UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

For the quarterly period ended SeptemberMarch 303, 20171,2019

or

For the transition period from _____to_____.

Commission File Number: 000-14801

Mikros Systems Corporation

(Exact name of registrant as specified in its charter)

707 Alexander Road, Building Two, Suite 208, Princeton, New Jersey 08540

(Address of Principal Executive Offices)

(609) 987-1513

(Registrant’sRegistrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

☒ Yes    ☐ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ☒ Yes    ☐ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐Yes ☒ No

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: There were 35,561,77535,568,775 issued and outstanding shares of the issuer’s common stock, $.01 par value per share, on NovemberMay 14, 2017.2019.

Securities registered pursuant to Section 12(b) of the Act:

TABLE OF CONTENTS

Note 1 – Basis of Presentation

The financial statements included herein have been prepared by Mikros Systems Corporation (the “Company” or “we”) pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. These condensed financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K10-K for the year ended December 31, 2016.2018.

In the opinion of the Company’s management, the accompanying unaudited interim condensed financial statements contain all adjustments, consisting solely of those which are of a normal recurring nature, necessary to present fairly its financial position as of September 30, 2017, March 31, 2019, the results of its operations for the three and nine months ended September 30, 2017 March 31, 2019 and 2016,2018, changes in stockholders’shareholders’ equity from January 1, 2017 2019 to September 30, 2017 March 31, 2019 and cash flows for the ninethree months ended September 30, 2017 March 31, 2019 and 2016.2018.

Note 2 – Recent Accounting Pronouncements

In May 2014, February 2016, the Financial Accounting Standards Board (“FASB”)FASB issued an Accounting Standards Update (“ASU”) for revenue recognition for contracts, superseding the previous revenue recognition requirements, along with most existing industry-specific guidance. The guidance requires an entity to review contracts in five steps: 1) identify the contract, 2) identify performance obligations, 3) determine the transaction price, 4) allocate the transaction price, and 5) recognize revenue.ASU 2016-02, Leases (Topic 842). The new standard will result in enhanced disclosures regardingsupersedes the nature, amount, timing,prior U.S. GAAP standard on leases and uncertainty of revenue arising from contracts with customers. In August 2015, requires substantially all leases to be reported on the FASB issued guidance approving a one-year deferral, making the standardbalance sheet as right-of-use assets and lease obligations. ASU 2016-02 is effective for annual reporting periods beginning after December 15, 2017, with early adoption permitted only for2018, and interim reporting periods beginning after December 15, 2016. In March 2016, within those annual reporting periods. Early adoption is permitted and in the original guidance the modified retrospective application was required, however, in July 2018 the FASB issued guidance to clarify the implementation guidance on principal versus agent considerations for reporting revenue gross rather than net,ASU 2018-11 which permits entities with the same deferred effective date. In April 2016, the FASB issued guidance to clarify the identification of performance obligations and licensing arrangements. In May 2016, the FASB issued guidance addressing the presentation of sales and other similar taxes collected from customers, providing clarification of the collectability criterion assessment, as well as clarifying certainanother transition requirements.

The Company has been analyzing the new standard and the related ASU's across all revenue streams to evaluate the impact of the new standard on revenue contracts. This includes reviewing current accounting policies and practices to identify potential differences that would result from applying the requirements under the new standard. The Company is completing contract evaluations and validating the results of applying the new revenue guidance and ismethod in the process of finalizing its accounting policies, drafting the new disclosures, quantifying the potential financial adjustment and completing its evaluation of the impact of the accounting and disclosure requirements on business processes, controls and systems. Full implementation will be completed by the end of 2017. The Company expects to adopt the new standard using the modified retrospective approach, under which the cumulative effecteffective date would be the date of initially applying the new guidance is recognized as aninitial application of transition. Under this optional transition method, we would recognize a cumulative-effect adjustment to the opening balance of retained earnings in the first quarterperiod of 2018.adoption. We adopted ASU 2016-02 as of January 1, 2019 using the modified retrospective approach and the optional transition method. In addition, we elected the package of practical expedients permitted under the transition guidance within the new standard, which among other things, allowed us to carry forward historical lease classifications.

Adoption of the new standard resulted in the recording of operating lease right-of-use assets of $470,648 and operating lease liabilities of $488,971 on our balance sheet, but did not have an impact on the Company's beginning retained earnings, statement of income, or statement of cash flows. The most significant impact was the recognition of right-of-use assets and lease liabilities for operating leases, while our accounting for finance leases remained substantially unchanged.

Note 3 – Significant Accounting Policies

Revenue Recognition

The Company is engaged in researchWe provide our products and developmentservices under fixed-price and cost-reimbursable contracts. Under fixed-price contracts withwe agree to perform the federal government to develop certain technology to be utilized byspecified work for a pre-determined price. To the U.S. Departmentextent our actual costs vary from the estimates upon which the price was negotiated, we will generate more or less profit or could incur a loss. Cost-reimbursable contracts provide for the payment of Defense (“DoD”). The contracts are cost plus fixed fee contracts and revenue is recognized on the basis of such measurement of partial performance as will reflect reasonably assured realization or delivery of completed articles. Fees earned under the Company’s contracts may also be accrued as they are billable, under the terms of the agreements, unless such accrual is not reasonably related to the proportionateallowable costs incurred during performance of the total workcontract. We also enter into cost-plus-fixed-fee contracts. The fixed-fee in a cost-plus-fixed-fee contract is negotiated at the inception of the contract and that fixed-fee does not vary with actual costs. We account for a contract after it has been approved by all parties to the arrangement, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable.

