ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following management’s discussion and analysis focuses on those factors that had a material effect on the Company’s financial results of operations during the third quarter of 2019 and first nine months of 2019, as well as the same periods of 2018. It should be read in connection with the Company’s condensed unaudited financial statements and notes thereto included in this Form 10-Q.
Critical Accounting Estimates
The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. Therefore, the Company is required to make certain estimates, judgments and assumptions that the Company believes are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The accounting estimates, which IKONICS believes are the most critical to aid in fully understanding and evaluating its reported financial results, include the following:
Trade Receivables. The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history and the customer’s current credit worthiness, as determined by review of the current credit information. The Company continuously monitors collections and payments from its customers and maintains a provision for estimated credit losses based upon historical experience and any specific customer collection issues that have been identified. While such credit losses have historically been within expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same collection history that has occurred in the past. The general payment terms are net 30-45 days for domestic customers and net 30-90 days for foreign customers. A small percentage of the trade receivables balance is denominated in a foreign currency with no concentration in any given country. At the end of each reporting period, the Company analyzes the receivable balance for customers paying in a foreign currency. These balances are adjusted to each quarter or year-end spot rate in accordance with FASB ASC 830, Foreign Currency Matters. The Company also maintains a provision for any customer related returns based upon historical experience of actual returns and any specifically identified product issues, refunds or credits.
Inventories. Inventories are valued at the lower of cost or net realizable value using the last in, first out (LIFO) method. The Company monitors its inventory for obsolescence and records reductions from cost when required.
Income Taxes. Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Deferred tax assets and liabilities are presented as long-term on a net basis. The Company follows the accounting standard on accounting for uncertainty in income taxes, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under this guidance, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement. The guidance on accounting for uncertainty in income taxes also addresses derecognition, classification, interest and penalties on income taxes, and accounting in interim periods.
Revenue recognition. Revenue is measured based on consideration specified in the contract with a customer, adjusted for any applicable estimates of variable consideration and other factors affecting the transaction price, including noncash consideration, consideration paid or payable to customers and significant financing components. While most of the Company’s revenue is contracted with customers through one-time purchase orders and short-term contracts, the Company does have long-term arrangements with certain customers. Revenue from all customers is recognized when a performance obligation is satisfied by transferring control of a distinct good or service to a customer.
Individually promised goods and services in a contract are considered a distinct performance obligation and accounted for separately if the customer can benefit from the individual good or service on its own or with other resources that are readily available to the customer and the good or service is separately identifiable from other promises in the arrangement. When an arrangement includes multiple performance obligations, the consideration is allocated between the performance obligations in proportion to their estimated standalone selling price. Costs related to products delivered are recognized in the period incurred, unless criteria for capitalization of costs are met. Costs of revenues consist primarily of direct labor, manufacturing overhead, materials and components. The Company does not incur significant upfront costs to obtain a contract. If costs to obtain a contract were to become material, the costs would be recorded as an asset and amortized to expense in a manner consistent with the related recognition of revenue.
The Company excludes governmental assessed and imposed taxes on revenue transactions that are invoiced to customers from revenue. The Company includes freight billed to customers in revenue. Shipping and handling costs associated with outbound freight after control over a product has transferred to a customer are accounted for as a fulfillment cost and are included in cost of goods sold.
The timing of revenue recognition, billings and cash collections results in accounts receivable on the balance sheet.
Performance obligations. A performance obligation is a promise in a contract to transfer a distinct good or service to the customer. A contract’s transaction price is allocated to each distinct performance obligation in proportion to its standalone selling price and recognized as revenue when, or as, the performance obligation is satisfied. The Company’s various performance obligations and the timing or method of revenue recognition are discussed below:
The Company sells its products to both distributors and end-users. Each unit of product delivered under a customer order represents a distinct and separate performance obligation as the customer can benefit from each unit on its own or with other resources that are readily available to the customer and each unit of product is separately identifiable from other products in the arrangement.
The transaction price for the Company’s products is the invoiced amount. The Company does not have variable consideration in the form of refunds, credits, rebates, price concessions, pricing incentives or other items impacting transaction price. The purchase order pricing in arrangements with customers is deemed to approximate standalone selling price; therefore, the Company does not need to allocate proceeds on a relative standalone selling price allocation between performance obligations. The Company applies the practical expedient in FASB ASC 606-10-50-14 and does not disclose information about remaining performance obligations that have original expected durations of one year or less. There are no material obligations that extend beyond one year.
