Mikros Systems Corporation

Notes to Condensed Financial Statements

(unaudited)

Note 4 – Income (Loss) Per Share (continued)

Diluted net loss per share for the three and nine months ended September 30, 2013 and 2012 do not reflect following potential common shares, as the effect would be antidilutive.

Note 5 – Income Tax Matters

The Company conducts an on-going analysis to review the deferred tax assets and the related valuation allowance that it has recorded against deferred tax assets, primarily associated with Federal net operating loss carryforwards.  As a result of this analysis and the actual results of operations, the Company has adjustedincreased its net deferred tax assets by $116,214$30,600 and $(5,000)$81,000 during the sixnine months ended JuneSeptember 30, 2013 and 2012, respectively.  The change in deferred tax assets is attributable to the change in the valuation allowance based on the Company’s forecasts of future results from operations.   

Note 6 – Share Based Compensation

During the three and sixnine months ended JuneSeptember 30, 2013, the Company issued 35,000 stock option awards and 4,000 80,000option awards were forfeited. There were no options granted or forfeited during 2012. In accordance with the recognition provisions of the FASB’s Accounting Standards Codification 718, Share-Based Payments, the Company recorded the fair value of the options issued at $0.02$0.03 per share. The fair value of the options was determined using the Black-Scholes option pricing model with the following assumptions: no dividend yield, risk-free interest rate of 0.75%, volatility of 66.25%, and an expected term of 6.5 years. The Company recognized stock-based compensation expense for stock options of $2,361$2,140 and $7,837 for the three months ended JuneSeptember 30, 2013 and 2012, respectively. The Company recognized stock-based compensation expense for stock options of $4,906$6,603 and $15,674$27,458 for the sixnine months ended JuneSeptember 30, 2013 and 2012, respectively. As of JuneSeptember 30, 2013 and 2012, there were 721,000 and 690,000, respectively, of645,000 options outstanding.

As of JuneSeptember 30, 2013 and 2012, there were 174,000103,000 and 245,000 restricted stock awards outstanding, respectively.  During the three and sixnine months ended JuneSeptember 30, 2013, 12,00027,000 restricted stock awards were forfeited. The Company recognized stock-based compensation expense for restricted stock of $1,328$1,206 and $1,2691,328 for the three months ended JuneSeptember 30, 2013 and 2012, respectively. The Company recognized stock-based compensation expense for restricted stock of $2,656$3,616 and $2,619$3,946 for the sixnine months ended JuneSeptember 30, 2013 and 2012, respectively.  

As of JuneSeptember 30, 2013, there was $22,400$14,746 of unrecognized stock-based compensation expense related to all outstanding equity awards that will be recognized in future periods.

Mikros Systems Corporation

Notes to Condensed Financial Statements

(unaudited)

Note 7 – Related Party Transactions

Ocean Power Technologies, Inc. (“OPT”("OPT") operates as a subcontractor to the Company. Thomas Meaney, the Company’s president and chief financial officer and member of the Company’s board of directors, also served as a director of OPT through October 2012. There were no subcontractor expenses incurred with OPT forDuring the three months ended JuneSeptember 30, 2013 and 2012. During2012, the sixCompany incurred subcontracting service costs from OPT of $0 and $12,731, respectively. For the nine months ended JuneSeptember 30, 2013 and 2012, the Company incurred subcontractor expenses from OPT of $31,025 and $18,857, respectively with OPT.$31,588, respectively.

Paul Casner, the chairman of the Company’s board of directors, also serves as the executive chairman and CEO of Precision Flight Systems, LLC (“Precision”), formerly known as Atair Aerospace Incorporation. In 2012, Precision provided subcontracting services to the Company relating to the design of the chassis component within the ADEPT units. During the three and six months ended JuneSeptember 30, 2013 and 2012, the Company incurred subcontracting service costs from Precision of $49,465$0 and $91,703, respectively. For the nine months ended September 30, 2013 and 2012, the Company incurred subcontractor expenses from Precision of $70,670 and $91,703, respectively. There were no subcontracting services provided by Precision during the comparable period in 2012.

