Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read in conjunction with the Financial Statements and Notes contained herein and with those in our Form 10-KSB for the year ended December 31, 2006.

 

Except for the historical information contained herein, the matters discussed in this Quarterly Report on Form 10-QSB include certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. Those statements include, but may not be limited to, all statements regarding our intent, belief, and expectations, such as statements concerning our future profitability and operating and growth strategy. Words such as “believe,” “anticipate,” “expect,” “will,” “may,” “should,” “intend,” “plan,” “estimate,” “predict,” “potential,” “continue,” “likely” and similar expressions are intended to identify forward-looking statements. Investors are cautioned that all forward-looking statements contained in this Quarterly Report on Form 10-QSB and in other statements we make involve risks and uncertainties including, without limitation, the factors set forth under the caption “Risk Factors” included in our Annual Report on Form 10-KSB for the year ended December 31, 2006, and other factors detailed from time to time in our other filings with the Securities and Exchange Commission. One or more of these factors have affected, and in the future could affect our business and financial condition and could cause actual results to differ materially from plans and projections. Although we believe the assumptions underlying the forward-looking statements contained herein are reasonable, there can be no assurance that any of the forward-looking statements included in this Quarterly Report on Form 10-QSB will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved.

 

Any forward-looking statement speaks only as of the date on which such statement is made, and we undertake no obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which such statements are made or reflect the occurrence of unanticipated events, unless necessary to prevent such statements from becoming misleading. New factors emerge from time to time and it is not possible for us to predict all factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

 

Overview

 

SCI Engineered Materials, Inc. (“SCI” or the “Company”), formerly Superconductive Components, Inc., an Ohio corporation, was incorporated in 1987, to develop, manufacture and market products based on or incorporating high temperature superconductive (“HTS”) materials. Currently, we manufacture ceramic and metal targets for a variety of industrial applications including: Photonics/Optical, Thin Film Battery, Semiconductor and, to a lesser extent HTS. Photonics/Optical currently represents the largest market for our targets. Thin Film Battery is a developing market where manufacturers of batteries use our targets to produce very small power supplies with small quantities of stored energy. Semiconductor is also a developing market. We hired additional marketing staff during the fourth quarter of 2006 to develop opportunities in these markets. During the second and the third quarter of 2007, we added additional staff to our Technology group for the development of innovative products.

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations (continued).

Executive Summary

For the three months ended September 30, 2007, we had revenues of $2,589,938. This was an increase of $525,441, or 25.5%, over the three months ended September 30, 2006. For the nine months ended September 30, 2007, we had revenues of $8,447,689. This was an increase of $4,024,135, or 91.0%, over the nine months ended September 30, 2006. The revenues for the first nine months of 2007 exceeded the total revenues of $8,045,792 for calendar year 2006.

For the three months ended September 30, 2007, we had net income applicable to common shares of $30,011 compared to $110,236 for the same period in 2006. For the nine months ended September 30, 2007, we had net income applicable to common shares of $186,706 compared to $8,463 for the same period in 2006.

Near the end of the first quarter 2007, the price of a high value raw material used by us to produce certain products reached a cyclical peak and then declined to approximately one-half of that amount by the end of the second quarter 2007. The price of the raw material had recovered to approximately 65% of the cyclical peak. Cost changes for this high value raw material are fully reflected in the final selling price which insulates us from market price fluctuations associated with the raw material. We anticipate that the cost of this high value raw material will continue to be lower for the second half of 2007 compared to the first half of this year. This will continue to have an adverse effect on our total revenues, and, to a lesser extent, gross profit during the second half of 2007 because this high value raw material has a substantially lower gross profit margin compared to our other products.

We received notification during the second quarter of 2007 from the Department of Energy of a Notice of Financial Assistance Award in the amount of $97,900. This award provides support for Phase I of a Small Business Innovative Research (SBIR) award entitled “Flux Pinning Additions to Increase Jc Performance in BSCCO-2212 Round Wire for Very High Field Magnets.” The work on the contract began during the third quarter of 2007.

RESULTS OF OPERATIONS

Nine months ended September 30, 2007 (unaudited) compared to nine months ended September 30, 2006 (unaudited):

Revenues    

Revenues for the nine months ended September 30, 2007 were $8,447,689 compared to $4,423,554, for the same period last year, an increase of $4,024,135 or 91.0%. The revenue growth can be attributed primarily to the growth in Photonics/Optical products combined with the ongoing purchase of raw materials whose prices have historically experienced periods of significant fluctuation, as well as Thin Film Battery products. We anticipate the cost of a high value raw material will be lower in the second half of 2007 compared to the first half of 2007 which will result in a reduction in revenues compared to the first half of 2007.

