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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2022

or

For the transition period from                       to                       

Commission file number: 0-31641

2839 Charter Street, Columbus, Ohio 43228

(Address of principal executive offices) (Zip Code)

(614) 486-0261

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address, and former fiscal year, if changed since last report)

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 preceding 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 every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit 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.

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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 ☒

4,515,379 shares of Common Stock, without par value, were outstanding at July 28, 2022.

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FORM 10-Q

SCI ENGINEERED MATERIALS, INC.

Table of Contents

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The accompanying notes are an integral part of these financial statements.

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The accompanying notes are an integral part of these financial statements.

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The accompanying notes are an integral part of these financial statements.

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SCI ENGINEERED MATERIALS, INC

Note 1.  Business Organization and Purpose

SCI Engineered Materials, Inc. (“SCI,” or the “Company”), an Ohio corporation, was incorporated in 1987. The Company operates in one segment as a global supplier and manufacturer of advanced materials for Physical Vapor Deposition (“PVD”) thin film applications. The Company is focused on markets within the photonics industry including Aerospace, Automotive, Defense, Glass, Optical Coatings and Solar. Substantially all revenues are generated from customers with multi-national operations. The Company develops innovative customized solutions enabling commercial success through collaboration with end users and Original Equipment Manufacturers.

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Note 2.  Summary of Significant Accounting Policies

Basis of Presentation - The accompanying unaudited financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for fair presentation of the results of operations for the periods presented have been included. The financial statements should be read in conjunction with the audited financial statements and the notes thereto for the year ended December 31, 2021. Interim results are not necessarily indicative of results for the full year.

Use of Estimates - The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Revenue Recognition - The Company enters into contracts with its customers that generally represent purchase orders specifying general terms and conditions, order quantities and per unit product prices. The Company has determined that each unit of product purchased represents a separate performance obligation. The Company satisfies its performance obligations and recognizes revenue at a point in time when control of a unit of product is transferred to the customer. Revenue is measured as the amount of consideration the Company expects to receive in exchange for transferring products. For the majority of product sales, transfer of control occurs when the products are shipped from the Company’s manufacturing facility to the customer. The cost of delivering products to the Company’s customers is recorded as a component of cost of products sold. Those costs may include the amounts paid to a third party to deliver the products. Any freight costs billed to and paid by a customer are included in revenue.  

The Company considers collectability of amounts due under a contract to be probable upon inception of a sale based on an evaluation of the credit worthiness of each customer. The Company sells its products typically under agreements with 30 day payment terms. The Company does not typically include extended payment terms or significant financing components in contracts with customers. The majority of the Company’s contracts have an obligation to transfer products within one year. Thus, the Company elects to use the practical expedient where incremental cost of obtaining a contract, such as commissions, is expensed when incurred because the amortization period for those costs is one year or less. The Company treats shipping and handling activities that occur after control of the product transfers as fulfillment activities, and therefore, does not account for shipping and handling costs as a separate performance obligation. Customer deposits are funds received in advance from customers and are recognized as revenue when the Company has transferred control of product to the customer. Product revenues are recognized upon shipment of goods as the customer has assumed the significant risks and rewards of ownership and the Company is entitled to payment at this point. Service revenues are recognized upon completion as the customer cannot realize the benefit of the service until fully completed.

All revenue was from the photonics industry during the six months ended June 30, 2022 and 2021. The top two customers represented approximately 87% and 79% of total revenue for the six months ended June 30, 2022 and 2021, respectively. International shipments resulted in 1% and 3% of total revenue for the first six months of 2022 and 2021, respectively.

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SCI ENGINEERED MATERIALS, INC

NOTES TO FINANCIAL STATEMENTS

Note 2.  Summary of Significant Accounting Policies (continued)

Employee Retention Credit (ERC) - The Company qualified for federal government assistance through Employee Retention Credit provisions of the Consolidated Appropriations Act of 2021 during the first six months of 2021 in the amount of $255,507 during the first quarter of 2021 and $151,701 during the second quarter of 2021. The purpose of the Employee Retention Credit was to encourage employers to keep employees on the payroll, even if they were not working during the covered period because of the coronavirus outbreak. These funds were recorded in the Statements of Income as an offset to payroll costs in their respective expense lines and as a tax receivable on the balance sheets. The Company also qualified for the ERC in the third quarter of 2021. A balance of $105,000 appears as a tax receivable on the balance sheets at June 30, 2022.