We assess each contract at its inception to determine whether it should be combined with other contracts. When making this determination, we consider factors such as whether two or more contracts were negotiated and executed at or near the same time or were negotiated with an overall profit objective. If combined, we treat the combined contracts as a single contract for revenue recognition purposes.

We evaluate the products or services to be performed by the Company frompromised in each contract at inception to completion. Underdetermine whether the terms of certaincontract should be accounted for as having one or more performance obligations. The products and services in our contracts fixed fees are typically not recognized until distinct from one another due to their complex relationships and the receipt of full payment has become unconditional, that is, whensignificant contract management functions required to perform under the product has been delivered and accepted by the federal government. Backlog represents the estimated amount of future revenues to be recognized under negotiated contracts as work is performed. The Company’s backlog includes future Adaptive Diagnostic Electronic Portable Testset (“ADEPT”) units to be developed and delivered to the federal government.contract.

Mikros Systems Corporation

Notes to Condensed Financial Statements

(unaudited)

The Company recognizesAccordingly, our contracts are typically accounted for as one performance obligation. Significant judgment is required in determining performance obligations, and these decisions could change the amount of revenue and profit recorded in a given period. We classify net sales as products or services on our statements of income based on the predominant attributes of the performance obligations.

We determine the transaction price for each contract based on the consideration we expect to receive for the products or services being provided under the contract. Our contracts do not include variable consideration. At the inception of a contract we estimate the transaction price based on our current rights and do not contemplate future modifications. Contracts are often subsequently modified to include changes in specifications, requirements or price, which may create new or change existing enforceable rights and obligations. Depending on the nature of the modification, we consider whether to account for the modification as an adjustment to the existing contract or as a separate contract. Generally, modifications to our contracts or delivery orders are distinct and will be accounted for as a separate contract.

We recognize revenue as it relatesperformance obligations are satisfied and the customer obtains control of the products and services. In determining when performance obligations are satisfied, we consider factors such as contract terms, payment terms and whether there is an alternative future use of the product or service. Substantially all of our revenue is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the licensecustomer. This continuous transfer of software when persuasive evidencecontrol of an arrangement exists, delivery has occurredthe work in process to the customer is supported by clauses in the contract that allow the customer to unilaterally terminate the contract for convenience, pay us for costs incurred plus a reasonable profit, and take control of any work in process.

For performance obligations to deliver products with continuous transfer of control to the customer, revenue is recognized based on the extent of progress towards completion of the performance obligation, generally using the cost-to-cost measure of progress for our contracts because it best depicts the transfer of control to the customer as we incur costs on our contracts. Under the cost-to-cost measure of progress, the extent of progress towards completion is measured based on the ratio of costs incurred to date to the total estimated costs to complete the performance obligation. For performance obligations to provide services to the customer, revenue is recognized over a period of time based on costs incurred as our customer receives and consumes the benefits.

Backlog (i.e., unfulfilled or services have been rendered,remaining performance obligations) represents the price is fixed or determinable, and collection is probable. The sale and/or license of softwaresales we expect to recognize for our products and technologyservices for which control has not yet transferred to the customer. The estimated consideration is deemed to have occurred when a customer either has taken possession of or has access to take immediate possessiondetermined at the outset of the softwarecontract and considers the risks related to the technical, schedule and cost impacts to complete the contract. Periodically, we review these risks and may increase or technology. Software license agreements include post-contract customer support ("PCS").decrease backlog accordingly. As the risks on such contracts are successfully retired, the estimated consideration from customers may be reduced, resulting in a reduction of backlog without a corresponding recognition of sales. As of March 31, 2019, our ending backlog was $2.7 million. For arrangements with the Company’s softwareU.S. Department of Defense, or DoD, we generally do not begin work on contracts until funding is appropriated by the customer. Billing timetables and software-related multiple element arrangements, where customers purchase both software related products and software related services, the Company uses vendor-specific objective evidence (“VSOE”) of fair value for software and software-related services to separate the elements and account for them separately. VSOE exists when a company can support what the fair value of its software and/or software-related services ispayment terms on our contracts vary based on evidence of the prices charged when the same elements are sold separately. VSOE of fair value is required, generally, in order to separate the accounting for various elements in a software and related services arrangement. The Company has established VSOE of fair value for the majority of the PCS, professional services, and training. Given the limited number of sales related to this software, andfactors, including the fact that the Company does not sell the PCS element separately, there is no VSOE currently available to bifurcate the PCS element from the contract.  In accordance with Accounting Standards Codification Topic 985-605-25-10a, the fees earned from sale of licenses to which the only undelivered element is the PCS, are recognized ratably over the life of the contract. Revenues from the sale of software licenses and maintenance for the three and nine months ended September 30, 2017 and 2016 were $10,000 and $10,695 and $22,500 and $72,196, respectively. At September 30, 2017 and December 31, 2016, deferred revenues amounted to $30,000 and $7,500, respectively.

