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Quarterly Report
ITEM 2. Management's Discussion and Analysis of Financial Condition or Results of Operations.
The following discussion should be read in conjunction with our financial statements and the notes related to those statements. Some of our discussion is forward-looking and involves risks and uncertainties. For information regarding risk factors that could have a material adverse effect on our business, refer to the risk factors section of the annual report for the year ended June 30, 2006 on Form 10-KSB.
CAUTION REGARDING FORWARD-LOOKING STATEMENTS
Our prospects are subject to uncertainties and risks. In this Quarterly Report on Form 10- QSB, we make forward-looking statements in this Item 2 and elsewhere that also involve substantial uncertainties and risks. These forward-looking statements are based upon our current expectations, estimates and projections about our business and our industry, and reflect our beliefs and assumptions based upon information available to us at the date of this report. In some cases, you can identify these statements by words such as "if," "may," "might," "will, "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential," "continue," and other similar terms. These forward-looking statements include, among other things, our current and future capital needs, uncertainty of capital funding, our clients' ability to cancel contracts with little or no penalty, government initiatives to implement homeland security measures, the likelihood of completing transactions for which we have entered into letters of intent, the state of the worldwide economy, competition, our customers' ability to pay our invoices within our standard credit terms and the trends we anticipate in our business and the markets in which we operate.
We caution readers that forward-looking statements are predictions based on our current expectations about future events. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Our actual results, performance or achievements could differ materially from those expressed or implied by the forward-looking statements as a result of a number of factors, including but not limited to the risks and uncertainties discussed in our other filings with the SEC. We undertake no obligation to revise or update any forward-looking statement for any reason.
Overview
Electronic Control Security Inc. designs, develops, manufactures and markets technology-based integrated security systems. We support systems integrators and dealer installers in the context of providing risk assessment and vulnerability studies to help ascertain a client's security requirements and in developing a comprehensive risk management and mitigation program, as well as offering product design and engineering support services.
We market our products domestically and internationally to:
- national and local government entities including the U.S. Department of Defense (DoD) and U.S. Department of Energy (DoE),
- large chemical and petrochemical facilities and major office complexes,
- energy facilities, including nuclear power stations, power utilities and pipelines,
- commercial transportation centers, such as airports and seaports and
- water and agricultural resources including reservoirs, dams, fish hatcheries and rivers.
- border security programs addressing both CONUS and OCONUS.
We believe we are one of the few true comprehensive security solution providers in the industry. We are able to analyze a security risk and develop security solutions specifically tailored to mitigate that risk, including design, engineering and manufacturing individual components of a system as may be necessary to deliver a fully integrated security system customized to a client's requirements. We are frequently engaged by security system integrators, security system dealers/installers, and commercial architects and engineers because we are able to deliver the integrated platform of design, engineering services and fully integrated security solutions that support their requirements for the completion of a given project.
We believe that we have developed a superior reputation as a provider of integrated security systems since our inception in 1976 because we:
- offer the complete range of solutions-driven responses to accommodate our customers' needs;
- offer technologically superior products;
- are able to design, engineer and manufacture systems customized to our clients' specific requirements;
- deliver systems that are easy to operate and maintain while providing superior life cycle cost performance compared to systems offered by competitors;
- have established solid credentials in protecting high value targets; and
- offer customers perhaps the best warranty in the industry.
During the recently completed quarter, we revised and updated certain agreements that can potentially result in significant business for us. In December 2006 we entered into an agreement with Hyundai Syscomm Corp., a California based company ("Hyundai") engaged in wireless mobile communications equipment, pursuant to which Hyundai is to provide to us at least $25 million of purchase orders for security worthy assets (including video surveillance systems) on terms beneficial to both parties on or prior to June 30, 2008. We entered into the agreements with Hyundai to explore the possibilities open to us in the Asian markets, where we do not have a significant presence.
In addition to the agreements with Hyundai, in April 2007 we received notice from Lockheed Martin Information and Technology Services that we have been awarded one of four prime contracts by the U.S. Navy on the Anti-Terrorism Force Protection (ATFP) NAVFAC Program to secure 54 United States naval bases over five (5 years. This program includes a 40% "Qualified Small Business Set Aside." The Department of Defense has earmarked $100,000,000 in funding under this program for fiscal 2008. Task orders are expected to be issued in the quarter beginning July 1, 2007. Lockheed Martin has already submitted subcontract agreements to ECSI as a key small business team member on this five-year security upgrade program.
Further, the Company has entered into a NDA as a Small Business technology supplier with Raytheon Corp. on the U.S. Navy Five (5) year ATFP- NAVFAC program addressing CONUS-OCONUS facilities. The Company has also entered into a NDA and Technology Supply Agreement with Vindicator, a wholly owned subsidiary of Honeywell Corp. for two of its proprietary product lines.
The United States Air Force has issued additional task orders to the Company in excess of $1 million under the existing IBDSS contract which we anticipate will be shipped and invoiced toward the end of our 2007 fourth fiscal quarter (which began on April 1, 2007) and the first quarter of our fiscal year 2008 (which will begin on July 1, 2007).
