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MKRS > SEC Filings for MKRS > Form 10-K on 1-Apr-2013All Recent SEC Filings

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Form 10-K for MIKROS SYSTEMS CORP


1-Apr-2013

Annual Report


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

This Management's Discussion and Analysis of Financial Condition and Results of Operations and other parts of this Annual Report on Form 10-K contain forward-looking statements that involve risks and uncertainties. All forward-looking statements included in this Annual Report on Form 10-K are based on information available to us on the date hereof, and except as required by law, we assume no obligation to update any such forward-looking statements. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth under the caption "Risk Factors" contained in this report and elsewhere herein. The following should be read in conjunction with our annual financial statements contained elsewhere in this report.

Overview

Our primary business focus is to pursue SBIR programs from the DoD, Department of Homeland Security, and other governmental authorities, and to expand this government funded research and development into products and services. Since 2002, we have been awarded several Phase I, II, and III SBIR contracts.

Revenues from our government contracts represented 100% of our revenues for the years ended December 31, 2012 and 2011. 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.


Contracts

On March 19, 2010, we were awarded and entered into a multi-year IDIQ contract with the Naval Surface Warfare Center related to our ADEPT product. 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 engineering and logistics support. For the years ended December 31, 2012 and 2011, we realized revenues of $4.6 million and $4.2 million, respectively, related to the ADEPT production orders. We expect additional delivery orders during the remaining term of the contract. It should be noted that contracting with the Federal government is a lengthy and complex process and that many factors could materialize that would negatively impact our ability to secure future ADEPT orders.

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. In January, 2013, we were awarded an additional $185,000 under this subcontract to continue our design of shipboard wireless networks.

Since 2010, we have been working with the Naval Sea Systems Command for development of a "Wave Energy MicroBuoy" to be used as an at-sea platform for a communications relay or network gateway. During 2012 and 2011, we worked on the design and development of a miniaturized, self-powered ocean buoy which can be deployed at sea for extended periods to support various on-board payload packages, such as network communications nodes. The main objective of the SBIR Phase II Program is the development and testing of a prototype MicroBuoy and demonstration of a persistent power level specified for the Navy system.

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 in 2012, and expected revenue over the next twelve 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 (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 the ADEPT described above, 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 phone 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.

In 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 prospective, 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.


Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). The preparation of financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, warranty costs, recoverability of long-lived assets, income taxes, stock-based compensation, backlog and commitments. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The accounting estimates and assumptions discussed in this section are those that we consider to be the most critical to an understanding of our financial statements because they inherently involve significant judgments and uncertainties.

Revenue Recognition

We are engaged in research and development contracts with the Federal government to develop certain technology to be utilized by the U.S. DoD. The contracts are cost plus fixed fee contracts and we account for these contracts using the percentage-of-completion accounting method. Under this method, revenue is recognized based on the extent of progress towards completion of the long term contract.

We generally use a variation of the cost to cost method to measure progress for all long term contracts unless we believe another method more clearly measures progress towards completion of the contract.

Revenues are recognized as costs are incurred and include estimated earned fees, or profit, calculated on the basis of the relationship between costs incurred and total estimated costs at completion. Under the terms of certain contracts, fixed fees are not recognized until the receipt of full payment has become unconditional, that is, when the product has been delivered and accepted by the Federal government. Backlog represents the estimated amount of future revenues to be recognized under negotiated contracts as work is performed.

Unbilled revenue reflects work performed, but not billed at the time, per contractual requirements. Billings to customers in excess of revenue earned are classified as advanced billings, and shown as a liability. As of December 31, 2012 and 2011, there were no advanced billings or unbilled revenue.

Accounts Receivable

Accounts receivable from government contracts are stated at outstanding balances. When necessary, an allowance for doubtful accounts is established through provisions charged against operations. Receivables deemed to be uncollectible are charged against the allowance and subsequent recoveries, if any, are credited to the allowance.

The allowance for doubtful accounts is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management's periodic evaluation of the adequacy of the allowance is based on past experience, aging of the receivables, adverse situations that may affect a customer's ability to pay, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires estimates that may be susceptible to significant change. Unpaid balances remaining after the stated payment terms are considered past due. All of our business is conducted with the Federal government in which nonpayment for awarded contracts is unlikely. No allowance for doubtful accounts was deemed necessary by management at December 31, 2012 and 2011.

Warranty Expense

We provide a limited warranty, as defined by the related warranty agreements, for our production units. Our warranties require us to repair or replace defective products during such warranty period. We estimate the costs that may be incurred under our warranty and record a liability in the amount of such costs at the time product revenue is recognized. Factors that affect our warranty liability include the number of units sold, expected and anticipated rates of warranty claims, and cost per claim. We periodically assess the adequacy of our recorded warranty liability and adjust the amount as necessary. We incurred warranty expense, which is a component of our cost of sales, of $(7,900) and $36,400 for the years ended December 31, 2012 and 2011, respectively. The warranty expense is attributable to the units produced and sold under the IDIQ contract. We had an accrued warranty expense of $69,655 and $86,400 for the years ended December 31, 2012 and 2011, respectively.