Unbilled revenue reflects work performed, but not billed at the time, per contractual requirements. As of September 30, 2017 and December 31, 2016, the Company had unbilled revenues of $226,130 and $235,421, respectively which are recorded within receivables on government contracts in the Company’s balance sheet. Billings to customers in excess of revenue earned are classified as advanced billings, and shown as a liability. As of September 30, 2017 and December 31, 2016, there were no advanced billings.contract type.

Warranty Expense

The Company provides a limited warranty, as defined by the related warranty agreements, for its production units. The Company’s warranties require the Company to repair or replace defective products during such warranty period. The Company estimates the costs that may be incurred under its warranty and records a liability in the amount of such costs at the time product revenue is recognized. Factors that affect the Company’s warranty liability include the number of units sold, expected and anticipated rates of warranty claims, and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the amount as necessary. During the three months ended September 30, 2017 March 31, 2019 and 2016,2018, the Company recognized adid not recognize any warranty benefitexpense. Since the inception of $0 and $65,500, respectively, and for the nine months ended September 30, 2017 and 2016,ADEPT IDIQ contract in March 2010, the Company recognized a warranty benefit of $238,967 and $86,301, respectively.has delivered 226 ADEPT units. As of September 30, 2017, noMarch 31, 2019, there were 37 ADEPT units remainremaining under the limited warranty coverage.

Mikros Systems Corporation

Notes to Condensed Financial Statements

(unaudited)

The following table reflects the reserve for product warranty activity for:

Mikros Systems Corporation

Notes to Condensed Financial Statements

(unaudited)

Research and Development Expense

Research and Developmentdevelopment expenditures for research and development of the Company's products are expensed when incurred and are included in general and administrative expenses. The Company recognized research and development costs as follows:

Note 4–IncomePerShare

Net income per common share information is as follows:

MikrosSystemsCorporation

Notes to Condensed Financial Statements

(unaudited)

The table below sets forth the calculation of the percentage of net earnings allocable to common shareholders under the two-class method in 2016.

Diluted net income per share for the three and nine months ended September 30, 2017 and 2016 does not reflect the following potential common shares, as the effect would be antidilutive.

Note5 – Income Tax Matters

At March 31, 2019, we estimated our annual effective tax rate for 2019 to be 31%. We recognized a tax expense of $36,835 for the three months ended March 31, 2019. At March 31, 2019, the difference from the statutory federal income tax rate is attributable to state income taxes and certain permanent book-tax differences.

The Company conducts an on-going analysis to review its net deferred tax asset and the need for a related valuation allowance. As a result of this analysis and the actual results of operations, the Company has increased its net deferred tax assets decreased by $63,260$(3,084) and $12,940$(9,901) during the ninethree months ended September 30, 2017 March 31, 2019 and 2016,2018, respectively. The change in deferred tax assets is attributable to the reversal ofchanges in various book/tax differences, utilizationdifferences.

Mikros Systems Corporation

Notes to Condensed Financial Statements

(unaudited)

Note 5–IncomePerShare

Net income per common share information is as follows:

Diluted net income per share for the three ended March 31, 2019 and 2018 does not reflect issuance of income tax attributes, primarily federal net operating losses,the following potential common shares, as the Company anticipates annual earnings from operations to continue.effect would be antidilutive.

Note6– Stock-Based CompensationOperating Leases

During 2017,The Company adopted the ASU Topic 842- Leases beginning January 1, 2019 and adopted the practical expedients consistently for all of its leases. Accordingly, the Company:

In addition, the Company issued 70,000 shareselected to retrospectively determine the lease term and assess impairment of restricted stock with a weighted average fairright of use asset.

At the date of transition, the Company recognized an operating lease liability and right of use asset. The amount of lease liability is equal to the present value of $0.46 per share. Asthe remaining lease payments as of September 30, 2017, there was $29,740January 1, 2019 discounted using the incremental borrowing rate of unrecognized stock-based compensation4.89%.

A right-of-use asset is measured at the amount of the lease liability adjusted for the amount of deferred straight-line rent, prepaid rent and lease incentive allowances previously recognized.

Mikros Systems Corporation

Notes to Condensed Financial Statements

(unaudited)

The determination of whether an arrangement is, or contains, a lease is based on the substance of the arrangement at the inception date and requires an assessment of whether the fulfillment of the arrangement is dependent on the use of a specific asset or assets or the arrangement conveys a right to use the asset. A reassessment is made after inception of the lease only if one of the following applies:

Whenever a reassessment is made, lease accounting shall commence or cease from the date when the change in circumstances gave rise to the reassessment for scenarios (a), (c) or (d) and at the date of renewal or extension period for scenario (b).

