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AERG > SEC Filings for AERG > Form 10-K on 29-Mar-2013All Recent SEC Filings

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Form 10-K for APPLIED ENERGETICS, INC.


29-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following management discussion and analysis ("MD&A") together with the risk factors set forth in Item 1A and with our audited Consolidated Financial Statements and Notes thereto included elsewhere herein.

Overview

Applied Energetics, Inc. ("company", "Applied Energetics", "we", "our" or "us") designs, develops and manufactures solid state Ultra Short Pulse (USP") lasers for commercial applications and applied energy systems for military applications. Through our technology development efforts, we have gained expertise and proprietary knowledge in high performance lasers and high-voltage electronics. We have suspended the majority of our Government work due to the lack of Government funding.

High-Voltage Technologies

We have acquired and developed unique high-voltage capabilities focused on providing high-voltage solutions for semiconductor, aerospace, chemical processing, and other military and commercial activities. Opportunities currently in process or under development include advanced electron-beam technologies, nested high-voltage generators and other unique power solutions for use in a wide range of commercial and military applications. We believe our electron beam technologies are more compact than competitive technologies and offer customers a capable solution for applications that require less space for implementation.

LGE and LIPC® Technologies

Upon our inception in 2002, we began developing LGE and LIPC technologies intended to precisely deliver high voltage electrical charges by using a laser to create a conductive path in the atmosphere. We have protected what we believe to be the enabling intellectual property through U.S. Patent filings. LGE development has been funded through multiple Department of Defense ("DoD") contracts in support of U.S. Navy, Army, Air Force, and the Office of Secretary of Defense programs, as well as through internally funded research initiatives.

We have completed all contracted work authorized under our contract with the U. S. Army's Research, Development and Engineering Command ("ARDEC"). We continue to respond to ARDEC requests for proposal on contracts for development of our LGE technology; however, there is no assurance that a contract will be awarded.

Counter-IED Technologies

We have developed and delivered a system that demonstrated significant capability in over 200 missions in Afghanistan countering IEDs from mid-2009 through early 2011.

Critical Accounting Policies

Use of Estimates

The preparation of consolidated financial statements in conformity with United States generally accepted accounting principles requires management to make estimates, judgments and assumptions that affect the amounts reported in the financial statements and accompanying notes. Management bases its assumptions on historical experiences and on various other inputs and estimates that it believes 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. In addition, management considers the basis and methodology used in developing and selecting these estimates, the trends in and amounts of these estimates, specific matters affecting the amount of and changes in these estimates, and any other relevant matters related to these estimates, including significant issues concerning accounting principles and financial statement presentation. Such estimates and assumptions could change in the future as more information becomes known which could impact the amounts reported and disclosed herein. Significant estimates include revenue recognition under the percentage of completion method of contract accounting, estimate to forecast loss on contracts under the completed contract method of accounting, the valuation of inventory, estimates of long-lived asset value, and estimate to forecast expected forfeiture rate on stock-based compensation and stock-based compensation expense.

Revenue Recognition

Revenue has been derived from ongoing contract work for systems development, effects testing and the design and development of demonstration systems and sub-systems for our Government and commercial customers. This work is expected to be generally performed under cost-plus contracts with Government customers.

Revenue under long-term Government contracts is generally recorded under the percentage of completion method. Revenue, billable monthly, under cost plus fixed fee contracts is recorded as costs are incurred and includes estimated earned fees in the proportion that costs incurred to date bear to total estimated costs. Costs include direct labor, direct materials, subcontractor costs and overhead. General and administrative expenses allowable under the terms of the contracts are allocated per contract depending on its direct labor and material proportion to total direct labor and material of all contracts. As contracts can extend over one or more accounting periods, revisions in earnings estimated during the course of work are reflected during the accounting period in which the facts become known. When the current contract estimate indicates a loss, a provision is made for the total anticipated loss in the period in which the facts become known. Management evaluates many variables and makes various assumptions related to the estimation of total cost of completion of long-term contracts. Management reviews the progress and performance of all contracts monthly.