Gross Profit

Gross profit for the nine months ended September 30, 2007 was $1,461,381, which represents a gross margin of 17.3% of total revenue compared to $1,022,520 and 23.1% of total revenue for the nine months ended September 30, 2006. The increase in the gross profit dollars is due primarily to the growth in Photonics/Optical products. Thin Film Battery products have also contributed to this increase.

 

 

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations (continued).

The decrease in the gross margin as a percentage of total revenue is due to product mix of higher value product with lower gross margins.

As mentioned earlier, we anticipate the cost of a raw material in the second half of 2007 will continue to be less than during the first half of 2007. We expect this to result in a reduction in revenues, and, to a lesser extent, gross profit during the second half of 2007 as compared to the first half of 2007 because this high value raw material has a substantially lower gross profit margin compared to our other products.   

Selling Expense

Selling expense for the nine months ended September 30, 2007 increased 57.8% to $331,703 from $210,162 for the same period in 2006. The increase was due to the addition of marketing staff and increased travel. The increased travel was partly due to our attendance at two conferences in September 2007 supporting solar and semiconductor marketing activities.

General and Administrative Expense

General and administrative expense for the nine months ended September 30, 2007 increased to $669,423 from $667,013 for the nine months ended September 30, 2006, or 0.4%. The slight increase was due to non-cash stock based compensation expense of $36,089. During the first nine months of 2006 non-cash stock based compensation expense was $2,700. This increase was offset by a reduction in professional fees.

Research and Development Expense

Research and development expense for the first nine months of 2007 was $253,980 compared to $144,974 for the same period in 2006, an increase of 75.2%. The increase was due to increased staff and continued development efforts associated with applications in Photonic, Solar, Thin Film Battery and Semiconductor markets.

Interest Income and Expense

Interest income was $48,721 and $32,501 for the nine months ended September 30, 2007 and 2006, respectively. The additional interest income was due to increased cash from operations.

Interest expense was $56,433 and $10,367 for the nine months ended September 30, 2007 and 2006, respectively. The increase was due to additional capital lease obligations incurred for the purchase of production equipment for increased production capacity.

 

INCOME APPLICABLE TO COMMON SHARES

In come applicable to common shares was $ 186 , 706   compared to $8,463 for the nine months ended September 30, 200 7 and 200 6 , respectively. Basic net income per common share before dividends on preferred stock was $ 0 .0 6 and $0. 01 for the nine months ended September 30, 200 7 and 200 6 , respectively. Basic n et income per common share based on income applicable to common shares for 200 7   and 2006 was $0.0 5 and $0. 00 , respectively. The income applicable to common shares includes net income from operations and the accretion of Series B preferred stock dividends.

 

 

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations (continued).

Dividends on the Series B preferred stock accrue at 10% annually on the outstanding shares. Accrued dividends   on the Series B preferred stock was $ 18,837 and $18,888 for the nine months ended September 30, 2007 and 2006, respectively.

 

Basic earn ings for the nine months ended September 30, 200 7 were $0.0 5 per common share based on 3,4 57 , 005 average shares outstanding compared to $0. 00 per common share based on 3 , 425,937 weighted average shares outstanding for the nine months ended September 30, 2006.

 

Diluted earnings per common share for the nine months ended September 30, 200 7 were $0.0 4   based on   4 , 224 , 899 average shares outstanding compared to $0. 00 per share based on 3 , 946,035 weighted average shares outstanding for the nine months ended September 30, 200 6 .

The following schedule represents our outstanding common shares during the period of 200 7 through 2016 assuming all outstanding stock options and stock warrants are exercised during the year of expiration. If each shareholder exercises his or her options or warrants, it could increase our common shares by 1,2 09,328 to 4, 683 , 666 by December 31, 2016. Exercise prices for options and warrants range from $1.00 to $4.00 at September 30, 2007. Assuming all such options and warrants are exercised in the year of expiration, the effect on shares outstanding is illustrated as follows:

	Options and Warrants due to expire	Potential Shares Outstanding
2007	-	3,474,338
2008	68,021	3,542,359
2009	160,418	3,702,777
2010	443,389	4,146,166
2011	70,000	4,216,166
2012	170,000	4,386,166
2013	30,500	4,416,666
2014	90,000	4,506,666
2015	140,000	4,646,666
2016	37,000	4,683,666

     