Leases where the lessor retains substantially all of the risks and rewards of ownership are classified as operating leases. Operating lease payments are recognized as an operating expense on a straight-line basis over the lease term.

The Company has operating lease agreements for each of its offices. The Company has determined that the risks and benefits related to the restricted stock issued during 2017, which will be recognized in future periods. Duringleased properties are retained by the nine months ended September 30, 2017, 67,000 options were exercisedlessors. Accordingly, these are accounted for proceeds amountingas operating leases. These lease agreements are for terms ranging from 5.25 to $12,350.5.33 years and provide for rental escalations of approximately 2.1%.

The intrinsicfollowing table presents the maturity profile of the Company’s operating lease liabilities based on the contractual undiscounted payments with a reconciliation of these amounts to the remaining net present value of the optionsoperating lease liability reported in the balance sheet as of September 30, 2017 is $56,550.March 31, 2019.

During

The weighted average remaining lease terms and discount rates for all of the three and nine months ended September 30, 2017 and 2016, the Company recognized stock-based compensation expenseCompany’s operating leases as of $3,571 and $614 and $9,782 and $1,864, respectively.March 31, 2019 were as follows:

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- lookingforward-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- lookingforward-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; changes in our sales strategy and product development plans; changes in the marketplace; continued services of our executive management team; our limited marketing experience; competition between us and other companies seeking Small Business Innovative Research (“SBIR”) grants; competitive pricing pressures; market acceptance of our products under development;development: delays in the development of products; our ability to adequately integrate our software offerings into our business model, our ability to develop and market solutions for commercial customers, numerous other matters of national, regional and global scale, including those of a political, economic, business and competitive nature; 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, 20162018 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.

Item 2.

This Management’s Discussion and Analysis of Financial PositionCondition and Results of Operations.Operations summarizes the significant factors affecting the operating results, financial condition, liquidity and cash flows of the Company as of and for the periods presented below. The following discussion and analysis should be read in conjunction with our unaudited condensed financial statements and related information contained herein and our audited financial statements as of December 31, 2018.

Overview

Mikros Systems Corporation (the “Company”, “we”, “Mikros” or “us”) designs and manufactures software, hardware and electronic systems used to maintain complex distributed systems. Examples of such systems include defense equipment such as radars and combat systems, and commercial and industrial applications such as printing presses, power distribution, and utility systems, and Federal Aviation Administration (“FAA”) systems.

Our primary business focus is to pursue SBIR programs from the U.S. Department of Defense, or 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, and several IDIQ contracts for our ADEPT and ADSSS products.

Revenues from our government contracts represented substantially all of our revenues for the three months ended march 31, 2019 and 2018. Over the past decade, our principal customer has been the U.S. Department of Defense,DoD, primarily the U.S. Navy.Navy (“Navy”). We provide the following two key systems to the Navy for maintenance of radars and combat systems:

More recently, we have developed and marketed software products to analyze maintenance data collected from target systems, optimize maintenance procedures, and predict failures. Our Prognostics Framework® (PF) and Diagnostic Profiler® (DP) products provide software capabilities which complement our maintenance hardware products (ADEPT and ADSSS), and allow us to provide complete hardware/software solutions for advanced maintenance, particularly of complex distributed systems. Now that we have a complete hardware/software solution for advanced maintenance, we are expanding into commercial and industrial markets.

ProductProductsPortfolio

Adaptive Diagnostic Electronic Portable Testset (ADEPT). ADEPT, also known as the AN/PSM-132, is an automated maintenance workstation designed to significantly reduce the time (ADEPT) required to align all variants of the AN/SPY-1SPY1 Radar System aboard U.S. Navy AegisAEGIS cruisers and destroyers while optimizing system performance and readiness. ADEPT Systemssystems are currently deploying on all AegisAEGIS CG and DDG platforms to support the AN/SPY1 radar system. ADEPT represents an innovative 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 provide integrated distance support capabilities for remote diagnostics and troubleshooting by shore-based Navy experts.

Since the system uses commercial instrument case and modules, ADEPT units can be modified to support both preventative maintenance and condition-based maintenance of other radars and complex electronic systems in military or commercial applications. In that regard, we have a service contract with the U.S. Navy to extend ADEPT to a second U.S. Navy radar system, the SPS-49. These services are expected to assist in optimizing performance for the Ballistic Missile Defense Mission. As of the date of this report, we have delivered a total of 194 226 ADEPT units.

AdaptiveADEPT Distance Support Sensor Suite (ADSSS).In 2013, we started development of the ADEPT Distance Support Sensor Suite, or ADSSS for the Navy’s Littoral Combat Ship (“LCS”). The LCS isLCS. Our system has now matured and has earned Nomenclature AN/SYM-3 from the U.S. Navy’s latest combat warship.Navy. ADSSS is a network-enabled system that can be configured to monitor multiple shipboard systems and report maintenance data onshore for further analysis to detect trends and predict failures. ADSSS provides an open architecture approach with industry standard hardware, and cybersecurity compliant software to acquire and process system operational and maintenance data. ADSSS fully automates the capture of system operation, environment and maintenance data to provide unattended operation. The system monitors key parameters and sends alert notifications when parameters move out of tolerance.