Note 8 – Commitments and Contingencies

During the quarter ended June 30, 2013, the Company renewed its line of credit agreement with Sun National bankBank and increased its borrowing capacity to $500,000. The facility matures on June 30, 2014 and accrues interest at a variable rate equal to the bank’s prime rate plus 250 basis points with a minimum interest rate of 4.500% per annum.  At JuneSeptember 30, 2013, the interest rate was 5.250%. Principal borrowings may be prepaid at any time without penalty, and the facility is secured by substantially all of the Company’s assets. Borrowings under the facility are limited to a percentage of aggregate outstanding receivables that are due within 90 days.  The facility contains customary affirmative and negative nonfinancial covenants and a net worth financial covenant.  As of September 30, 2013 and December 31 2012, there were no amounts outstanding under the facility. There were no borrowings under the facility during the nine months ended September 30, 2013 and 2012. The Company was in compliance with its covenants under the line of credit facility at JuneSeptember 30, 2013. As of June 30, 2013 and December 31 2012, there were no amounts outstanding under the facility.

Note 9 – Subsequent Events

In August 2013, the Company was awarded a new delivery order under our IDIQ agreement for $5.5 million. The work under this delivery order will be incrementally funded. This order includes tasking for ADEPT improvements and technical support. The initial funding for this new delivery order was $793,170.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains “forward-looking statements” – that is, statements related to future, not past, events. In this context, forward-looking statements often address our expected future business and financial performance and financial condition, and often contain words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “see,” or “will.” These forward-looking statements are not guarantees and are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements.  For us, particular uncertainties that could cause our actual results to be materially different than those expressed in our forward-looking statements include: changes in business conditions; a decline or redirection of the U.S. Defense budget; the termination of any contracts with the U.S. Government; the continued “sequestration” under the Budget Control Act of 2011; any potential adverse effects associated with the recent federal government shutdown or any future government shutdowns; changes in our sales strategy and product development plans; changes in the marketplace; continued services of our executive management team; our limited marketing experience; security breaches; competition between us and other companies seeking Small Business Innovative Research (“SBIR”) grants; competitive pricing pressures; ability to obtain financing if needed; market acceptance of our products under development; delays in the development of products; and statements of assumption underlying any of the foregoing, as well as other factors set forth under the caption “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission.

All subsequent written and oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by the foregoing.  Except as required by law, we assume no duty to update or revise our forward-looking statements based on changes in internal estimates or expectations or otherwise.

Item 2.   Management’s Discussion and Analysis of Financial PositionCondition and Results of Operations

Mikros Systems Corporation (“Mikros,” the “Company,” “we” or “us”) is an advanced technology company specializing in the research and development of electronic systems technology primarily for military applications.  Classified by the Department of Defense (“DoD”) as a small business, our capabilities include technology management, electronic systems engineering and integration, radar systems engineering, combat/command, control, communications, computers and intelligence (“C4I”) systems engineering, and communications engineering.

Overview

Our primary business focus is to pursue Small Business Innovative Research (“SBIR”) programs from the DoD, Department of Homeland Security, and other governmental authorities, and to expand this government funded research and development into products and services.  Since 2002, we have been awarded several Phase I, II, and III SBIR contracts.

Revenues from our government contracts represented 100% of our revenues for the three and sixnine months ended JuneSeptember 30, 2013 and 2012.  We believe that we can utilize the intellectual property developed under our various SBIR awards to develop proprietary products for both the government and commercial marketplace.

ADEPT®ADEPT®

Originally designated as the Multiple Function Distributed Test and Analysis Tool, the ADEPT began as an SBIR investigation in 2002. Additional ADEPT development was completed through a series of SBIR grants and contracts. ADEPT is an automated maintenance workstation designed to significantly reduce the man-hours required to align the AN/SPY-1 Radar System aboard U.S. Navy AEGIS cruisers and destroyers, while optimizing system performance and readiness.  ADEPT represents a new approach to Navy shipboard maintenance, integrating modular instrumentation cards in a rugged enclosure with an onboard computer, input and output devices, networking hardware, removable hard drives, and a touch screen display.  A custom software application provides the user interface and integrates the hardware with a database that stores user information, instrument readings, maintenance requirements, and training aids.  ADEPT is designed to be adapted to other complex shipboard systems, and to provide integrated distance support capabilities for remote diagnostics and troubleshooting by shore-based Navy experts.

Key benefits of ADEPT include:

The goal for ADEPT has been to obtain a multi-year Indefinite-Delivery, Indefinite-Quantity (“IDIQ”) contract for production, engineering, and logistics support.  On March 19, 2010, we were awarded and entered into an IDIQ contract with the Naval Surface Warfare Center.  The contract is for a term of five years and provides for the purchase and sale of up to $26 million of ADEPT units and related support.   