Note 3.  Recent Accounting Pronouncements

In June 2016, the FASB issued ASU No. 2016-13 “Credit Losses - Measurement of Credit Losses on Financial Instruments.” ASU No. 2016-13 significantly changes how entities will measure credit losses for most financial assets, including accounts and notes receivables, by replacing today’s “incurred loss” approach with an “expected loss” model under which allowances will be recognized based on expected rather than incurred losses. ASU No. 2016-13 will become effective for us in the first quarter of 2023. We are evaluating the impact that the adoption of this update will have on our financial statements.

Note 4.  Common Stock and Stock Options

Stock Based Compensation cost for all stock awards is based on the grant date fair value and recognized over the required service (vesting) period. Noncash stock-based compensation expense was $8,673 and $8,675 for the three months ended June 30, 2022, and 2021, respectively. Noncash stock-based compensation expense was $31,972 and $30,563 for the six months ended June 30, 2022, and 2021, respectively.

Unrecognized compensation expense was $3,941 as of June 30, 2022 and will be recognized through 2023. There was no tax benefit recorded for this compensation cost as the expense relates to incentive stock options that do not qualify for a tax deduction until, and only if, a qualifying disposition occurs.

The non-employee Board members received compensation of 4,610 and 5,265 aggregate shares of common stock of the Company during the six months ended June 30, 2022 and 2021, respectively. The stock had an aggregate value of $14,982 and $14,987 for the six months ended June 30, 2022 and 2021, respectively, and was recorded as non-cash stock compensation expense in the financial statements.

Employees received compensation of 4,500 and 4,804 aggregate shares of common stock of the Company during the six months ended June 30, 2022 and 2021, respectfully. These shares had an aggregate value of $14,625 and $13,211 and was recorded as non-cash stock compensation expense in the financial statements for the six months ended June 30, 2022 and 2021, respectively. In addition, during the six months ended June 30, 2021, a total of 30,181 stock options were exercised by management.

The cumulative status of options granted and outstanding at June 30, 2022, and December 31, 2021, as well as options which became exercisable in connection with the Company’s stock option plans is summarized as follows:

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SCI ENGINEERED MATERIALS, INC

NOTES TO FINANCIAL STATEMENTS

Note 4.  Common Stock and Stock Options (continued)

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Exercise prices for options ranged from $0.84 to $1.25 at June 30, 2022. The weighted average option price for all options outstanding at June 30, 2022, was $1.05 with a weighted average remaining contractual life of 4.1 years. There were no non-employee director stock options outstanding during 2022 and 2021.

Note 5.  Preferred Stock

The Board of Directors voted in November 2021 to authorize full redemption of the 24,152 shares of the Company’s Convertible Preferred Stock, Series B (“Series B”) outstanding effective December 31, 2021. This involved cash payments of $248,766 ($10.30 per Series B share, which includes a 3% premium to the stated value of $10 per share), plus unpaid annual dividends of $265,672 ($11.00 per Series B share).

Dividends on the Convertible Preferred Stock, Series B accrued at 10% annually on the outstanding shares prior to the redemption in 2021 and were $6,038 and $12,076 for the three and six months ended June 30, 2021, respectively. During June 2021, a cash dividend payment of $24,152 was made to preferred shareholders.

Note 7.  Earnings Per Share

Basic income per share is calculated as income applicable to common shareholders divided by the weighted average of common shares outstanding. Diluted earnings per share is calculated as diluted income applicable to common shareholders divided by the diluted weighted average number of common shares. Diluted weighted average number of common shares gives effect to all dilutive potential common shares outstanding during the period using the treasury stock method and convertible preferred stock using the if-converted method. Diluted earnings per share exclude all diluted potential shares if their effect is anti-dilutive. All common stock options listed in Note 4 that were out-of-the-money or anti-dilutive were excluded from diluted earnings per share. The following is provided to reconcile the earnings per share calculations:

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SCI ENGINEERED MATERIALS, INC

NOTES TO FINANCIAL STATEMENTS

Note 8.   Notes Payable

On April 17, 2020, the Company entered into an unsecured promissory note under the Paycheck Protection Program (the “PPP”), with a principal amount of $325,300. Under the terms of the CARES Act, PPP loan recipients were eligible to apply for, and be granted, forgiveness for all or a portion of loans granted. Such forgiveness was subject to limitations and ongoing rulemaking by the SBA, based on the use of loan proceeds for payroll costs and mortgage interest, rent or utility costs and the maintenance of employee and compensation levels. The Company applied for forgiveness of the entire amount of the loan during the fourth quarter of 2020, and the SBA approved the Forgiveness Application in full during the first quarter of 2021. This amount is included in the Statements of Income as gain on extinguishment of debt for the six months ended June 30, 2021.