A pilot version of ADSSS has been deployed on the LCS Class since 2014. Development of the production system is ongoing and initial shipboard testing was completed in 2016. In July 2017, we installed the first ADSSS system on the LCS Class. We expect ADSSS to be used on both variants of the LCS, currently planned to be at least 32 ships. ADSSS, with its remote monitoring and prognostics capabilities, has also generated interest in other ship classes, including Aegis, and we are currently pursuing several related opportunities.

Diagnostic Profiler. Profiler. The Diagnostic Profiler is an integrated development environment for developing diagnostic capabilities used in maintenance, embedded diagnostics, and troubleshooting applications. The software provides diagnostic services to its host application, including fault call-outs, suggested “next best” test to further isolate faults, and direct maintenance actions. When additional faults are identified, the software prioritizes the fault call-outscallouts by probability. The use of the diagnostic profiler eliminates the need for the development and maintenance of diagnostic flow charts and hard-coded text sequences. This reduces the effort required to correct bugs and design changes and over the life of the system, could result in significant cost savings. This system is used by commercial customers and has also generated yearly support contracts for service. We are under contract with Northrup Grumman to provide more capabilities to this system and onsite support.

Prognostics Framework. Framework. Prognostics Framework is an analysisanalytic software framework for framework that implementsimplementing real-time prognostics, diagnostics, and status monitoring to support embedded prognostic applications, health management systems and condition-based maintenance applications. The Prognostics Framework software institutes an information framework that organizes relevant data related to: (i) the condition of the system; (ii) the system’s ability to perform required functions over specific time intervals; and (iii) the need for maintenance actions and repair parts. The Prognostics Framework has been used to implement a complete health management system on one of the first radar systems to require prognostics as a key element of its overall solutions. Other potential applications include complex computer networks, power generators, power supply, cooling, C4I (Command, Control, Communications, Computers & Intelligence), environmental and environmentalimaging systems.

Government Contracts

In April 2016, we received three contracts to continue logistics support of the ADEPT maintenance automation workstation. A contract valued at approximately $0.3 million to provide ADEPT General Engineering and Support was awarded, along with two other logistics contracts to perform necessary updates, repair and calibration on the ADEPT units, totaling $0.25 million. Along with the contracts received for our ADEPT product, we received a follow-on contract in the amount of $0.1 million, for technical support on the USS Fort Worth (LCS3) using the latest version of our ADSSS.

In September 2016, we were awarded and entered into a multi-year IDIQ contract with the Naval Surface Warfare Center, Port Hueneme Division, relating to theour ADSSS product. The contract has a term of five years and provides for the purchase and sale of up to $48 million of ADSSS units and related engineering and logistics support. The IDIQ contract covers the first eight ships of the 28 ship program. Since the award, we have received multiple delivery order in the amountawards, some of $3.0 million was awarded on September 15, 2016, to perform installations, support, and logistics for the LCS class.which are described below.

In February 2017, we were awarded a follow-on multi-year Small Business Innovation Research (SBIR)SBIR Phase III IDIQ contract with the Naval Surface Warfare Center, Crane Division, for our ADEPT program. The contract provides for the purchase and sale of up to $35.1 million of ADEPT units and related engineering, such as calibration, repair, training and other sustainmentlogistics services. The firstSince the award, we have received multiple delivery order for $1.1 million was awarded in February 2017 to build eleven ADEPT systems for continuing fleet support on all Aegis cruisers and destroyers.orders, some of which are described below.

In March and April 2017, we were awarded the second, third and thirdfourth delivery orders forunder the ADEPT IDIQ Contract. The second delivery order covers engineering services in the amount of $11.5 million which will be funded incrementally and facilitate the engineering and technical support for the ADEPT program during the nextover a three years.year period. The third delivery order contract for $0.6 million is to provide sustainment services, such as calibration, repair, evaluations, and screenings of ADEPT units to be performed in our Manufacturing and Depot (M&D) Center (‘M&D Center”) in Largo, Florida. The fourth delivery order for $0.1 million is to provide training to sailors in the fleet to operate the ADEPT maintenance automation workstation.

In April 2017, we received contract awards totaling $2.0 million from the U.S. Navy to extend the capabilities of the ADSSS Condition-Based Maintenance (CBM) system to support a fourth Navy radar system, the MK 99. The Small Business Innovation Research (SBIR)SBIR office in Dahlgren, VA provided $0.5 million of the total funding to support this effort. Along with those awards, we received the fourth delivery order for $0.1 million under the existing ADEPT IDIQ contract, to provide training to sailors in the fleet to operate the ADEPT maintenance automation workstation.

In July 2017 and November 2017, we received modifications which added funding to our ADEPT IDIQ Contract, for engineering services in the amounts of $0.4 million and $0.1 million, respectively. These awards will allow us to continue to support of the ADEPT product line in the fleet, implement necessary software enhancements, and provide general support of the program.