The asset caption "accounts receivable" includes costs and estimated earnings in excess of billings on uncompleted contracts, which represents revenue recognized in excess of amounts billed. Such revenue is billable under the terms of the contracts at the end of the year, yet was not invoiced until January, 2013, and is generally expected to be collected within one year. The liability "billings in excess of costs and estimated earnings on uncompleted contracts" represents billings in excess of revenue recognized.

Revenue for other products and services is recognized when such products and services are delivered or performed and, in connection with certain sales to certain customers, when the products and services are accepted, which is normally negotiated as part of the initial contract. Revenue from commercial, non-Governmental customers has historically been based on fixed price contracts where the sale is recognized upon acceptance of the product or performance of the service and when payment is probable. Contract costs are accumulated in the same manner as inventory costs and are charged to operations as the related revenue from contract is recognized. When the current contract estimate indicates a loss, a provision is made for the total anticipated loss in the period in which the facts become known.

Inventories

Inventories include material, direct labor and related manufacturing and administrative overhead and are stated at the lower-of-cost (determined on a weighted average basis) or market for raw materials and work-in-process inventory. When actual contract cost and the estimate to complete exceed the estimated contract revenues, a loss provision is recorded. Due to the nature of our inventory, we analyze inventory on an item-by-item basis compared to future usage and sales for obsolescence quarterly.

Share-Based Payments

Stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as an expense over the requisite service period.

The fair value of each option grant is estimated at the date of grant using the Black-Scholes-Merton option valuation model. We make the following assumptions relative to this model: (i) the annual dividend yield is zero as we do not pay dividends on our common stock, (ii) the weighted-average expected life is based on a midpoint scenario, where the expected life is determined to be half of the time from grant to expiration, regardless of vesting, (iii) the risk free interest rate is based on the U.S. Treasury security rate for the expected life, and (iv) the volatility is based on the level of fluctuations in our historical share price for a period equal to the weighted-average expected life. We estimate forfeitures when recognizing compensation expense and adjust this estimate over the requisite service period should actual forfeitures differ from such estimates. Changes in estimated forfeitures are recognized through a cumulative adjustment, which is recognized in the period of change and which impacts the amount of unamortized compensation expense to be recognized in future periods.

Recoverability of Property and Equipment

We assess recoverability of property and equipment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable.

We assess the recoverability of property and equipment by determining whether the amortization of the balances over their remaining lives can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is measured based on projected discounted future operating cash flows. The assessment of the recoverability of long-lived assets will be impacted if estimated future operating cash flows are not achieved.

Income Taxes

Deferred tax assets and liabilities are recognized currently for the future tax consequences attributable to the temporary differences between the financial statement carrying amounts of assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets if it is more likely than not that such assets will not be realized.

Results of Operations

Our consolidated financial information for the years ending December 31, 2012, and 2011 is as follows:

                                                     2012             2011
        Revenue                                  $  1,335,421     $  5,070,156
        Cost of revenue                             1,148,906        4,793,181
        General and administrative                  2,757,510        3,811,028
        Selling and marketing                         776,054        1,151,213
        Research and development                      157,313        1,674,158
        Other (expense) income:
        Interest expense                               (1,651 )         (4,156 )
        Interest income                                 2,536            3,477
        Loss before provision for income taxes     (3,503,477 )     (6,360,103 )
        Provision (benefit) for income taxes                -                -
        Net loss                                 $ (3,503,477 )   $ (6,360,103 )

Revenue

Revenue decreased approximately $3.7 million to $1.3 million for the year ended December 31, 2012 compared to 2011 primarily as a result of the reduction in Government spending on our technologies. Our counter-IED revenue decreased by $2.2 million to $0 in 2012; as we completed all deliverables and testing required under our contract with the USMC in the second quarter of 2011. LGE revenue decreased by $1.5 million to $633,000 as we exhausted the available funding under our contract with ARDEC. Additionally, our USP Laser revenues decreased by $181,000 for the year ended 2012 due to the delivery of our USP Laser to the Navy in June of 2011. Offsetting these decreases in revenue was an increase in our HV revenue of $112,000 for the year ended 2012.

