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ITEM 2.
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.
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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, 2012 on Form 10-K.
CAUTION REGARDING FORWARD-LOOKING STATEMENTS
Our Company and its representatives may
from time to time make written or verbal forward-looking statements, including statements contained in this report and other Company
filings with the Securities and Exchange Commission and in our reports to shareholders. Statements that relate to other than strictly
historical facts, such as statements about our plans and strategies, expectations for future financial performance, new and existing
products and technologies, and markets for our products are forward-looking statements. Generally, the words "believe,"
"expect," "intend," "estimate," "anticipate," "will" and other similar expressions
identify forward-looking statements. The forward-looking statements are and will be based on our management's then-current views
and assumptions regarding future events and operating performance, and speak only as of their dates. Investors are cautioned that
such statements involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated
results due to many factors including, but not limited to, our current and future capital needs, uncertainty of capital funding,
our clients' ability to cancel contracts with little or no penalty, ongoing delays by federal agencies of approved projects; cash
flow impact arising from the dispute with prime contractors; government initiatives to implement Homeland Security measures, the state of the worldwide economy, competition,
customers’ ability to pay our invoices within our standard credit terms, and other risks detailed in our Company's most recent
Annual Report on Form 10-K and other Securities and Exchange Commission filings. We undertake no obligation to publicly update
or revise any forward-looking statements.
OVERVIEW
We design, develop, manufacture and market
stand-alone and fully integrated state-of-the-art entry control and perimeter intrusion detection systems for Department of Defense,
Department of Energy, nuclear power stations, and various international customers. We offer U.S. Air Force certified technology
and a comprehensive services portfolio that includes: site survey/risk assessment, design & engineering, systems manufacturing
and integration, factory acceptance testing, installation supervision, commissioning, operations and maintenance training.
We work closely with architects, engineers,
systems integrators, construction managers and owners in the development and design of security monitoring and control systems
that will afford a normative but secure environment for management, staff and visitors. To support such efforts, ECSI’s team
of key personnel are technically accomplished and fully familiar with advances in planning, programming and designing systems utilizing
standard peripheral components, mini/micro architecture, user friendly software/firmware selection and application.
Our mission is to establish ourselves as
a Small Business (SB) prime contractor to take advantage of the small business opportunities that exist today and in the foreseeable
future. To achieve that end we have formed a team of both small and large corporation agreements to support our company in the
pursuit of this market. We believe that our past performance and in depth experience as well as that of our teaming partners will
place us in a lead position to capture a good share of this market.
We entered into strategic partnerships,
teaming, and representative relationships with major multi-national corporations in each of the industries that comprise our target
markets. These companies generally enjoy a strong market presence in their respective industries and we believe that our teaming
agreements with these entities afford us added credibility. These entities frequently subcontract our services and purchase our
products in connection with larger projects and, in turn, support the company on projects we are pursuing as the prime contractor.
During fiscal 2012, we entered into teaming and marketing agreements with ITSI, SAIC, Fortis, Calnet, Honeywell, Culmen, ERIS,
and Boeing.
During fiscal 2012, we submitted proposals
on projects for Department of Defense facilities and certain nuclear power stations in the United States and Southeast Asia valued
at approximately $146,550,000. We anticipate decisions relating to these proposals during fiscal 2013.
Recent Developments
Our revenues and results from
operations for the year ended June 30, 2012, and the three and six month periods ended December 31, 2012, continue to be
negatively impacted by the ongoing delays by agencies of the U.S. Government in proceeding with approved projects,
funding projects already awarded, and in awarding new contracts. We have invested significant time and personnel resources in
fiscal 2012 and to date in fiscal 2013 in providing proposals on future projects, both as a prime contractor (Small Business)
and as a subcontractor. We are awaiting the results of the bidding process. No assurance can however, be provided that we
will be awarded any projects. Our cash flow and liquidity continue to be severely impacted by the refusal by Lockheed Martin
to pay us for the accounts receivable due from them totaling almost $1 million. These amounts are the subject of
litigation initiated by us in March 2012, as described in Item 3 of our Annual Report on Form 10-K for the year ended June
30, 2012.
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 that 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 has there
been 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.
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 the 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 currently have a reserve of $80,000
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 for 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 on the Black-Scholes valuation model, which involves estimates of stock volatility, expected life
of the instruments and other assumptions.
RESULTS OF OPERATIONS
COMPARISON OF THE SIX AND THREE MONTH
PERIODS ENDED DECEMBER 31, 2012 COMPARED TO THE SIX AND THREE MONTH PERIODS ENDED DECEMBER 31, 2011
REVENUES. We had net revenues for the six
months ended December 31, 2012 of $854,178 compared to $1,667,000 in the corresponding period in 2011, representing a decrease
of approximately 49%. Revenues for the three months ended December 31, 2012 were $422,104 compared to $552,569, representing a
decrease of approximately 24%. The decreases in net revenues in the six and three month periods ended December 31, 2012 compared
to the corresponding periods in 2011 are primarily attributable to a decrease in deliverable products and support services billings
resulting from continuing delays in release of funding at the Department of Defense and Department of Energy on projects where
we serve as a subcontractor as well as at other customers. The budget constraints and budget uncertainty at the U.S. government
agencies have significantly reduced the issuance of orders and delayed projects for all participants in our industry.
GROSS MARGINS. Gross margins for the six
months ended December 31, 2012 were 56% as compared to 47% for the corresponding period in 2011 and the gross margins were 59%
for the three months ended December 31, 2012 as compared to 16% for the three months ended December 31, 2011. The increase in gross
margins for the six and three month periods of 2012 compared to the same periods in 2011 is primarily attributable to a change
in the mix of equipment sales and support services billings and a reduction in personnel costs due to the lower revenues, partially
offset by the decrease in revenues discussed above.