We entered into a teaming agreement with KBR - E2 - SGE to pursue the DoE-NNSE Second Line of Defense program for installation of our core security technologies for port security worldwide. In addition, we also entered into a teaming agreement with Secure Global Engineering (SEG) to supply security technologies for United States embassies worldwide.
CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements and accompanying notes have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires we make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Management continually evaluates the accounting policies and estimates it uses to prepare the consolidated financial statements. We base our estimates on historical experience and assumptions believed to be reasonable under current facts and circumstances. Actual amounts and results could differ from these estimates made by management.
We do not participate in, nor have we created, any off-balance sheet special purpose entities or other off-balance sheet financing. In addition, we do not enter into any derivative financial instruments for speculative purposes and uses derivative financial instruments primarily for managing its exposure to changes in interest rates.
We have identified the following critical accounting policies that affect the more significant judgments and estimates used in the preparation of our condensed consolidated financial statements.
Inventory Valuation
Inventories are valued at lower of cost or market. We routinely evaluate the composition of our inventory to identify obsolete or otherwise impaired inventories. Inventories identified as impaired are evaluated to determine if reserves are required. We do not currently have any reserves against inventory.
Allowance for Doubtful Accounts
The allowance for doubtful accounts is comprised of two parts, a specific account analysis and a general reserve. Accounts where specific information indicates a potential loss may exist are reviewed and a specific reserve against amounts due is recorded. As additional information becomes available such specific account reserves are updated. Additionally, a general reserve is applied to the aging categories based on historical collection and write-off experience.
Accounting for Income Taxes
We record a valuation allowance to our deferred tax assets to the amount that is more likely than not to be realized. While we consider historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event that we determine that we would be able to realize deferred tax assets in the future in excess of the net amount recorded, an adjustment to the deferred tax asset would increase income in the period such determination has been made. Likewise, should we determine that we would not be able to realize all or part of the net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged against income in the period such determination was made.
Fair Value of Equity Instruments
The valuation of certain items, including valuation of warrants or stock options that may be offered as compensation for goods or services, involve significant estimations with underlying assumptions judgmentally determined. Warrants are valued using the most reliable measure of fair value, such as the value of the goods or services rendered, if obtainable, if such value is not readily obtainable, the valuation of warrants and stock options are then based upon the Black-Scholes valuation model, which involves estimates of stock volatility, expected life of the instruments and other assumptions.
RESULTS OF OPERATIONS
Nine Months Ended March 31, 2007 ( the "2007 Period") Compared to Nine Months ended March 31, 2006 (the "2006 Period") and Three Months Ended March 31, 2007 Compared to Three Months Ended March 31, 2006.
REVENUES. We had net revenues of $4,473,518 for the 2007 Period as compared to net revenues of $5,043,622 for the 2006 Period, representing a decrease of approximately 11%. Net revenues for the three months ended March 31, 2007 were $702,574 as compared to $984,057 for the corresponding three months in 2006. The decrease in net revenues during the 2007 Period as compared to the 2006 Period is primarily attributable to the Company's commitment to achieve an increase in commercial industrial contracts which are expected to yield higher gross margins than the government contracts entered into during the 2006 Period. The decrease in net revenues during the three months ended March 31, 2007 as compared to the corresponding three-month period in 2006 is primarily attributable to the Company meeting its objectives in delivering manufactured product at higher gross margins rather than higher sales at lower gross margins.
GROSS MARGINS. Gross margins for the 2007 Period were 25% of revenue as compared to 23% of revenue for the 2006 Period and 37% of revenue for the three months ended March 31, 2007 as compared to 25% for the corresponding three-month period in 2006. The increase in gross margins for each of the 2007 Periods and the three months ended March 31, 2007 as compared to the corresponding periods in 2006 is primarily attributable to an increase in commercial industrial project sales and an increase in the order mix of our manufactured products having higher gross margins during each of the periods in 2007. In the corresponding periods in 2006 we performed a greater percentage of lower gross profit generating activities such as government task orders and outside purchased equipment.
RESEARCH AND DEVELOPMENT. Research and development expenses consist primarily of expenses incurred in designing and developing upgrades to existing products and systems as well as new product development work on the Sentinal water technologies. Research and development expenses for the 2007 Period and for the three months ended March 31, 2007 were $113,422 and 27,834, respectively, as compared to $159,100 and $49,998 for the corresponding periods in 2006. The decrease in research and development expenses during each of the periods in 2007 compared to the corresponding periods in 2006 is primarily attributable to the completion or termination of certain research and development programs.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses for the 2007 Period and for the three months ended March 31, 2007 were $1,181,634 and $343,639, respectively, as compared to $1,803,302 and $666,603 for each of the corresponding periods in 2006. The decrease in selling, general and administrative expense during the 2007 periods is attributable to a reduction in general and administrative as a result of cost reduction initiative that were put into place during the 2006 Period with respect to the operations of our wholly-owned subsidiary, Clarion Systems, Inc. and our operations in the Middle East.