Revenue is recognized when transfer of control occurs as defined by the terms in the customer agreement. The Company immediately recognizes incidental items that are immaterial in the context of the contract. The Company has also applied the practical expedient in FASB ASC 606-10-32-18 regarding the adjustment of the promised amount of consideration for the effects of a significant financing component when the customer pays for that good or service within one year or less, as the Company does not have any significant financing components in its customer arrangements as payment is received at or shortly after the point of sale, generally thirty to ninety days.
The Company estimates returns based on an analysis of historical experience if the right to return products is granted to its customers. The Company does not record a return asset as non-conforming products are generally not returned. The Company’s return policy does not vary by geography. The customer has no rotation or price protection rights. The Company is not under a warranty obligation except as described below.
Trade receivables. Trade receivables include amounts invoiced and currently due from customers. The amounts due are stated at their net estimated realizable value. The Company records an allowance for doubtful accounts to provide for the estimated amount of receivables that will not be collected. The allowance is based on a review of all outstanding amounts on an on-going basis. Management determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considers a customer’s financial condition, credit history, and current economic conditions. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received. Accounts are considered past due if payment is not received according to agreed-upon terms.
Sales commissions. Sales commissions paid to sales representatives are eligible for capitalization as they are incremental costs that would not have been incurred without entering into a specific sales arrangement and are recoverable through the expected margin on the transaction. The Company has elected to apply the practical expedient provided by FASB ASC 340-40-25-4 and recognize the incremental costs of obtaining contracts as an expense when incurred, as the amortization period of the assets that would have otherwise been recognized is one year or less. The Company records these costs in selling, general, and administrative expense.
Product warranty. The Company offers warranties on various products and services. These warranties are assurance type warranties that are not sold on a standalone basis; therefore, they are not considered distinct performance obligations. The Company estimates the costs that may be incurred under its warranties and records a liability in the amount of such costs at the time the revenue is recognized for the product sale.
International revenue. The Company markets its products to numerous countries in North America, Europe, Latin America, Asia and other parts of the world. Foreign sales were approximately 29% of total sales during the first nine months of 2019 and 2018.
Results of Operations
Quarter Ended September 30, 2019 Compared to Quarter Ended September 30, 2018
Sales. The Company’s 2019 third quarter sales of $4.5 million were $121,000, or 2.6%, lower than the 2018 third quarter sales of $4.7 million. Chromaline third quarter 2019 sales of $2.9 million decreased by 5.9% from third quarter 2018 sales of $3.0 million. Most of the Chromaline sales decrease is related to lower domestic sales in addition to lower sales in China as tariffs continue to be a drag on the Chinese markets. DTX 2019 third quarter sales decreased by $74,000, or 46.7%, compared to the same period last year. DTX third quarter 2018 sales benefitted from an $86,000 film order which occurs approximately every other year. AMS sales for the third quarter of 2019 where down $9,000, or 2.0%, versus the same period in 2018. Partially offsetting these sales decreases, IKONICS Imaging 2019 third quarter sales of $1.1 million where $141,000, or 14.5%, higher than the 2018 third quarter sales. IKONICS Imaging sales during the current year third quarter were favorably impacted by increased film and equipment sales and sales from the Company's recently introduce IKONART™ product.
Gross Profit. Gross profit was $1.4 million, or 31.2% of sales, in the third quarter of 2019 compared to $1.5 million, or 32.8% of sales, for the same period in 2018. The Chromaline gross margin decrease from 30.7% in the third quarter of 2018 to 26.3% for the third quarter of 2019 was due to lower sales volumes and a less favorable sales mix as an increase in lower margin sales into Asia were offset by a decrease in higher margin domestic sales. An increase in certain raw material pricing along with Chinese tariffs has also unfavorably impacted the gross margin for Chromaline products. The DTX gross margin for the third quarter of 2019 was also lower at 63.1% compared to 80.9% for the same period in 2018 due to a decrease in higher margin film sales. Despite lower sales volumes, the AMS gross margin improved to 25.2% in the third quarter of 2019, up from 10.2% in the third quarter of 2018 as a result of lower costs in 2019. Increased sales volume improved the IKONICS Imaging gross margin from 42.6% in the third quarter of 2018 to 43.8% in the third quarter of 2019.
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $1.3 million, or 29.7% of sales, in the third quarter of 2019 compared to $1.4 million, or 29.4% of sales, for the same period in 2018. Selling, general and administrative expenses for the third quarter of 2019 decreased primarily due to lower medical insurance and promotional expenses.