Income Taxes

Deferred tax assets and liabilities are determined based on the differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities, and are measured at the prevailing enacted tax rates that will be in effect when these differences are settled or realized. Deferred tax assets, including tax loss and credit carryforwards, and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. During 2012, we utilized federal net operating loss carryforwards of $298,382 and $40,574 of net operating loss carryforwards expired for purposes of our tax provision. The valuation allowance associated with the related deferred tax assets was decreased by approximately $108,565 and $253,081 in 2012 and 2011, respectively. The reductions to our valuation allowance were attributable to our new contracts and continued profitability on existing contracts.


Share-based Compensation

We record compensation expense associated with stock options and other forms of equity compensation based on the estimated fair value at the grant date. There were no stock options issued for the year ended December 31, 2012. We use the Black-Scholes-Merton ("BSM") option-pricing model to determine the fair value of stock-based awards. Expected volatility is based on historical volatility of our common stock. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant.

The expected term is estimated consistent with the simplified method, as identified in Accounting Standards Codification ("ASC") 718. In December 2007, the SEC issued guidance that allows companies, in certain circumstances, to utilize a simplified method in determining the expected term of stock option grants when calculating the compensation expense to be recorded under GAAP for employee stock options. The simplified method can be used after December 31, 2007 only if a company's stock option exercise experience does not provide a reasonable basis upon which to estimate the expected option term. Through 2007, we used the simplified method to determine the expected option term, based upon the vesting and original contractual terms of the option. We have continued to use the simplified method to determine the expected option term since our stock option exercise experience does not provide a reasonable basis upon which to estimate the expected option term.

Recently Issued Accounting Pronouncements

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards (ASU 2011-04). The amendments in this ASU are intended to improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and International Financial Reporting Standards ("IFRS"). The amendments in this ASU explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. This ASU is to be applied on a prospective basis for interim and annual periods beginning after December 15, 2011. Early application is not permitted. We adopted the provision of ASU 2011-04 and it did not impact our financial statements or results of operations.

Results of Operations

Years ended December 31, 2012 and 2011

Total contract revenues were $4,825,068 in 2012 compared to $5,347,564 in 2011, a decrease of $522,496, or 10%. The decrease was primarily due to the delay in receiving additional ADEPT orders under the IDIQ contract in 2012.

Cost of sales consists of direct contract costs including labor, material, subcontracts, warranty expense for ADEPT units that have been delivered, travel, and other direct costs. Costs of sales were $2,690,510 in 2012 compared to $3,213,476 in 2011, a decrease of $522,966, or approximately 16%. The decrease was primarily due to the delay in receiving additional ADEPT orders under the IDIQ contract in 2012 and a reduction in our warranty expense due to expiration of warranty coverage for previously issued units outpacing shipped and delivered units in 2012.

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 remained constant at $747,084 in 2012 compared to $757,307 in 2011.

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 expenses remained constant at $1,133,788 in 2012 compared to $1,134,667 in 2011.

The provision for income taxes was $26,675 in 2012 compared to $73,325 in 2011, representing an effective income tax rate of 10.5%, and 30.2%, respectively. The decrease in the effective federal income tax rate is attributable to the continued utilization of federal net operating loss carry forwards and the reduction of our valuation allowance for our deferred tax asset. These decreases were offset by increases in income from operations.

We generated net income of $227,109 in 2012 as compared to $169,619 in 2011, an increase of $57,490 or 34%. The increase in net income is primarily attributable to the reduction of our valuation allowance due to the utilization of federal net operating carry forwards as well as the reduction in our warranty expense for expiration of warranty coverage for previously issued units outpacing shipped and delivered units 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.

At December 31, 2012, we had cash and cash equivalents of $887,140 and net working capital of $1,379,678. During the year ended December 31, 2012, net cash used in operating activities was $73,070 compared to net cash provided by operating activities of $327,878 in 2011. The decrease was attributable to a delay in receiving additional orders under our ADEPT program in 2012. Due to the delay, accounts payable and accrued expenses decreased more than accounts receivable.

During the year ended December 31, 2012, net cash used in investment activities remained relatively constant at $3,346 as compared to $2,428 in 2011.

In August 2012, we renewed our line of credit agreement. The facility matures on August 13, 2013 and accrues interest at a variable rate equal to the bank's prime rate plus 300 basis points with a minimum annual interest rate of 5.25%. 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.

We believe our available cash resources and expected cash flows from operations will be sufficient to fund operations for the next twelve months. We do not expect to incur any material capital expenditures during the next twelve months.

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 December 31, 2012, 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.

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