From 2010 through 2012,Over the past several years, we received orders to design, produce, deliver, and further enhance the ADEPT. An initial delivery order for 27 ADEPT units valued at $2.3 million was awarded on March 22, 2010. In September 2010, we were awarded a new production order from the U.S. Navy to build additional ADEPT equipment for deployment on U.S. AEGIS Cruiserscruisers and Destroyers,destroyers, as well as the Navy’s new Littoral Combat Ship.littoral combat ship.  Under this order, we delivered an additional 18 ADEPT units and upgraded to the Low-Rate Initial Production Units manufactured under previous contracts. Some of the funding associated with this award allowed our engineers to enhance the distance support capabilities of ADEPT and incorporate new design features to enable ADEPT to be used on other U.S. Navy systems.  In July 2011, we received $3.1 million in orders to produce and deliver an additional 36 ADEPT units and related support services, and in September 2011 we received a $2.1 million delivery order from the U.S. Navy for additional research, development, and support of ADEPT units. In April, June, and July 2012, we received commitments of $385,000, $852,000 and $88,000, respectively, under the IDIQ to provide additional engineering and logistics support. Finally, inIn August and September 2012, we received new task orders to produce and deliver 35 ADEPT units. In January and April 2013, we were awarded an additional $185,000 and $187,238, respectively, under the IDIQ contract to provide additional engineering and logistics support related to ADEPT. In June 2013, we were awarded $667,000 in new task orders under the ADEPT contract to produce and deliver six ADEPT units and related support services.

In June 2013, we were awarded a $2,803,845 service contract with Condition-Based Maintenance For Littoral Combat Ship (“LCS”) Systems Using the ADEPT Distance Support Sensor Suite. This project will extend the development of the ADEPT to better facilitate the integration of multiple distributed sensors and Portable Data Collection Units; provide enhanced automated data collection and processing capabilities; and, support hosting of prognostics modeling tools that use the collected date to predict remaining end of life for Equipment Under Test components. Specific objectives of this project will be realized using a phased approach and will contain specific milestones.

Wireless Local Area Network Systems

Since June 2004, we have been working with the Office of Naval Research regarding emerging Wireless Local Area Network systems (“WLANs”) and DoD radar systems to, among other things, evaluate and quantify the potential improvements which may be afforded by selected mitigation techniques.  We continue to perform contracts in connection with this project and have worked closely with engineers from the Naval Air Warfare Center, Weapons Division.  Specifically, in April 2010, we were awarded a $250,000 subcontract with a major defense prime contractor to perform design of shipboard wireless networks for a new U.S. Navy communications program.  

Recent Developments

In JuneAugust 2013, we were awarded a $2,803,845$5,492,143 service contract with Condition-Based Maintenance (“CBM”) for Littoral Combat Ship Systems using the ADEPT Distance Support Sensor Suite. This project will extend the development of the ADEPT to better facilitate the integration of multiple distributed sensors and portable data collection units; provide enhanced automated data collection and processing capabilities; and support hosting of prognostics modeling tools that use the collected data to predict remaining end of life for equipment under test components. Specific objectives of this project will be realized using a phased approach and will contain specific milestones.

In June 2013, we were also awarded $667,000 in new task orders under the ADEPTour IDIQ contract to produceprovide necessary research, development, and deliver 6program management and implementation of improvements to ADEPT units and related support services.

In May 2013, we were awarded a $24,000units. We received an initial commitment of $842,612 under this service contract by the Naval Surface Warfare Centerthat was increased to produce and deliver 25 hard drive assemblies.

In January and April 2013, we were awarded an additional $185,000 and $187,238, respectively, under the IDIQ to provide additional engineering and logistics support related to ADEPT.$896,612 in September 2013.

Key Performance Indicator

As substantially all of our revenue is derived from contracts with the federal government, our key performance indicator is the dollar volume of contracts awarded to us.  Increases in the number and value of contracts awarded will generally result in increased revenues in future periods and, assuming relatively stable variable costs associated with our fulfilling such contracts, increased profits in future periods.  The timing of such awards is uncertain as we sell to federal government agencies where the process of obtaining such awards can be lengthy and at times uncertain.  As the majority of our revenue during the first and second quarters of 2013, and expected revenue over the next six months, is or will be from sales of ADEPT units under our IDIQ contract, continued generation of task orders and our ability to expand the market and potential customer base for ADEPT units will be a key indicator of future revenue.