LIQUIDITY AND WORKING CAPITAL

At September 30, 2007, working capital was $1,475,136 compared to $1,347,462 at September 30, 2006. The increase is due to an increase in cash and inventory. This increase has been offset by increases in capital lease obligations and accounts payable. We provided cash from operations of approximately $1,165,000 and $466,000 for the nine months ended September 30, 2007 and 2006, respectively. Significant non-cash items including depreciation, accretion and amortization, stock based compensation expense, inventory reserve on excess and obsolete inventory, and provision for doubtful accounts were approximately $270,000 and $166,000, respectively, for the nine months ended September 30, 2007 and 2006. Accounts receivable, inventory, prepaid expenses and other assets increased approximately $108,000 for the nine months ended September 30, 2007. This increase was due to an increase in inventory which was partially offset by the return of a large deposit for equipment that was subsequently leased. Accounts receivable, inventory, prepaid expenses and other assets increased approximately $254,000 for the nine months ended September 30, 2006. Accounts payable, accrued expenses and customer deposits increased approximately $589,000 for the nine months ended September 30, 2007 and approximately $527,000 for the same period in 2006.

 

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations (continued).

Cash of approximately $193,000 and $164,000 was used for investing activities for the nine months ended September 30, 2007, and 2006, respectively. The amounts invested were used to purchase machinery and equipment for increased production capacity and new product lines. Proceeds on sale of equipment were approximately $19,000 during the first nine months of 2007.

 

Cash of approximately $103,000 was used for financing activities during the nine months ended September 30, 2007. Cash payments to third parties for capital lease obligations approximated $107,000. Cash payments for services provided for the registration of common stock were approximately $32,000. Proceeds received from the exercise of common stock warrants were approximately $27,000. Proceeds received from the exercise of common stock options were $9,625. We incurred new capital lease obligations of approximately $1,067,000 for new production equipment during the first nine months of 2007.

Cash of approximately $95,000 was used for financing activities during the nine months ended September 30, 2006. Cash payments to third parties for capital lease obligations approximated $46,000. Cash payments for services provided for the registration of common stock were approximately $50,000. Proceeds received from the exercise of common stock options were $1,200. The Company incurred new leases of approximately $134,000 for new production equipment and a forklift during the first nine months of 2006.

 

While certain of our major shareholders have advanced funds in the form of secured debt, subordinated debt, accounts payable and guaranteeing bank debt in the past, there is no commitment by these individuals to continue funding us or guaranteeing bank debt in the future. We will continue to seek new financing or equity financing arrangements. However, we cannot be certain that it will be successful in efforts to raise additional funds.

 

RISK FACTORS

We desire to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The following factors, as well as the factors listed under the caption “Risk Factors” in our Form 10-KSB filed with the Securities and Exchange Commission on March 7, 2007, have affected or could affect our actual results and could cause such results to differ materially from those expressed in any forward-looking statements made by us. Investors should consider carefully these risks and speculative factors inherent in and affecting our business and an investment in our common stock.

Historically we have experienced significant operating losses and may continue to do so in the future.  

We reported net income applicable to common shares of $186,706 for the nine months ended September 30, 2007. Our accumulated deficit since inception in 1987 was $7,653,544 (unaudited) at September 30, 2007.

Historically, we have financed the losses primarily from additional investments and loans by our major shareholders and two private offerings of common stock and warrants to purchase common stock. We cannot assure you, however, that we will be able to raise additional capital in the future to fund our operations.

 

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations (continued).

Off Balance Sheet Arrangements

We have no off balance sheet arrangements including special purpose entities.

Critical Accounting Policies

 

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Financial Statements and accompanying notes . Note 2 to the Financial Statements in our Annual Report on Form 10-KSB for the year ended December 31, 2006 describes the significant accounting policies and methods used in the preparation of the Financial Statements. Estimates are used for, but not limited to, accounting for the allowance for doubtful accounts, inventory allowances, property and equipment depreciable lives, patents and licenses useful lives, and assessing changes in which impairment of certain long- lived assets may occur. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Financial Statements. The allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts and the aging of the accounts receivable. If there is a deterioration of a major customer’s credit worthiness or actual defaults are higher than our historical experience, our estimates of the recoverability of amounts due us could be adversely affected. Inventory purchases and commitments are based upon future demand forecasts.

If there is a sudden and significant decrease in demand for our products or   there is a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, we may be required to increase our inventory allowances and our gross margin could be adversely affected. Depreciable and useful lives estimated for property and equipment, licenses and patents are based on initial expectations of the period of time these assets and intangibles will benefit us. Changes in circumstances related to a change in our business, change in technology or other factors could result in these assets becoming impaired, which could adversely affect the value of these assets.