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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, 2013 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 2011, 2012 and 2013 we entered into teaming and marketing agreements with ITSI, SAIC, Fortis, Calnet,
Honeywell, Culmen, ERIS, and Boeing.
During fiscal 2012 and 2013,
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 $162,750,000. Of these, other bidders were awarded $16 million and we have been awarded,
as the prime contractor and as a subcontractor, contracts with an approximate value of $35 million over five years. We anticipate
decisions relating to the still-open proposals during fiscal 2014.
Recent Developments
Our revenues and results
from operations for the years ended June 30, 2013 and 2012, and the six and three month periods ended December 31, 2013, continued
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 2013
and 2012 and to date in fiscal 2014 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. Additionally, our cash flow and liquidity continue to be
severely impacted with 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, as described in Item 3 of our Annual Report on Form 10-K for the year ended June 30,
2013.
On June 28, 2013, one
of our wholly-owned subsidiaries amended its previous line of credit agreement with Atlantic Stewardship Bank (“ASB”).
Under the terms of the amended loan agreement, the principal balance outstanding on June 28, 2013 will be paid in monthly installments
of $5,000 including interest, beginning July 15, 2013 and continuing through May 15, 2015. The remaining outstanding balance is
due on June 15, 2015. Under the terms of the amended agreement, the variable interest rate increased to the prime rate plus 1%,
with a minimum of 5.875%. The prior line of credit agreement had carried an interest rate of the prime rate plus .25%, with a minimum
rate of 4.5%. The previous covenant requiring a minimum debt service coverage ratio was eliminated in the amended agreement.
The above term loan is
collateralized by the subsidiary’s accounts receivable, inventories, equipment and general intangibles. As part of the amended
agreement, our President and Chief Executive Officer provided a personal guaranty of the amounts due to ASB, up to a maximum of
$250,000. Three of our officers executed subordination agreements which subordinated a combined total of $848,080 of amounts due
to those officers to amounts due by the subsidiary to ASB. Because these subordinated amounts are not to be paid until ASB has
been repaid, the subordinated amounts have been classified as noncurrent liabilities.
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, 2013 COMPARED TO THE SIX AND THREE MONTH PERIODS ENDED DECEMBER 31, 2012
REVENUES. We had net revenues
for the six months ended December 31, 2013 of $233,007 compared to $854,178 in the corresponding period in 2012, representing a
decrease of approximately 73%. Revenues for the three months ended December 31, 2012 were $61,988 compared to $422,104, representing
a decrease of approximately 85%. The decreases in net revenues in the six and three month periods ended December 31, 2013 compared
to the corresponding periods in 2012 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 PROFIT (LOSS). We had
a gross loss for the six months ended December 31, 2013 of $(23,964) as compared to a gross profit of $479,537 for the
corresponding period in 2012, and we had a gross loss for the three months ended December 31, 2013 of $(37,366) as compared
to a gross profit of $247,653 for the three months ended December 31, 2012. The decrease in gross profit for the six and
three month periods of 2013 compared to the same periods in 2012 is primarily attributable to the decrease in revenues
discussed above.
RESEARCH AND DEVELOPMENT.
Research and development expenses were $33,605 and $17,442 for the six and three months ended December 31, 2013, respectively,
compared to $46,794 and $21,863 for the corresponding six months and three months, respectively, in 2012. 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 $427,563 for the six months ended December 31, 2013 compared to $489,060
for the corresponding six months in 2012. The decrease in selling, general and administrative expenses during the six month period
ended December 31, 2013 as compared to the corresponding period in 2012 is primarily attributable to due to reduced personnel costs.
LOSS FROM OPERATIONS. The loss from operations
for the six months ended December 31, 2013 was $(485,132) compared to a loss of $(56,317) for the corresponding six months of 2012.
The increase in the loss from operations during the 2013 period compared to the 2012 period was primarily attributable to the lower
revenues.