Outlook

Our strategy for continued growth is three-fold.  First, we expect to continue expanding our technology base, backlog and revenue by continuing our active participation in the DoD SBIR program and bidding on projects that fall within our areas of expertise.  These areas include electronic systems engineering and integration, radar systems engineering, combat/C4I systems engineering, and communications engineering.  We believe that we can utilize the intellectual property developed under our various SBIR awards to develop proprietary products, such as the ADEPT, with broad appeal in both the government and commercial marketplace.  This state-of-the-art test equipment can be used by many commercial and governmental customers such as the FAA, radio and television stations, cellular service providers, and airlines.  Second, we will continue to pursue SBIR projects with the Department of Homeland Security, the U.S. Navy, and other government agencies.  Third, we believe that through our marketing of products such as ADEPT we will develop key relationships with prime defense system contractors.  Our strategy is to develop these relationships into longer-term, key subcontractor roles on future major defense programs awarded to these prime contractors.

For the remainder of 2013, our primary strategic focus is to continue to: (i) establish ourselves as a premium provider of research and development and product development services to the defense industry; and (ii) grow our business, generate profits and increase our cash reserves through obtaining additional SBIR contracts and positioning ourselves to obtain future SBIR contracts.  From an operational perspective, we expect to focus substantial resources on generating purchase orders under the IDIQ contract for ADEPT units and exploring commercialization opportunities.  We intend to capitalize on the Navy modernization program, which could result in two or three ADEPT units being placed on each destroyer and cruiser in the U.S. Navy, with the potential to install multiple units on additional U.S. Navy ships and submarines.

Over the longer term, we expect to further develop technology based on existing and additional SBIR contracts and to develop these technologies into products for wide deployment to DoD customers and contractors, as well as developing potential commercial applications.  

Changes to Critical Accounting Policies and Estimates

Our critical accounting policies and estimates are set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012.   As of JuneSeptember 30, 2013, there have been no changes to such critical accounting policies and estimates.  

Results of Operations

The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and the requirements of the SEC.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate our estimates, including those related to bad debts, recoverability of long-lived assets, income taxes and commitments.  We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.conditions and those differences may be material.  The accounting estimates and assumptions discussed in the notes to our condensed financial statements included herein are those that we consider to be the most critical to an understanding of our financial statements because they inherently involve significant judgments and uncertainties.

Three Months Ended JuneSeptember 30, 2013 and 2012

We generated revenues of $367,558$904,908 during the three months ended JuneSeptember 30, 2013 compared to $479,369$1,124,211 during the three months ended JuneSeptember 30, 2012, a decrease of $111,811,$219,303, or 23%20%.  The decrease was primarily due to the delay in receiving orders for additional ADEPT units in 2013 as well asmix of costs associated with the change in our revenue mix.IDIQ contracts. Revenues earned are based upon the labor, subcontracting services, materials, and other direct costs that we incur. Generally labor and other direct costs generate higher revenues whilethen subcontracting services and material costs are less.costs. During the three months ended JuneSeptember 30, 2013, revenues derived from subcontracting services and materialslabor hours outpaced revenues derived from labor hourssubcontracting and materials completed. During the three months ended JuneSeptember 30, 2012, revenues derived from labor hourssubcontracting and materials completed outpaced subcontracting services and materials,labor hours, resulting in higher revenues earned in 2012.2012 as compared to the three months ended September 30, 2013.   

Cost of sales consists of direct contract costs including labor, material, subcontracts, and warranty expense for ADEPT units that have been delivered, travel, and other direct costs. Cost of sales for the three months ended JuneSeptember 30, 2013 was $215,442$433,316 compared to $204,852$662,812 for the three months ended JuneSeptember 30, 2012, an increasea decrease of $10,590,$229,496, or 5%35%. The increasedecrease was primarily attributable to the change in the mix of costs incurred and an increase in our warranty reserve.revenue described above. Our cost of sales during the three months ended JuneSeptember 30, 2013 waswere comprised of moreless subcontracting services and material purchases and lessmore direct labor hours. Labor costs were significantly higherlower during the comparable period in 2012. Our warranty reservecosts increased by $24,500 during the three months ended JuneSeptember 30, 2013 whilecompared to the same period in 2012 due to the increase in the number of units under the ADEPT limited warranty coverage. Our warranty reserve remained unchangedfairly constant during the three months ended September 30, 2013 and decreased during the comparable period in 2012. The change is due to the timing of units shipped during 2013.