The Company commenced a line of credit with Fifth Third Bank for $1 million during 2021. The line of credit bears interest equal to the rate of interest per annum established by Fifth Third Bank as its Prime Rate. This line of credit has a maturity date of August 29, 2022. No amounts were drawn on this line of credit as of June 30, 2022.

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Deferred tax assets and liabilities result from temporary differences in the recognition of income and expense for tax and financial reporting purposes. The Company had net operating loss carryforwards available for federal and state tax purposes of approximately $2,100,000 at December 31, 2021, which expire in varying amounts through 2041.

As of December 31, 2021, management determined that there was sufficient positive evidence to conclude that it is more likely than not that deferred taxes of $663,820 were realizable principally because we achieved five consecutive years of pretax income, expect profits to continue for the foreseeable future and implemented new efficiencies in the Company’s manufacturing process. As of each reporting date, management considers new evidence, both positive and negative, that could affect its view of the future realization of deferred tax assets. Accordingly, management determined that no valuation allowance was necessary, and the deferred tax asset was $531,720 at June 30, 2022.

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Note 10. Operating Lease

The Company entered into an operating lease with a third party on March 18, 2014 for its headquarters in Columbus, Ohio. The terms of the lease include monthly payments ranging from $9,200 to $9,700 with a maturity date of November 30, 2024. The Company has the option to extend the lease period for an additional five years beyond the original expiration date. There are no restrictions or covenants associated with the lease. The lease costs were approximately $56,200 and $55,000 during the six months ended June 30, 2022 and 2021, respectively.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Several issues continue to affect national and global market conditions. First, inflation has accelerated, impacting raw material costs and transportation expenses. We have generally been able to pass on these increases to customers but are unable to predict how future or sustained inflationary pressure may impact our results. Second, supply chain disruptions are adversely impacting customers in certain markets. Thus far, we have not experienced material adverse effects regarding product shipments; however, timely deliveries and sourcing of certain materials is of increased concern. Third, published articles and corporate announcements continue to address the global semiconductor chip shortage, which is anticipated to continue at least into the fourth quarter of 2022. This shortage is affecting some of our customers which could impact the Company’s revenue, volume, and profitability. Fourth, there are increased political uncertainties affecting global markets. Although we currently have no customers or vendors in Russia or Ukraine, we continue to monitor the situation as some raw material comes from Russia for the PVD industry. We continue to actively monitor these developments, including ongoing contact with our suppliers and customers, and adapting to their specific circumstances and forecasts.

On April 17, 2020, we entered into an unsecured promissory note under the Paycheck Protection Program (the “PPP”), with a principal amount of $325,300. The PPP was established under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) and administered by the U.S. Small Business Administration (the “SBA”). The SBA approved our Forgiveness Application in full on January 6, 2021 and appears as gain on extinguishment of debt in the Statements of Income during the six months ended June 30, 2021.

The Employee Retention Credit (“ERC”), as originally enacted on March 27, 2020, by the CARES Act, was a refundable tax credit against certain employment taxes equal to 50% of the qualified wages an eligible employer paid to employees after March 12, 2020, and before January 1, 2021. The Taxpayer Certainty and Disaster Tax Relief Act (the “Relief Act”), enacted on December 27, 2020, amended, and extended the ERC. On March 1, 2021, the IRS released Notice 2021-20 to provide guidance on the original ERC, as modified by the Relief Act. During 2021 we filed Form 941-X to claim a credit of $105,000 on qualified wages paid in 2020. This receivable appears on the balance sheets as of June 30, 2022 and December 31, 2021, as Tax Receivable, and as a credit to wages in the Statements of Income during the six months ended June 30, 2021.

The Relief Act extended and enhanced the ERC for qualified wages paid after December 31, 2020, through June 30, 2021. Under the Relief Act, eligible employers may claim a refundable tax credit against certain employment taxes equal to 70% of the qualified wages an eligible employer paid to employees after December 31, 2020, through June 30, 2021. As of the March 11, 2021, passage of the American Rescue Plan Act, the ERC was available for all four quarters of 2021. However, the Infrastructure Investment and Jobs Act enacted on November 15, 2021, ended the ERC effective September 30, 2021.