DIVIDENDS RELATED TO
CONVERTIBLE PREFERRED STOCK. We recorded dividends totaling $80,134 on our Series B Convertible Preferred Stock in the six months
ended December 31, 2013 and $72,597 in the corresponding six months in 2012. 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
The consolidated financial
statements have been prepared based on our continuing as a going concern, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. We incurred losses before dividends of $435,182 in the six months
ended December 31, 2013, and $1,221,153 and $1,531,773 in the years ended June 30, 2013 and 2012, respectively. Our cash flow and
liquidity have been severely impacted by the refusal of Lockheed Martin to pay us for the accounts receivable due from them totaling
nearly $1 million. Atlantic Stewardship Bank (the “Bank”) has converted the prior line of credit to a term loan, and
no further borrowings are available under the agreement. Through the periods ended December 31, 2013, June 30, 2013 and 2012, the
principal source of funds used to finance the Company’s operations has been advances from officers, shareholders and affiliates
and accrued costs due to those parties. There is no assurance that those parties will continue to provide the operating funds needed
to maintain operations. Through Fiscal 2012 and 2013, there were continuing delays in release of funding at the Department of Defense
and Department of Energy on projects where we serve as a prime contractor and as a subcontractor. 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. These factors were addressed in our Form 10-K for the year ended June 30, 2013.
We have working capital
of approximately $593,000 and stockholders’ equity of approximately $987,000 as of December 31, 2013. In June 2013, the Bank
converted the prior line of credit into a term loan, due in installments from July 2013 through June 2015. In connection with this
agreement, three of the Company’s officers agreed to subordination agreements with the Bank, under which a total of $848,040
of amounts due to those officers has been subordinated to amounts due to the Bank. The classification of the portion of the Bank
loan due after June 30, 2014 and the amounts subordinated by the officers resulted in increased the Company’s working capital
by $1,288,637. Officers, shareholders and affiliates provided funds in the form of cash advances and deferral of accrued costs
and expenses due to them during Fiscal 2013 of $524,412 and $308,418 during the six months ended December 31, 2013. . In January
2014, the Company received a letter from Amerisource Funding (“Amerisource”) in which Amerisource expressed interest
in re-establishing a working capital credit facility with the Company in accordance with the terms under which Amerisource had
provided the Company a $5 million line supported by accounts receivable.
In Fiscal 2013 we were
awarded, as the prime contractor or as a subcontractor, several contracts from units of the Department of Defense. These contracts
awarded provide that task orders under the contracts will require competitive bids to be submitted by us as those task orders are
issued. Through Fiscal 2012 and 2013 and to date in Fiscal 2014, we have sought to expand our business both domestically and internationally
by continuing to submit proposals in response to Request for Proposals (“RFP’s”).
Our ability to continue
operations is dependent upon our ability to generate sufficient cash flow either from operations, from continued funds from officers
and shareholders or from additional financing.
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, 2013. Nonetheless, we believe that cash on hand, together
with collection of anticipated accounts receivable during the short term, will be sufficient to maintain
operations 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. In January
2014, the Company received a letter from Amerisource Funding (“Amerisource”) in which Amerisource expressed
interest in re-establishing a working capital credit facility with the Company in accordance with the terms under which
Amerisource had provided the Company a $5 million line supported by accounts receivable. In addition to Americsource , we
have held discussions with various parties in order to raise additional funds through debt or equity issuance; to date
we have not entered into any agreements; however, no assurance can be provided that we will be able to enter into such
agreements on commercially reasonable terms..
Inventories increased by
$33,444 in the six months ended December 31, 2013, because we produced additional finished goods in anticipation of future orders
from our customers.
Accounts payable and accrued
expenses have increased by $185,769 to $1,328,160 for the six months ended December 31, 2013. Current liabilities to officers,
shareholders and affiliates increased by $308,418 to $750,189 in the six months ended December 31, 2013.
We do not have any major
material commitments for capital expenditures going forward.