In August 2017, we received a modification to our ADEPT sustainment delivery order, adding $0.5 million to allow our M&D Center in Largo, Florida to continue providingto provide bi-annual sustainment services for units from the fleet cycling through the depot center from the fleet. The sustainment efforts include implementing modifications of existing units (54 in total) awaiting fielding.our M&D Center.

In September 2017, we received a delivery order in the amount of $2.4 million for the production and delivery of additional ADEPT units under our Phase III IDIQ contract at NSWC Crane.units. These new units will continue our fleet support on Aegis cruisers and destroyers in the U.S. Navy. In 2018, we received additional modifications to our ADEPT IDIQ Contract and incremental awards for continued engineering services in the aggregate amount of $0.42 million. This funding will support necessary software enhancements to sustainment services for the ADEPT product out of our M&D Center.

In February and March 2018, we received modifications to our ADEPT sustainment delivery orders, adding $0.25 million to allow us to continue to provide bi-annual sustainment services for units from the fleet cycling through the M&D Center. In addition to those sustainment services, it allows our team at the M&D Center to provide training to sailors in the fleet to operate the ADEPT maintenance automation workstation.

Between January 2018 and April 2018, we received multiple contract awards which increased funding on our ADEPT IDIQ Contract for Engineering Services. The total amount awarded in the first quarter of 2018 was $0.5 million and an additional $1.6 million was awarded in April 2018. This funding will allow us to continue supporting the ADEPT product line in the fleet and implementing necessary software enhancements to increase readiness.

In June 2018, we received the second delivery order on our current multi-year IDIQ contract with the Naval Surface Warfare Center, Port Hueneme Division, relating to our ADSSS product. The award totaling $2.5 million will support the MK 99 FCS development, test and installation.

In August 2018, we received a contract modification to add funding to our ADEPT IDIQ Contract for engineering services in the amount of $1.3 million. This additional funding will support the ADEPT product line in the fleet, implement necessary software enhancements and provide general support.

In September 2018, we received modifications to our ADEPT sustainment delivery orders, adding $0.25 million. This funding allows the M&D Center to provide bi-annual sustainment services for units from the fleet.

In November 2018, we received a contract modification to add funding to our ADEPT IDIQ Contract for engineering services in the amount of $0.2 million. This additional funding will support the ADEPT product line in the fleet, implement necessary software enhancements and provide general support.

In May 2019, we received a contract modifications to add funding to our ADEPT IDIQ Contract in the amounts of $0.05 million for sustainment services and $0.8 million for engineering services. These awards will allow us to continue to support the ADEPT product line in the fleet, implement necessary software enhancements, and provide general support of the program.

Commercial Contracts

In May 2019, our long-time customer HP Indigo renewed its annual contract for Diagnostic Profiler and Diagnostician Software Maintenance and Support.

Key Performance Indicator

As substantially all of our revenue is derived from contracts with the federalU.S. Federal government, our key performance indicator is the dollar volume of contracts and deliverytask orders awarded to us under our IDIQ contracts. Increases in the number and value of contracts and trade orders awarded will generally result in increased revenues in future periods and, assuming relatively stable variable costs associated with our fulfilling such awards, increased profits in future periods. The timing of such awards is uncertain as we sell to federalFederal government agencies where the process of obtaining such awards can be lengthy and at times uncertain. As the substantial majority of our revenue in 2016,2018, and expected revenue in 2017,2019, is or will be from sales of ADEPT units and ADSSS systems under our IDIQ contracts,contracts, continued generation of deliverytask orders and our ability to expand the market and potential customer base for ADEPT units will be a key indicator of future revenue. ADEPT units must be serviced and calibrated every two years. Accordingly, as we continue to increase the installed base of ADEPT units and expand the units to other radar systems, we expect to generate future recurring maintenance and service revenue.

Outlook

Our strategy for continued growth is based on continuing expansion of our defense business plusand executing new initiatives to apply our advanced maintenance technology in commercial markets. With regard to the defense industry, 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 (Command, Control, Communications, Computers & Intelligence) systems engineering, and communications engineering. We believe that we can useutilize the technology and intellectual property developed under our various SBIR awards to develop proprietary products, such as ADEPT and ADSSS, with broad appeal in both the government and commercial markets.marketplace. Our state of the art test equipment can be used by many commercial and governmental customers such as the FAA, radio and television stations, cell phone stations, 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 contractors. Our strategy is to develop these relationships into long-term, key subcontractor roles on future major defense programs awarded to these prime contractors.

With regard to commercial markets, our Diagnostics Profiler and Prognostics Framework software offerings complement our hardware products and allow us to provide complete hardware/software solutions for advanced maintenance applications. Current customers for these systems include major multinational corporations such as HP, which recently extended our Diagnostic Profiler software support with for a fifthsixth year. We continue to receive repeat orders from these customers to support their applications. We plan to provide “condition-based maintenance” systems for applications such as FAA radar surveillance and support systems, power distribution and utilities infrastructure, commercial shipping, cooling and environmental systems, and other “complex distributed systems” to commercial customers. In that regard, we are currently developing a condition-based maintenance solution for heating ventilation, air conditioning and refrigeration (HVAC) equipment based on our proprietary Prognostics Framework solution. We have deployed two active pilot systems that are providing key maintenance data on a daily basis to service technicians. More recently, we commenced a pilot program with an energy consulting firm to collect energy consumption data to reduce power consumption, decrease system downtime, and recommend proactive maintenance to commercial and industrial energy users. We are also in discussions with additional commercial companies regarding the use of our condition based maintenance applications.