Research and Development Expenses. Research and development expenses during the third quarter of 2019 were $218,000, or 4.8% of sales, versus $180,000, or 3.9%, of sales for the same period in 2018. The 2019 third quarter increase is related to additional research and development staffing expenses. Additionally, legal and patent expenses in the third quarter of 2019 increased due to the write off of patent application costs of $16,000 that were previously recorded as an asset, as the Company determined that it would no longer continue to pursue those patent applications.
Interest Expense. Interest expense for the third quarter of 2019 and 2018 was $23,000.
Income Taxes. For the third quarter of 2019, the Company realized income tax expense of $2,000, or an effective tax rate of 1.5%, compared to a benefit of $7,000, or an effective tax rate of 21.4% for the three months ended September 30, 2018. The primary driver of the change in the Company's effective tax rate is a valuation allowance recorded against deferred tax assets generated during the third quarter of 2019. The income tax provision for 2018 differs from the expected tax benefit due to unfavorable non-deductible items and generation of research and development tax credits.
Nine Months Ended September 30, 2019 Compared to Nine Months Ended September 30, 2018
Sales. The Company’s 2019 September year-to-date sales of $12.7 million were 5.3% lower than the same period sales in 2018 of $13.4 million. Chromaline sales for the first nine months of 2019 decreased by $483,000, or 5.7%, compared to the first nine months of 2018. Chromaline 2019 September year-to-date sales were adversely affected by cold weather shipping constraints in the first quarter since its emulsion products are not freeze-thaw stable. Additionally, Chromaline domestic sales continue to lag behind last year and sales into China have been negatively impacted by tariffs. AMS sales for the first nine months of 2019 decreased from $1.4 million during the same period in 2018 to $1.2 million, a 12.2% decrease, resulting from lower sales to its two largest customers. DTX sales for the first nine months of 2019 decreased by $52,000, or 15.2%, compared to the same period last year. DTX sales in 2018 benefitted from an $86,000 film order which occurs approximately every other year. IKONICS Imaging sales of $3.2 million for first nine months of 2019 were flat with 2018 September year-to-date sales.
Gross Profit. Gross profit was $3.8 million, or 30.4% of sales, in the first nine month of 2019 compared to $4.6 million, or 34.1% of sales, for the same period in 2018. The Chromaline 2019 September year-to-date gross margin decreased to 25.7% from 31.5% in the first nine months of 2018 due to lower sales volumes and a less favorable sales mix as an increase in lower margin sales into Asia were offset by a decrease in higher margin domestic sales. Chinese tariffs have also unfavorably impacted Chromaline's 2019 gross margins. An increase in certain raw material pricing has also unfavorably impacted the gross margin for some Chromaline emulsion products. The DTX gross margin for the first nine months of 2019 was also lower at 59.7% compared to 73.9% for the same period in 2018 due to a decrease in higher margin film sales. Despite lower sales volumes, cost reductions resulted in the AMS gross margin increasing from 11.4% during the first nine months of 2018 to 14.3% for the same period in 2019 while the IKONICS Imaging gross margin for the first nine months of the year was similar in 2019 and 2018.
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $4.1 million, or 32.1% of sales, in the first nine months of 2019 compared to $4.0 million, or 30.1% of sales, for the same period in 2018. Selling, general and administrative expenses for the first nine months of 2019 increased primarily due to higher consulting and health insurance expenses.
Research and Development Expenses. Research and development expenses during the first nine months of 2019 were $668,000, or 5.3% of sales, versus $490,000, or 3.7%, of sales for the same period in 2018. The increase for the first nine months of 2019 is related to additional research and development staffing expenses. Additionally, legal and patent expenses in the first nine months of 2019 increased due to the write off of $87,000 in patent application costs that were previously recorded as an asset as the Company determined that it would no longer continue to pursue those patent applications.
Interest Expense. Interest expense for the first nine months of 2019 was $68,000 compared to interest expense of $67,000 during the first nine months of 2018.
Income Taxes. For the first nine months of 2019, the Company realized an income tax benefit of $171,000, or an effective rate of 18.9%, compared to expense of $12,000, or an effective tax of 552.3% for the nine months ended September 30, 2018. The primary driver of the change in the effective tax rate is a valuation allowance recorded against net deferred tax assets generated during the first nine months of 2019. The income tax provision for 2018 differs from the expected tax benefit due to unfavorable non-deductible items and generation of research and development tax credits.