During the first and second quarter of 2021, we were qualified to receive the ERC. The ERC of $150,507 and $151,701 on qualified wages paid in the first and second quarter of 2021, respectively,  appears as a credit to wages in the Statements of Income.

Consistent with our growth strategy, we have identified niche markets that can benefit from our expertise in custom powder solutions, such as near-infrared doped phosphors and short-wave infrared applications. These applications enable extended life of phosphors for specific nighttime identification needs of defense personnel and first responders.

New initiatives are also being pursued that utilize our vacuum hot press, cold isostatic press, and kilns for increased production and development projects, including diffusion bonding. We recently manufactured and sold conductive metal oxides for direct current sputtering of Tungsten Oxide and Molybdenum Oxide materials. We continue to invest in developing new products for all our markets including specialty bonding processes for Aerospace customers. Those products continue to require research and development expense to accelerate time to market.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

RESULTS OF OPERATIONS

Three and six months ended June 30, 2022 (unaudited) compared to three and six months ended June 30, 2021 (unaudited):

Revenue

For the three months ended June 30, 2022, we had record total revenue of $6,505,005. This was an increase of $4,532,956 compared to the three months ended June 30, 2021. For the six months ended June 30, 2022, we had record total revenue of $11,831,437. This was an increase of $6,837,078 compared to the six months ended June 30, 2021. Higher pricing, primarily attributable to increased raw material costs, higher volume and product mix were key factors that contributed to the increase.

Gross profit

Gross profit was $1,377,668 for the three months ended June 30, 2022, compared to $562,554 for the same three months in 2021, an increase of $815,114. Gross profit as a percentage of revenue (gross margin) was 21.2% for the second quarter of 2022 compared to 28.5% for the same period in 2021. Gross profit was $2,371,769 for the six months ended June 30, 2022, compared to $1,365,590 for the first six months of 2021, an increase of $1,006,179.  Gross margin was 20.0% for the first six months of 2022 compared to 27.3% for the same period in 2021.

The increases in gross profit were due to higher revenue during 2022. The Employee Retention Credit (ERC) reduced cost of revenue in the three and six months ended June 30, 2021, by approximately $87,000 and $238,000, respectively. The lower gross margin in 2022 compared to a year ago was due to higher raw material costs in the first half of 2022.

General and administrative expense

General and administrative expense for the three months ended June 30, 2022, and 2021, was $423,401 and $283,708, respectively, an increase of 49.2%. General and administrative expense for the six months ended June 30, 2022, and 2021, was $796,589 and $571,589, respectively, an increase of 39.4%. During 2022 there was an increase in staff resulting in higher compensation of approximately $44,000. Business liability insurance (due to higher revenue) and professional fees, primarily related to SEC compliance costs for legal, accounting and stockholder relations fees, increased approximately $59,000. The three and six months ended June 30, 2021 included the ERC of $21,000 and $57,000, respectively.

Research and development expense

Research and development expense for the three months ended June 30, 2022, was $92,085 compared to $54,377 for the same period in 2021, an increase of 69.3%. Research and development expense for the six months ended June 30, 2022, was $179,116 compared to $92,596 for the same period in 2021, an increase of 93.4%. The ERC of $22,750 and $61,750 was included in the three and six months ended June 30, 2021, respectively. Specialty materials are being researched for use in niche markets which include custom applications and additive manufacturing. Our development efforts utilize a disciplined innovation approach focused on accelerating time to market for these applications and involve ongoing research and development expense.

Marketing and sales expense

Marketing and sales expense was $108,140 and $46,434 for the three months ended June 30, 2022, and 2021, respectively. This was an increase of 132.9%. Marketing and sales expense was $190,328 and $97,827 for the six months ended June 30, 2022, and 2021, respectively, an increase of 94.6%.

Travel expenses increased approximately $22,000 and $39,000 during the three and six months ended June 30, 2022, respectively, versus the same periods in 2021, as we resumed in-person meetings with some customers and participated onsite in industry trade shows. The three and six months ended June 30, 2021, included the ERC of approximately $21,000 and $50,000, respectively.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Stock compensation expense

Included in total expenses were noncash stock-based compensation costs of $8,673 and $8,675 for the three months ended June 30, 2022, and 2021, respectively, and $31,972 and $30,563 for the six months ended June 30, 2022, and 2021, respectively. Compensation expense for all stock-based awards is based on the grant date fair value and recognized over the required service (vesting) period. Unrecognized non-cash stock-based compensation expense was $3,941 as of June 30, 2022 and will be recognized through 2023.