Cost of Revenue

Cost of revenue includes manufacturing labor, benefits and overhead, and an allocation of allowable general and administration and research and development costs in accordance with the terms of our government contracts.

Cost of revenue decreased by $3.6 million for the year ended December 31, 2012 compared to 2011. The decrease in cost of revenue is directly tied to the decrease in sales activity of approximately 74%. Cost of revenue as a percentage of revenue improved to 86% from 95% last year.

General and Administrative

General and administrative expenses decreased approximately $1.1 million for the year ended December 31, 2012 compared to 2011. Salaries and wages decreased by approximately $2.3 million, professional services decreased by approximately $1.3 million, employee benefits decreased by approximately $491,000, supplies and building related expenses decreased by approximately $458,000, non-cash compensation costs decreased by approximately $185,000, insurance and miscellaneous fees decreased by approximately $162,000 and depreciation and amortization decreased by approximately $145,000. Offsetting these reductions in operating expenses was a decrease in absorption of labor and overheads of approximately $3.5 million previously charged to government contracts because our staffing exceeded our operational requirements as a result of the reduced volume of government contract business. These reductions reflect the various cost saving measures implemented in 2011 and continuing through 2012 to compensate for the decrease in government revenues; which included reducing our workforce, exiting our leased facilities, and reductions in other operating expenses.

At December 31, 2012, there were approximately $44,000 of unrecognized compensation costs related to unvested restricted stock awards. The costs for restricted stock awards are expected to be recognized on a weighted-average basis over approximately one year.

Selling and Marketing

Selling and marketing expenses decreased by approximately $375,000 for the year ended December 31, 2012 compared to 2011. The decrease was mostly due to the reduction of workforce as well as the reduction of our bid and proposal activity in 2012.

Research and Development

Research and development expenses decreased approximately $1.5 million for the year ended December 31, 2012 compared to 2011. Our investment in internally funded research decreased during 2012 as we completed the building prototypes at the end of 2011 and early 2012.

Other Income (Expense)

Other income (expense) primarily consists of interest income and interest expense. Net interest income for 2012 was higher by approximately $2,000 from 2011 primarily due to the lower financing costs incurred in 2012.

Net Loss

Our operations in 2012 resulted in a net loss of approximately $3.5 million, a decrease of approximately $2.9 million compared to the approximately $6.4 million net loss for 2011. Our net loss attributable to common stockholders per common share - basic and diluted decreased from approximately $0.07 per share to $0.04 per share due to the decrease of net loss.

Inflation and Seasonality

We do not believe that inflation has a material effect on the operations or financial condition of our business, nor do we believe that we are subject to significant seasonal swings in our business.

Trend Discussion

We expect revenues for 2013 to further decline due to the unresolved issues regarding the Federal Budget and how deficit reduction will affect the budgets of our Government customers.

As a result, to reduce our cost of revenue, research and development and general and administrative expenses, we have made a strategic decision not to invest internal funds on the further development and advancement of our LGE, LIPC, counter-IED and high voltage systems and have reduced our work force to a level consistent with our expected operations.

Liquidity and Capital Resources

At December 31, 2012, we had approximately $2.6 million of cash and cash equivalents, a decrease of approximately $1.3 million from December 31, 2011. In 2012, we used approximately $2.6 million in operating activities. This amount is comprised primarily of our net loss of $3.5 million and decreases in our accrued expenses and deposits of $754,000, accounts payable of $201,000 and net gain on equipment disposal of $119,000, partially offset by the $720,000 loss on building and land sold, $447,000 decrease in accounts receivables, $205,000 decrease in long term receivables, $193,000 depreciation and amortization and $147,000 decrease in prepaid expenses, deposits and other assets. Investing activities resulted in net cash inflow of approximately $1.5 million, resulting primarily from the sale of our building and financing activities resulted in net cash outflow of approximately $174,000.