RESEARCH AND DEVELOPMENT. Research and
development expenses were $46,794 and $21,863 for the six and three months ended December 31, 2012, respectively, compared
to $69,011 and $34,505 for the corresponding six months and three months, respectively, in 2011. The reduction in research and
development expenses was due to reductions in personnel costs.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES.
Selling, general and administrative expenses were $489,060 for the six months ended December 31, 2012 compared to $860,011 for
the corresponding six months in 2011. Selling, general and administrative expenses were $249,255 for the three months ended December
31, 2012 compared to $336,876 for the corresponding six months in 2011. The decrease in selling, general and administrative expenses
during the six month period ended December 31, 2012 as compared to the corresponding period in 2011 is primarily attributable to
an increase in 2011 in our allowance for doubtful accounts in the amount of $200,000. In the six and three month periods ended
December 31, 2012 as compared to the same periods in 2011, the other components of the selling, general and administrative expenses
decreased by 26% primarily due to reduced personnel costs.
STOCK
BASED COMPENSATION.
From time to time, we issue stock options to our directors and employees and consultants.
In
the quarter ended December 31, 2011, we recognized expense for stock based compensation of $96,815. Stock-based compensation is
non-cash and, therefore, has no impact on cash flow or liquidity. We issued no stock options in the six and three month periods
ended December 31, 2012.
LOSS FROM OPERATIONS. The
loss from operations for the three months ended December 31, 2012 of $(23,465) compared to a loss of $(377,822) for the
corresponding three months of 2011. The decrease in the loss from operations during the three months ended December 31, 2012
compared to the same period in 2011 was primarily attributable to the 2011 increase in the allowance for doubtful accounts of
$200,000, the 2011 stock based compensation of $96,815 and to reductions in personnel costs in 2012.
The loss from operations for the six months ended December 31, 2012 was $(56,317) compared to a loss of $(245,813) for the
corresponding six months of 2011. The decrease in the loss from operations during the six months ended December 31, 2012
period compared to the same period in 2011 was primarily attributable to the 2011 increase in the allowance for doubtful
accounts of $200,000, the 2011 stock based compensation of $96,815 and to reductions in personnel costs in 2012. In the six
months, these items were partially offset by the higher revenues in the six months of 2011.
DIVIDENDS RELATED TO CONVERTIBLE PREFERRED
STOCK. We recorded dividends totaling $72,597 on our Series B Convertible Preferred Stock in the six months ended December 31,
2012 and $80,635 in the corresponding six months in 2011. The reduction in these dividends is due to conversion in fiscal 2011
of a portion of the outstanding Series B Convertible Preferred Stock. In lieu of a cash payment, we have elected, under the terms
of 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
Our cash flow has been adversely impacted
by the refusal of Lockheed Martin to forward to us the proceeds of accounts receivable payable to us. This matter is currently
the subject matter of litigation initiated by us in March 2012 and discussed in Item 3 of our Annual Report on Form 10-K for the
year ended June 30, 2012. Nonetheless, we believe that cash on hand, together with anticipated collection of accounts receivable
during the short term, will be sufficient to provide for our working capital needs for the next 12 months. However, we may need
to raise funds in order to allow for shortfalls in anticipated revenue or to expand existing capacities and/or to satisfy any additional
significant purchase orders that we may receive. At the present time, we have no assurances of additional revenue beyond the firm
purchase orders we have received. We are in discussions with Atlantic Stewardship Bank regarding the existing line of credit, which
was fully utilized with a balance of $475,000 at December 31, 2012. These discussions include potentially extending the line of
credit or converting it to a term loan. The line of credit is due on February 15, 2013.
Our working capital was approximately $639,000
at December 31, 2012 as compared to $501,000 at June 30, 2012. The increase in working capital was primarily due to the conversion
by certain officers of $160,000 in interest bearing loans into common stock. Net cash used in operating activities for the six
months ended December 31, 2012 was $(105,097) as compared to $(36,141) used in operating activities for the corresponding six months
in 2011.
Accounts receivable increased by similar
amounts in the six months ended December 31, 2012 and in the six months ended December 31, 2011.
Accounts payable and accrued expenses have
increased by $36,191 to $1,068,390 for the six months ended December 31, 2012 as compared to an increase of $258,046 in the corresponding
six months in 2011.
In order to conserve our cash resources,
we did not purchase any property, plant and equipment during the six months ended December 31, 2012. We do not have any major material
commitments for capital expenditures going forward.
Subsequent Event – Contract Award
On January 17, 2013, we were advised that a contract was awarded
to ECSI’s team, of which ECSI is small business prime contractor, for support and technology services to the Department of
Defense (“DoD”). The cumulative contract ceiling of the award to include thirteen prime contractors and their respective
subcontractors is $249,000,000 over five years. The contract is an Indefinite Delivery Indefinite Quantity (“IDIQ”)
contract, and the work to be performed under it will be awarded to the thirteen teams on individual task orders on a competitive
basis. With its subcontractors, ECSI has a strong competitive team; however, there is no assurance that ECSI will be awarded work
under any task orders on the contract.
The contract is in response to initiatives promulgated by the
DoD and other Government agencies, require engineering development, design, procurement, fabrication of entry control and perimeter
detection technologies, installation, information assurance, logistics, maintenance, and life cycle support services for Infrastructure
Protection purposes. These systems will support the operational requirements of high value DoD and other Government agencies where
security is of high or vital interest.