Liquidity and Capital Resources
Outside of the building expansion, for which $3.4 million in financing was obtained during 2016, the Company has financed its operations principally with funds generated from operations. These funds have been sufficient to cover the Company’s normal operating expenditures, annual capital requirements, and research and development expenditures. The Company was not in compliance with its loan covenants as of September 30, 2019, but obtained a waiver for the covenant violation. There is no certainty that a waiver can be obtained if the Company is non-compliant with the covenant in the future. In the future if the Company is non-compliant its covenants, and is unable to obtain appropriate waivers, it could have a significant adverse effect on the Company's liquidity. The Company believes that any adverse effect of such a possible outcome is mitigated by it strong working capital including cash, cash equivalents, and short-term investments of $3.2 million along with the Company's $2.0 million available line of credit as of September 30, 2019.
Cash and cash equivalents were $759,000 and $1.6 million at September 30, 2019 and December 31, 2018, respectively. Operating activities used $620,000 in cash during the first nine months of 2019 compared to providing $1.1 million of cash during the same period in 2018. Cash provided by (used in) operating activities is primarily the result of net losses adjusted for non-cash depreciation, amortization, and certain changes in working capital components discussed in the following paragraph.
During the first nine months of 2019, trade receivables decreased $4,000. The Company believes that the quality of its receivables is high and that strong internal controls are in place to maintain proper collections. Inventories increased by $527,000 due to higher finished goods levels as the Company is ramping up inventory levels to meet demand for the remainder of 2019 in addition to lower than expected sales for the first nine months of 2019. Prepaid expenses and other assets increased by $577,000. The increase is due to a $694,000 receivable related to the reimbursement of medical insurance costs that the Company will receive from its stop-loss insurance carrier. Accrued expenses increased $674,000, reflecting an increase in the accrual for health insurance costs. Accounts payable increased by $125,000 due to the timing of vendor payments. Income taxes receivable decreased by $3,000.
During the first nine months of 2018, the timing of collections resulted in a $215,000 decrease in trade receivables. The Company believes that the quality of its receivables is high and that strong internal controls are in place to maintain proper collections. Inventories increased by $185,000 due to higher raw material and finished goods levels as the Company is increasing inventory levels to meet expected fourth quarter sales demand. Prepaid expenses and other assets increased by $42,000, reflecting prepayments on annual software license agreements. Accounts payable increased by $389,000 due to the timing of vendor payments for recent large raw materials purchases. Accrued expenses increased by $75,000, reflecting an increase in the accrual for health insurance costs while income taxes receivable increased by $8,000 due to the timing of estimated tax payments compared to the calculated 2018 tax liability.
During the first nine months of 2019, cash used in investing activities was $90,000. Eighteen certificates of deposits totaling $4.4 million matured during the first nine months of 2019. The Company purchased seventeen certificates of deposits totaling $4.2 million. The Company’s purchases of property and equipment of $334,000 were mainly for improvements to production and process capabilities and to replace two vehicles. The Company received $16,000 in proceeds from the sale of two vehicles and equipment. Also, during the first nine months of 2019, the Company incurred $18,000 in patent application costs that the Company records as an asset and amortizes upon successful completion of the application process.
During the first nine months of 2018, cash used in investing activities was $338,000. Eighteen certificates of deposits totaling $4.3 million matured during the first nine months of 2018. The Company purchased seventeen certificates of deposits totaling $4.1 million. The Company’s purchases of property and equipment of $501,000 were mainly for building upgrades and improvements to production and process capabilities. Also, during the first nine months of 2018, the Company incurred $36,000 in patent application costs that the Company records as an asset and amortizes upon successful completion of the application process.
Cash used in investing activities during the first nine months of 2019 and 2018 was $154,000 and $103,000, respectively. Related to the Company’s loan, the Company made principal payments of $105,000 during the first nine months of 2019 and $103,000 during the first nine months of 2018. During the first nine months of 2019, Company repurchased 7,199 shares of its own stock for $50,000.
A bank line of credit providing for borrowings of up to $2,050,000 expired on June 30, 2019. The line of credit was renewed and will expire on August 30, 2021. The line of credit is collateralized by the Company’s assets and bears interest at 1.8 percentage points over the 30-day LIBOR rate. The Company did not utilize this line of credit during the first nine months of 2019 or 2018, and there were no borrowings outstanding as of September 30, 2019 or December 31, 2018. There are no financial covenants related to the line of credit.