The majority of our engineering costs consist of (i) salary, wages and related fringe benefits paid to engineering employees, (ii) rent-related costs, and (iii) consulting fees paid to engineering consultants.  As the nature of these costs benefit the entire organization and all research and development efforts, and their benefits cannot be identified with a specific project or contract, these engineering costs are classified as part of “engineering overhead” and included in operating expenses.  Engineering costs for the three months ended JuneSeptember 30, 2013 were $203,109$214,461 compared to $146,455$174,203 for the three months ended JuneSeptember 30, 2012, an increase of $56,654,$40,258, or 39%23%.  The increase was primarily due to the increase in engineering salaries and an increase in the allocation of engineering overhead due to the delay in receiving new task orders.

General and administrative expenses consist primarily of salary, intellectual property, consulting fees and related costs, professional fees, business insurance, franchise tax, SEC compliance costs, travel, and unallowable expenses (representing those expenses for which the government will not reimburse us).  General and administrative costs for the three months ended JuneSeptember 30, 2013 were $285,006$236,030 compared to $273,701$251,712 for the three months ended JuneSeptember 30, 2012, an increasea decrease of $11,305,$15,682, or 4%6%.   The increasedecrease was primarily due to an increase in research and development related expenses and director fees, offset by a reduction in administrative salaries and professional fees.modest fluctuations of various expenses.   

At JuneSeptember 30, 2013, we estimate our annual effective tax rate for 2013 to be 33.4%approximately 0%.  We recognized aare recognizing tax benefitexpense of $154,814$130,729 for the quarter ended JuneSeptember 30, 2013 primarily due to state income taxes and the expected change in the valuation allowance established for net deferred tax assets.  The tax benefitexpense for the quarter includes a discrete benefitprovision of $47,600$17,000 related to the expected future use of federal net operating losses. The expected change in our valuation allowance during 2013 is based on ADEPT and ADSS contracts awarded to us during the three months ended Junethrough September 30, 2013, and the determination by management that the future realization of a portion of the net deferred tax assets was judged to be more-likely-than-not.At JuneSeptember 30, 2013, the difference from the expected federal income tax rate is attributable to state income taxes, certain permanent book-tax differences and the income tax impact of the change in the valuation allowance established for net deferred tax assets. 

We incurredhad a net loss of $181,185$109,628 during the three months ended JuneSeptember 30, 2013 as compared to $119,745net income of $118,484 during the three months ended JuneSeptember 30, 2012.  The increasedecrease in net lossincome was primarily due to the change in the mix of costs and services we provided in 2013 compared to 2012 that limited the amount of revenue we were eligible to recognize. The increase in net loss was also due to the timing in which we completed delivery order contracts for ADEPT units. Lastly, the increase in net loss was attributable to the increase in our warranty expense and the decrease in the income tax benefit whenexpense incurred in 2013 compared to recoveries and benefits, respectively, during the comparable periodbenefit received in 2012.

SixNine Months Ended JuneSeptember 30, 2013 and 2012

We generated revenues of $1,269,754$2,174,662 during the sixnine months ended JuneSeptember 30, 2013 compared to $1,238,492$2,362,703 during the sixnine months ended JuneSeptember 30, 2012, an increasea decrease of $31,262,$188,041, or 3%8%.  The increasedecrease was primarily due to decreases in the timingnumber of the productiondeliverable units in 2013 and delivery of ADEPT units offset by thean unfavorable change in the revenue mix between 2013 and 2012. We experienced a delay in new delivery orders for ADEPT units during the six months ended June 30, 2012.of revenues earned. Revenues for subcontracting and materials outpaced direct labor hours and costs during the sixnine months ended JuneSeptember 30, 2013 compared to a higher mix of labor hours and direct costs during the comparable period in 2012.   

Cost of sales for the sixnine months ended JuneSeptember 30, 2013 was $677,393$1,110,709 compared to $465,082$1,119,994 for the sixnine months ended JuneSeptember 30, 2012, an increasea decrease of $212,311,$9,285, or 46%less than 1%.  The increase was primarily attributable to the change in the mix of costs incurred and an increase in our warranty reserve.revenue described above. Our cost of sales during the sixnine months ended JuneSeptember 30, 2013 waswere comprised of more subcontracting services and less material purchases and less direct labor hours. Labor costs were significantly higher during the comparable period in 2012. Our warranty reserve increased during the sixnine months ended JuneSeptember 30, 2013 while the reserve decreased during the comparable period in 2012. The change is a direct result in the timing of units shipped during 2013 while the expiration of warranty coverage and reversal of accrued warranties outpaced the warranty provision for shipped units for the comparable period in 2012.