STOCK BASED COMPENSATION. In the 2007 Period, we issued stock options to our directors and various employees valued at $215,000. The value of these options is being amortized over their two year vesting period. In the 2006 Period, we issued immediately vested stock to various consultants and to the directors that were valued at $150,337 at the time of issuance. Stock-based compensation is non-cash and, therefore, has no impact on cash flow or liquidity.
INTEREST EXPENSE. Interest expense in the 2007 Period was $241,909 as compared to $104,061 incurred during the 2006 Period. The increase in the 2007 Period is attributable to the higher average amount of outstanding debt balances. Included in interest expense in the 2007 Period is $104,106 of amortization of deferred finance costs relating the offering costs and the value of the warrant issued in the private placement in January 2006 of the convertible debentures.
AMORTIZATION OF BENEFICIAL CONVERSION FEATURE. In accordance with EITF No. 00-27, we recorded an additional discount in the amount of $118,748 upon the issuance in January 2006 of our convertible debentures to reflect the beneficial conversion feature of the debt and the amortizing this amount to the date of maturity. In the 2007 period the Company recorded amortization of $29,660 .
MINORITY INTEREST IN SUBSIDIARY LOSS. The minority interest in the loss attributable to the foreign subsidiary was $4,464 for the 2007 Period as compared to the $28,784 for the 2006 Period. This decrease was due to the reduction in overhead and general operating expenses.
NET LOSS. Net loss before deemed dividends related to preferred stock for the 2007 and 2006 Periods is $(437,819) and $(1,040,736), respectively. The net loss before deemed dividends, for the three months ended March 31, 2007 was $(208,449) and a net loss before deemed dividends of $(608,360) for the corresponding period in 2006.
DIVIDENDS RELATED TO PREFERRED STOCK.
In July 2005, we declared and paid dividends equal to $153,042 on our Series A Convertible Preferred Stock for the years ended March 31, 2004 and 2005. The dividend was paid by the issuance of 99,378 shares of our Common Stock.
We also recorded dividends totaling $74,173 on our Series B Convertible Preferred Stock in the 2007 Period and $257,997 in the 2006 Period. In lieu of a cash payment we have elected under the terms of the agreement which sold these securities to add this amount to the stated value of the Series B Convertible Preferred Stock.
These dividends are non-cash and, therefore, have no impact on our net worth, cash flow or liquidity.
Liquidity and Capital Resources
At March 31, 2007, we had working capital of approximately $2.35million compared to approximately $2.36million at June 30, 2006. Net cash provided by operating activities for the 2007 period was $488,411 as compared to net cash used by operating activities of $(557,836) for the 2006 period.
Inventory has decreased by $156,092 during the nine months ended March 31, 2007 but has still remained relatively high in anticipation of shipments for committed projects.
Accounts receivables have decreased although days sales outstanding (DSO) were 130 days at March 31, 2007 as compared to 97 days at June 30, 2006. This is due to certain payments and retainage on the Tinker Air Force Base work being held until final completion of projects , which is expected to occur in the first quarter of fiscal year 2008.
Accounts payable and accrued expenses have decreased by $449,178 to approximately $1.4 million for the nine months ended March 31, 2007 as payments to vendors have been increased to match the corresponding increase in collection of accounts receivables.
Investing activities for the 2007 period included the purchase of equipment and software required to upgrade two major product lines at a cost of $100,463 . We do not have any material commitments for capital expenditures going forward.
Financing activities include the following:
In January 2006, we raised net proceeds of $831,000 from the proceeds of the private placement of $1million in principal amount of our Senior Secured Convertible Debentures ("the Debentures"). Our obligations with respect to the Debentures are secured by a lien on all of our assets, including our intellectual property. The Debentures have a term of three years and are convertible at the option of the holder at any time into shares of the Company's Common Stock at a conversion price of $.75 per share, subject to certain adjustments. Interest is payable at a rate equal to the greater of 8% per annum or the prime rate for the applicable interest period plus 2.5%.
In April 2006 we entered into a factoring, agreement with a financing company. All borrowings are secured by outstanding receivables specifically assigned to the financing company. Assigned receivables are at the sole discretion of the financing company and advances are made on 95% of approved receivables assigned. Payments on assigned receivables are received directly by the financing company, and applied to outstanding advances. All outstanding advances and uncollected assigned receivables are subject to fees and interest charges ranging from 0.05 percent to 7.2 percent, with a minimum annual fee of 0.8 percent. All receivables assigned and advances made are subject to return and recall by the financing company, respectively. The agreement may be terminated by giving the financing company 30 days notice. As of March 31, 2007, there were no outstanding advances under the program.
Remaining long-term bank debt in the aggregate amount of $29,410 at March 31, 2007 is payable in monthly installments of $2,750 plus interest at the rate of prime plus 1/2% per annum. This outstanding debt is attributable to the Asset Purchase of Clarion Sensing Systems.
Officers' loans have increased in the 2007 period by $161,313 to $777,736. In April 2007, $150,000 in officers' loans were converted in to 200,000 shares of common stock.
We did not realize any proceeds from the exercise of outstanding stock options and warrants in the 2007 Period and $54,400 in the 2006 Period.
We expect that cash on hand together with anticipated collection of accounts receivable will be sufficient to provide for our working capital needs for the next 12 months.
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