The Company believes that current financial resources, its line of credit, cash generated from operations and secured through debt financing, and short-term investments, along with the Company’s capacity for additional debt and/or equity financing will be sufficient to fund current and anticipated business operations. The Company also believes that it is unlikely that a decrease in demand for the Company’s products would impair the Company’s ability to fund operations given its excess cash and available line of credit which it expects to renew once the existing line of credit expires.
The Company was out of compliance with its loan covenants as of September 30, 2019, but obtained a waiver for the covenant violation. There is no certainty that a waiver can be obtained in the future if similar violations occur. If the Company has future violations of its covenants, and is unable to obtain appropriate waivers, it could have a significant adverse effect on the Company's liquidity. The Company feels that any adverse effect of such a possible outcome is mitigated by it strong working capital including cash, cash equivalents, and short-term investments of $3.2 million along with the Company's $2.0 million available line of credit as of September 30, 2019.
Capital Expenditures
Through the first nine months of 2019, the Company incurred $334,000 of capital expenditures mainly for improvements to production and process capabilities and to replace two vehicles.
The Company expects additional capital expenditures in 2019 of approximately $240,000 including improvements to the Company's coating capabilities, process improvements and information technology upgrades. Currently, the Company expects to fund its capital expenditures with existing cash and cash generated from operating activities.
International Activity
The Company markets its products to numerous countries in North America, Europe, Latin America, Asia and other parts of the world. Foreign sales were approximately 29% of total sales during the first nine months of 2019 and 2018. The fluctuations of certain foreign currencies have not significantly impacted the Company’s operations, as the Company’s foreign sales are not concentrated in any one region of the world, although a strong U.S. dollar does make the Company’s products less competitive internationally. The Company believes its vulnerability due to uncertainties in foreign currency fluctuations and general economic conditions in foreign countries is not significant.
The Company’s foreign transactions are primarily negotiated, invoiced and paid in U.S. dollars, while a portion is transacted in Euros. The Company has not implemented an economic hedging strategy to reduce the risk of foreign currency translation or transaction exposures, as management does not believe this to be a significant risk based on the scope and geographic diversity of the Company’s foreign operations as of September 30, 2019. Furthermore, the impact of foreign exchange on the Company’s balance sheet and operating results was not material in either 2019 or 2018.
Future Outlook
IKONICS has spent an average of approximately 5.0% of annual sales in research and development and has made capital expenditures related to new products and programs. The Company plans to maintain its efforts in these areas to expedite internal product development as well as to form technological alliances with outside entities to commercialize new product opportunities.
Despite lower sales for the first nine months of 2019, the Company continues to make progress on its AMS business. The Company has three long-term sales agreements in place for its technology with major aerospace companies.
The Company is also continuing to pursue DTX-related business initiatives. In addition to making efforts towards growing the inkjet technology business, the Company offers a range of products for creating texture surfaces and has introduced a fluid for use in prototyping. The Company is currently working on production improvements as part of its joint development agreement with AKK, a German manufacturer of high quality printers, to enhance its customer offerings. The Company has been awarded European, Japanese, and United States patents on its DTX technologies. The Company has also modified its DTX technology to facilitate entry into the market for prototyping.
Both the Chromaline and IKONICS Imaging units remain profitable in mature markets. Although these business units require aggressive strategies to grow market share, both are developing new products and business relationships that the Company believes will contribute to growth. In October 2017, the Company introduced SubTHAT!™, a patent-pending product for the dye-sublimation market. Early in 2019 the Company introduced its new IKONART™ product to positive reviews and is generating sales. IKONART™ provides a new way to make custom reusable stencils for the creative arts markets. In addition to its traditional emphasis on domestic markets, the Company will continue efforts to grow its business internationally by attempting to develop new markets and expanding market share where it has already established a presence. However, the strong U.S. dollar has made international growth challenging.
Other future activities undertaken to expand the Company’s business may include strategic partnerships, acquisitions, building improvements, equipment additions, new product development and marketing opportunities.
Recent Accounting Pronouncements
During February 2016, the FASB issued ASU No. 2016-02, Leases. ASU No. 2016-02 was issued to increase transparency and comparability among organizations by recognizing all lease transactions (with terms in excess of 12 months) on the balance sheet as a lease liability and a right-of-use asset (as defined). ASU No. 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with earlier application permitted. Upon adoption, the lessee will apply the new standard retrospectively to all periods presented or retrospectively using a cumulative effect adjustment in the year of adoption. The Company adopted ASU No. 2016-02 as of January 1, 2019. The adoption of this standard did not have a material impact on its financial statements.
Off Balance Sheet Arrangements
The Company has no off-balance sheet arrangements.