Engineering costs for the sixnine months ended JuneSeptember 30, 2013 were $405,007$619,468 compared to $306,753$480,956 for the sixnine months ended JuneSeptember 30, 2012, an increase of $98,254,$138,512, or 32%29%.  The increase was primarily due to the increase in engineering salaries, travel and an increase in the allocation of engineering overhead due to the delay in receiving new task orders.

General and administrative expenses consist primarily of salary, intellectual property, consulting fees and related costs, professional fees, business insurance, franchise tax, SEC compliance costs, travel, and unallowable expenses (representing those expenses for which the government will not reimburse us).  General and administrative costs for the sixnine months ended JuneSeptember 30, 2013 were $548,396$784,426 compared to $594,488$854,100 for the sixnine months ended JuneSeptember 30, 2012, a decrease of $46,092,$69,674, or 8%.  The decrease was primarily due to a reduction in administrativebid and proposal costs, salaries, and professional fees that were offset by an increase in research and development related expenses.consulting costs.

We recognizedare recognizing a tax benefit of $160,214$29,485 for the sixnine months ended JuneSeptember 30, 2013 primarily due to state income taxes and the expected change in the valuation allowance established for net deferred tax assets. The tax benefit for the quarterthis period includes a discrete benefit of $47,600$30,600 related to the expected future use of federal net operating losses. The expected change in our valuation allowance during 2013 was based on the ADEPT and ADSS contracts awarded to us during sixthe nine months ended JuneSeptember 30, 2013, and the determination by management that the future realization of a portion of the net deferred tax assets was judged to be more-likely-than-not.At JuneSeptember 30, 2013, the difference from the expected federal income tax rate is attributable to state income taxes, certain permanent book-tax differences and the income tax impact of the change in the valuation allowance established for net deferred tax assets.

We incurred a net loss of $200,811$310,440 during the sixnine months ended JuneSeptember 30, 2013 as compared to $105,733net income of $12,751 during the sixnine months ended JuneSeptember 30, 2012.  The increase in net lossdecrease is primarily attributable to the change in the mix of costs and services we provided in 2013 compared to 2012 that limited the amount of revenue we were eligible to recognize. The decrease was also due to the timing in which we completed delivery order contracts for ADEPT units, the related warranty expense for ADEPT units. Lastly, the decrease was also attributable to the increases in our warranty expense and decreases in our income tax benefits when compared to recoveries and benefits, respectively, during the comparable perioddeliverable units in 2012.2013.

Liquidity and Capital Resources

Since our inception, we have financed our operations through debt, private and public offerings of equity securities, and cash generated by operations.

During the sixnine months ended JuneSeptember 30, 2013, net cash provided byused in operations was $166,823$45,795 compared to $35,155$90,576 during the sixnine months ended JuneSeptember 30, 2012. The increasedecrease was due primarily to timing of payments related to our operating assets and liabilities. We had a decrease in accounts receivable as a result of receiving payments and decreases in accounts payable and accrued expenses, including accrued payroll and payroll taxes due to the timing of our vendor payments and payroll processing.  We had working capital of $1,070,083$1,046,390 as of JuneSeptember 30, 2013 as compared to $1,379,678 as of December 31, 2012.  

During the sixnine months ended JuneSeptember 30, 2013, net cash used in investing activities was $1,500$4,741 compared to $1,102 during the sixnine months ended JuneSeptember 30, 2012.  The increase was due to capital expenditures.

In June 2013, we renewed our line ofWe have a $500,000 credit agreement.facility with Sun National Bank.  The facility matures on June 30, 2014 and accrues interest at a variable rate equal to the bank’s prime rate plus 250 basis points with a minimum annual interest rate of 4.500%. We increased the facility’s borrowing capacity to $500,000. Principal borrowings may be prepaid at any time without penalty, and the facility is secured by substantially all of our assets. Borrowings under the facility are limited to a percentage of aggregate outstanding receivables that are due within 90 days.  The facility contains customary affirmative and negative nonfinancial covenants and a net worth financial covenant.  As of the date of this report, there are no amounts outstanding under the facility. The Company was in compliance with its covenants under the line of credit facility at September 30, 2013.