Interest

Interest expense was $5,769 for the three months ended June 30, 2022, and $9,014 for the three months ended June 30, 2021. Interest expense was $12,262 for the six months ended June 30, 2022, and $16,652 for the six months ended June 30, 2021. The decrease was due to final payments of multiple finance leases during 2021.

Income taxes

Income tax expense was $83,400 and $47,473 for the three months ended June 30, 2022, and 2021, respectively, and $144,200 and $138,093 for the six months ended June 30, 2022, and 2021, respectively. At December 31, 2021, the deferred tax asset was $663,820. Management considered new evidence, both positive and negative, during the first half of 2022 that could affect its view of the future realization of deferred tax assets and determined that no valuation allowance was necessary, and the deferred tax asset was $531,720 at June 30, 2022.

Income applicable to common stock

Income applicable to common stock for the three months ended June 30, 2022, and 2021, was $664,873 and $115,510, respectively. Income applicable to common stock for the six months ended June 30, 2022, and 2021, was $1,049,274 and $762,057, respectively. The increase was primarily the result of higher revenue and gross profit.

Liquidity and Capital Resources

Cash

As of June 30, 2022, cash on hand was $5,409,210 compared to $4,140,942 at December 31, 2021. The increase was principally due to record total revenue and higher gross profit for the first six months of 2022.

Working capital

At June 30, 2022 working capital was $5,085,961 compared to $3,907,135 at December 31, 2021, an increase of $1,178,826 or 30.2%. Cash increased $1,268,268, receivables increased $287,692, inventories increased $2,544,430, customer deposits increased $2,137,883, while prepaid expenses decreased $632,305.

Cash from operations

Net cash provided by operating activities during the six months ended June 30, 2022, was $1,490,066 and $1,249,462 for the six months ended June 30, 2021. In addition to the net income generated, this included depreciation and amortization of $249,992 and $273,688, and noncash stock-based compensation costs of $31,972 and $30,563 for the six months ended June 30, 2022, and 2021, respectively.

The decrease in prepaid expenses was related to the receipt of inventory paid for in December 2021 and received in January 2022. Inventories and customer deposits increased due to orders received late in 2021 and throughout the first six months of 2022.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Cash from investing activities

Cash of $179,140 and $558,828 was used in investing activities during the six months ended June 30, 2022, and June 30, 2021, respectively, for the acquisition of production equipment.

Cash from financing activities

Cash of $47,824 and $87,422 was used in financing activities for principal payments to third parties for finance lease obligations during the six months ended June 30, 2022, and 2021, respectively. The decrease was due to final payments of multiple finance leases during 2021. A cash dividend payment of $24,152 was made to owners of our Series B preferred stock during the six months ended June 30, 2021.

Debt outstanding

Total debt outstanding was $195,392 at June 30, 2022, compared to $243,218 at December 31, 2021, a decrease of 19.7%. As previously mentioned, cash of $47,824 was used for principal payments for finance lease obligations during 2022.

Off Balance Sheet Arrangements

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

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Financial Statements and accompanying notes. Note 2 to the Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2021, describes the significant accounting policies and methods used in the preparation of the Financial Statements. Estimates are used for, but not limited to, accounting for the allowance for doubtful accounts, inventory allowances, property and equipment depreciable lives, patents and licenses useful lives, revenue recognition, income tax expense, deferred tax assets and liabilities, realization of deferred tax assets, stock-based compensation and assessing changes in which impairment of certain long-lived assets may occur. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Financial Statements. The allowance for doubtful accounts is based on our assessment of the collectability of specific customer accounts and the aging of the accounts receivable. If there is a deterioration of a major customer’s credit worthiness or actual defaults are higher than our historical experience, our estimates of the recoverability of amounts due us could be adversely affected. Inventory purchases and commitments are based upon future demand forecasts. If there is a sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, we may be required to increase our inventory allowances and our gross margin could be adversely affected. The tax valuation allowance is based on our consideration of new evidence, both positive and negative, that could affect our view of the future realization of deferred tax assets. If we were to determine we would not be able to realize all or part of the deferred tax asset in the future, an adjustment to the deferred tax asset would be necessary which would reduce our net income for that period. Depreciable and useful lives estimated for property and equipment, licenses and patents are based on initial expectations of the period of time these assets and intangibles will benefit us. Changes in circumstances related to a change in our business, change in technology or other factors could result in these assets becoming impaired, which could adversely affect the value of these assets.

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