The fiscal year 2012 Department of Defense budget was approved in January of 2012. This budget and the President's proposed budget for 2013 reflect significant reductions in research and development funding for the foreseeable future. This area has historically generated greater than 90% of revenues. We have suspended the majority of our Government work due to the lack of Government funding, therefore we expect to continue having significantly reduced revenues from the US Government. Furthermore, it is expected that revenue generated from commercial sales of our new USP laser and High Voltage systems will not become significant for at least the next twelve months as these products gain market acceptance. The combination of these conditions will cause further depletion our cash reserves during the transition to commercialize our USP laser technologies. We are considering strategic alternatives, including mergers, the acquisition of one or more businesses or technologies, and/or the disposition of one or more of our existing businesses.

Our continuance in business beyond 2013 is dependent on successful development of new commercial customers and sales of our USP laser systems and high voltage systems, obtaining profitable operations and additional financing necessary to fund our operations. Additional contracts from our Department of Defense customers, if available and substantial, may assist in funding our operations and contribute to our overall cash flow.

In their report accompanying our financial statements, our independent auditors stated that our financial statements for the year ended December 31, 2012 were prepared assuming that we would continue as a going concern, and that they have substantial doubt as to our ability to continue as a going concern. Our auditors' have noted that our recurring losses from operations and negative cash flow from operations and the concern that we may incur additional losses due to the reduction in Government contract activity raise substantial doubt about our ability to continue as a going concern.

Backlog

At December 31, 2012 and 2011, we had a backlog (i.e., work load remaining on signed contracts) of approximately $26,000 and $390,000, respectively, to be completed within the twelve months following those dates. As of March 18, 2013, our backlog was approximately $0.0.

Contractual Obligations:



The following table summarizes our contractual obligations and other commercial
commitments as of December 31, 2012:



                                            Payment by Period
                                                      Less than 1
                                         Total           Year

                    Operating leases   $  20,288     $      20,288

                    Total              $  20,288     $      20,288

Not included in the above table are the dividends on our Series A Preferred Stock that are approximately $174,000 each year (approximately $43,000 each quarter), assuming no conversion of the outstanding shares of Series A Preferred Stock into shares of common stock.

Operating Leases

We have, in the past, operated in leased premises under operating leases. Total rent expense on premises amounted to approximately $23,000 and $97,000 for 2012 and 2011, respectively.

Preferred Stock

The Series A Preferred Stock has a liquidation preference of $25.00 per share. The Series A Preferred Stock bears dividends at the rate of 6.5% of the liquidation preference per share per annum, which accrues from the date of issuance, and is payable quarterly, when declared. The holders of the Series A Preferred Stock have a right to put the stock to the Company for an aggregate amount equal to the liquidation preference ($2.7 million) in the event of a change in control. Dividends are payable in: (i) cash, (ii) shares of our common stock (valued for such purpose at 95% of the weighted average of the last sales prices of our common stock for each of the trading days in the ten trading day period ending on the third trading day prior to the applicable dividend payment date), provided that the issuance and/or resale of all such shares of our common stock are then covered by an effective registration statement or (iii) any combination of the foregoing. As of December 31, 2012, there were 107,172 shares of Series A Preferred Stock outstanding.

Recent Accounting Pronouncements

Refer to Note 2 of Notes to Consolidated Financial Statements for a discussion of recent accounting standards and pronouncements.

Off-Balance Sheet Arrangements

As of December 31, 2012, we had no significant off-balance sheet arrangements other than operating leases. For a description of our operating leases, see Note 11 to the Consolidated Financial Statements.

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