As of JuneSeptember 30, 2013, we had cash resources of approximately $1,052,463.$836,604. We believe that our available cash resources, availability under line of credit and expected cash flows from operations will be sufficient to fund operations for the next twelve months.  We do not expect to incur any material capital expenditures during the next twelve months.

In order to pursue strategic opportunities, obtain additional SBIR contracts, or acquire strategic assets or businesses, we may need to obtain additional financing or seek strategic alliances or other partnership agreements with other entities.  In order to raise any such financing, we anticipate considering the sale of additional debt or equity securities under appropriate market conditions.  There can be no assurance, assuming we successfully raise additional funds or enter into business alliances, that any such transaction will achieve profitability or generate positive cash flow.

Off-Balance Sheet Arrangements

As of JuneSeptember 30, 2013, we did not have any relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or variable interest entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.  As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. We have not made any guarantees for outside parties and have not entered into any derivative instruments.

Item 4.  Controls and Procedures.

An evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934) was carried out by us under the supervision and with the participation of our president, who serves as our principal executive officer and principal financial officer.  Based upon that evaluation, our president concluded that as of JuneSeptember 30, 2013, our disclosure controls and procedures were effective to ensure (i) that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (ii) that such information is accumulated and communicated to management, including our president, in order to allow timely decisions regarding required disclosure.

There were no changes in our internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) or 15d-15(f)) that occurred during the fiscal quarter ended JuneSeptember 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II.  OTHER INFORMATION

Item 1A. Risk Factors

The following is an update to our risk factors described in our 2012 Annual Report on Form 10-K and should be read in conjunction with the risk factors therein.

Significant delays or reductions in appropriations for our programs and U.S. Government funding more broadly may negatively impact our business and programs and could have a material adverse effect on our financial position, results of operations or cash flows.

The impact, severity and duration of the current U.S. economic situation and plans adopted by theU.S. Government, along with pressures on, and uncertainty surrounding, the federal budget and the permissible federal debt limit, could adversely affect the funding for individual programs and delay purchasing or payment decisions by the U.S. government. In the event that government funding for our programs becomes unavailable, or is reduced or delayed, our contract or subcontract under such programs may be terminated or adjusted by the U.S. Government or the prime contractor, which could have a material adverse effect on our financial position, results of operations and/or cash flows.

Part I of the Budget Control Act of 2011 (Budget Control Act) provided for a reduction in planned defense budgets of at least $487 billion over a ten year period, and the fiscal year (FY) 2013 impacts were incorporated in the government's FY 2013 budget. Part II mandated substantial additional reductions through a process known as "sequestration," which took effect March 1, 2013, and resulted in approximately $40 billion of additional reductions to the FY 2013 defense budget.

FY 2014 began on October 1, 2013 without appropriations legislation or a continuing resolution for FY 2014 and many parts of the U.S. Government temporarily shut down. Although Congress has not yet passed FY 2014 appropriations, on October 16, 2013, Congress passed a continuing resolution, which funds the government through January 15, 2014 and suspended the statutory limit on the amount of permissible federal debt (the debt ceiling) through February 7, 2014. It is unclear when or if annual appropriations bills will be enacted for FY 2014.

Congressional appropriation and authorization of FY 2014 spending, including defense spending, and the application of sequestration remain marked by significant debate and an uncertain schedule. Congress and the Administration also continue to debate the debt ceiling, among other fiscal issues, as they negotiate plans for long-term national fiscal policy. The outcome of these debates could have a significant impact on future defense spending broadly and our programs, in particular.

Unless Congress passes appropriations legislation or provides for a continuing resolution throughout FY 2014, or if the existing debt ceiling is not raised, we may be required to continue to perform for some period of time on certain of our U.S. Government contracts even if the U.S. Government is unable to make timely payments. If a prolonged government shutdown occurs, it could result in program cancellations and stop work orders and could limit our ability to perform on our U.S. Government contracts. A debt ceiling breach could, among other impacts, negatively affect the U.S. Government's timely payment of our billings. Either a prolonged shutdown or a breach of the debt ceiling could have significant near and long-term consequences for us, our employees, our suppliers and the defense industry. Either could result in delayed cash collections and/or have a material adverse effect on our financial position, results of operations and/or cash flows.

Item 6.   Exhibits

* XBRL information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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