of this report, there are no amounts outstanding under the facility.
As of June 30, 2013, we had cash resources of approximately $1,052,463. We believe that 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.
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 any such transaction will achieve profitability or generate positive cash flow.
Off-Balance Sheet Arrangements
As of June 30, 2013, we did not have any relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or variable interest 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. We have not made any guarantees for outside parties and have not entered into any derivative instruments.
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