In 2017,2019, our primary strategic focus is to continue as a premium provider of R&D and product development services to the defense industry, generate multiple deliverytask orders under our two IDIQ contracts, extend ADEPT and ADSSS to additional combat systems and ship classes, and expand our commercial business through marketing and sales of our Prognostics Framework and Diagnostic Profiler software products. In furtherance of this strategy, we have made material investments in our engineering and technical staffs to provide broader and deeper expertise to our customers. We will also seek to generate incremental revenue through providing light assembly and production services to commercial customers at our manufacturing and depot centerM&D Center in Largo, Florida.

Over the longer term, we intend to further develop advanced maintenance technologies and implement these technologies in products for deployment in defense applications and to expand into additionalmore commercial applications. We believe that many of our core capabilities, remote monitoring, rugged systems, predictive maintenance and communications expertise, are applicable to other industries that work with complex distributed systems, such as utilities, communications and transportation systems, and building maintenance.systems. We are currently in discussions with certain industry participants regarding this initiative.

During the past two fiscalrecent years, the combination of spending caps, discretionary spending cuts, sequestration and further proposed reductionschanges in defense spending hasand priorities have caused, and may in the future continue to cause, delays in funding certain projects. This may negatively impact our revenues and profits.

Changes to Critical Accounting Policies and Estimates

Our critical accounting policiesIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The new standard supersedes the prior U.S. GAAP standard on leases and estimates are set forthrequires substantially all leases to be reported on the balance sheet as right-of-use assets and lease obligations. ASU 2016-02 is effective for annual reporting periods beginning after December 15, 2018, and interim reporting periods within those annual reporting periods. Early adoption is permitted and in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016. Asoriginal guidance the modified retrospective application was required, however, in July 2018 the FASB issued ASU 2018-11 which permits entities with another transition method in which the effective date would be the date of September 30, 2017, there have been no changesinitial application of transition. Under this optional transition method, we would recognize a cumulative-effect adjustment to such critical accounting policiesthe opening balance of retained earnings in the period of adoption. We adopted ASU 2016-02 as of January 1, 2019 using the modified retrospective approach and estimates.the optional transition method. In addition, we elected the package of practical expedients permitted under the transition guidance within the new standard, which among other things, allowed us to carry forward historical lease classifications.

Adoption of the new standard resulted in the recording of operating lease right-of-use assets of $470,648 and operating lease liabilities of $488,971 on our balance sheet, but did not have an impact on the Company's beginning retained earnings, statement of income or statement of cash flows. The most significant impact was the recognition of right-of-use assets and lease liabilities for operating leases, while our accounting for finance leases remained substantially unchanged.

Results of Operations

Three Months Ended September 30March 31, 20172019 and 2016March 31, 2018

We generated revenues of $1,551,620$2,020,265 during the three months ended September 30, 2017March 31, 2019 compared to $1,180,491$2,490,660 during the three months ended September 30, 2016, an increaseMarch 31, 2018, a decrease of $371,129,$470,395, or 31%19%. The increase was dueThis resulted primarily tofrom a reduction in the production order for 11of ADEPT units from 26 partial production in February 2017 and the receiptfirst quarter of additional contracts for2018 to no ADEPT units produced in the first quarter of 2019. Revenues in the first quarter of 2019 consisted entirely of engineering support services support and repairs and calibration services amounting to $3,355,938.contracts.

Cost of sales consists of direct contract costs including labor, material, subcontracts warranty expense for the ADEPT units that have been delivered, travel, and other direct costs. Cost of sales for the three months ended September 30, 2017March 31, 2019 was $636,128$778,542 compared to $446,810$1,177,032 for the three months ended September 30, 2016, an increaseMarch 31, 2018, a decrease of $189,318$398,490 or 42%34%. The increase was due primarily toreduction resulted from a change in the receiptmix of a production order for 11revenue in the first quarter of 2019. In 2019, we did not produce any ADEPT units in February 2017 and the receipt of four additional contracts forall revenue was generated from engineering services, support and repairs and calibration services. As a percentage of revenue, cost of sales was 41% of revenues for the three months ended September 30, 2017 as compared to 38% of revenues for the three months ended September 30, 2016. The increase is due to an increase in production costs and other direct costs.

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 benefit 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 September 30, 2017March 31, 2019 were $530,477$662,250 compared to $421,296$640,293 for the three months ended September 30, 2016,March 31, 2018, an increase of $109,181,$21,957, or 26%3%. The increase was due to significant increases in fringe benefits and engineering salaries due to the hiring of six additional employees, recruiting costs, travel and subsistence expenses, engineering consulting costs, and incentive compensation.

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, including independent research and development (IR&D) which consists of research and development expenses unrelated to our defense contracts). General and administrative costs for the three months ended September 30, 2017March 31, 2019 were $379,407$463,565 as compared to $261,528$451,678 for the three months ended September 30, 2016,March 31, 2018, an increase of $117,879,$11,887, or 45%3%. The increase was due primarily to increases in salaries, incentive compensation, research and development costs, and professional fees.

At September 30, 2017, we estimated our annual effective tax rate for 2017 to be 46%. We recognizedreported a tax benefitnet income of $(22,695) for$80,805 in the three months ended September 30, 2017 primarily dueMarch 31, 2109 as compared to stock compensation related tax deductions and tax credits. At September 30, 2017, the difference from the expected federal income tax rate is attributable to state income taxes and certain permanent book-tax differences. 

NineMonthsEndedSeptember 30, 2017and2016

We generated revenues of $5,047,456 during the nine$153,305 in three months ended September 30, 2017 compared to $3,146,792 during the nine months ended September 30, 2016, an increase of $1,900,664, or 60%.March 31, 2018. The increasedecrease was due primarily to a production order for 11 ADEPT units in February 2017 and the receipt of ten additional contracts for engineering services, support and repairs and calibration services amounting to $6,756,321.

Cost of sales for the nine months ended September 30, 2017 was $1,909,246 compared to $1,120,664 for the nine months ended September 30, 2016, an increase of $788,582 or 70%. The increase was dueattributable primarily to the receiptdecrease in revenues in the first quarter of a production order for 11 ADEPT units in February 2017 and the receipt of ten additional contracts for engineering services, support and repairs, and calibration services. As a percentage of revenue, cost of sales was 38% for the nine months ended September 30, 2017 as compared to 36% of revenues for the nine months ended September 30, 2016. The increase is due to an increase in production costs and other direct costs.

Engineering costs for the nine months ended September 30, 2017 were $1,587,069 compared to $1,058,058 for the nine months ended September 30, 2016, an increase of $529,011, or 50%. The increase was due to significant increases in fringe benefits and engineering salaries due to the hiring of six additional employees, recruiting costs, travel and subsistence expenses, engineering consulting costs and incentive compensation.

General and administrative costs for the nine months ended September 30, 2017 were $1,218,694 compared to $894,430 for the nine months ended September 30, 2016, an increase of $324,264, or 36%. The increase was due primarily to increases in salaries, incentive compensation, research and development costs, and professional fees.

At September 30, 2017, we estimated our annual effective tax rate for 2017 to be 42%. We recognized a tax expense of $139,064 for the nine months ended September 30, 2017 primarily due to expected net income for the remainder of 2017. At September 30, 2017, the difference from the expected federal income tax rate is attributable to state income taxes and certain permanent book-tax differences.2019.  

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 ninethree months ended September 30, 2017,March 31, 2019, net cash used in operations was $559,073 compared to net cash provided by operations was $302,293 compared to net cash used in operations of $965,768$262,905 during the ninethree months ended September 30, 2016.March 31, 2018. The increasedecrease was due primarily to an increase in net income of $164,978 and the timing of receipts and payments related to our operating assets and liabilities.

Net cash used in investing activities was $30,842 in the three months ended March 31, 2019 as compared to $19,317 in the three months ended March 31, 2018, an increase of $11,525. The increase was due to the increase in purchases of equipment, furniture and fixtures related to an expansion of our offices in Pennsylvania.

We currently do not haveOn January 31, 2018, we entered into a $550,000 credit facility with PNC Bank. The facility initially matured on January 31, 2019 and has been extended to January 31, 2020. The facility accrues interest at a variable rate equal to the Daily LIBOR Rate plus 250 basis points. Interest is paid monthly. Principal borrowings may be prepaid at any time without penalty and the facility is secured by substantially all of our assets. The facility contains customary affirmative and negative nonfinancial covenants. As of March 31, 2019, no amounts were outstanding loan or line of credit with any bank or financial institution. We believe our available cash resources and expected cash flows from operations will be sufficient to fund operations forunder the next twelve months. We do not expect to incur any material capital expenditures during the next twelve months.facility.

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 we will remain profitable or continue to generate positive cash flow.

Off-Balance Sheet Arrangements

As of September 30, 2017,March 31, 2019, we did not have any relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or special purpose 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.

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 Chief Executive Officer, who serves as our principal executive officer and principal financial officer. Based upon that evaluation, our Chief Executive Officer concluded that as of September 30, 2017,March 31, 2019, 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, as amended, 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 September 30, 2017March 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

During the quarter ended September 30, 2017, we issued 5,000 shares of common stock to an employee upon exercise of options in consideration of cash payment of $1,000. The forgoing shares were issued pursuant to the exemption from registration provided by Section 4(a)(2) of the Securities Act of 1933, as amended.

During the quarter ended September 30, 2017, we issued 10,000 shares of restricted common stock to a new employee which vest in equal annual installments over a five year period. The forgoing shares were issued pursuant to the exemption from registration provided by Section 4(a)(2) of the Securities Act of 1933, as amended.

Item 6.   Exhibits

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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