UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-K

(Mark One)

☒Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Fiscal Year Ended December 31, 2017

or

☐Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Transition Period From                           to                             .

Commission file number 000-25727

IKONICS CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code:  (218) 628-2217

Securities registered under Section 12(b) of the Act:

Securities registered under Section 12(g) of the Act:  None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes ☐  No ☒

Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act.  Yes ☐  No ☒

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained in this form, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K.  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See 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 ☒

The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2017 was $12,454,213 based on the most recent closing price for the issuer’s Common Stock on such date as reported on the Nasdaq Capital Market.  For purposes of determining this number, all officers and directors of the issuer are considered to be affiliates of the issuer, as well as individual stockholders holding more than 10% of the issuer’s outstanding Common Stock.  This number is provided only for the purpose of this report on Form 10-K and does not represent an admission by either the issuer or any such person as to the status of such person.

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practical date:  Common Stock, $.10 par value — 1,983,553 issued and outstanding as of February 23, 2018.

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amended, relating to future events or the future financial performance of the Company.  In some cases, you can identify forward-looking statements by the following words: “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “ongoing,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would,” or the negative of these terms or other comparable terminology, although not all forward-looking statements contain these words. Forward-looking statements are only predictions or statements of intention subject to risks and uncertainties and actual events or results could differ materially from those projected.  Forward-looking statements are based on information available at the time the statements are made and involve known and unknown risks, uncertainties and other factors that may cause our results, levels of activity, performance or achievements to be materially different from the information expressed or implied by the forward-looking statements in this Annual Report on Form 10-K. Factors that could cause actual results to differ include the risks, uncertainties and other matters set forth below under the caption “Risk Factors” and the matters set forth under the captions “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as those discussed elsewhere in this Annual Report on Form 10-K.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Company’s definitive proxy statement for its 2018 Annual Meeting of Shareholders are incorporated by reference in Part III.

PART I

Item 1.  Business

General

IKONICS Corporation (“IKONICS” or the “Company”) was incorporated in Minnesota as Chroma-Glo, Inc. in 1952 and changed its name to The Chromaline Corporation in 1982.  In December 2002, the Company changed its name to IKONICS Corporation.  The Company’s three traditional businesses, Domestic, IKONICS Imaging and Export, have been the development, manufacture and selling of photosensitive liquids (“emulsions”) and films for the screen printing  awards and recognition industries and dye sublimation markets.  These sales have been augmented with inkjet receptive films, ancillary chemicals and related equipment to provide a full line of products and services to its customers. These products are sold worldwide primarily through distributors.  In 2006, the Company began a major effort to diversify and expand its business to industrial markets. These efforts now include the Company’s Advanced Material Solutions (“AMS”) business unit which uses the Company’s proprietary processes and photoresist film for the abrasive etching of composite materials, industrial ceramics, silicon wafers, and glass wafers.  The customer base for AMS is primarily the aerospace and electronics industries.  Based on its expertise in ultraviolet curable fluids and inkjet receptive substrates, the Company has also developed a patented digital texturing technology (“DTX”) for putting patterns and textures into steel molds for the plastic injection molding industry. The original equipment manufacturer (“OEM”) for the Company’s DTX technology is primarily the automotive industry. The Company offers a suite of products to the mold making industry.  Industrial inkjet printers, which are integral to the DTX system, are manufactured by a third party and sold by IKONICS.  The Company’s business plan is to sell consumable fluids and transfer films.  For most markets, these sales are direct to the mold maker.  The DTX technology is also utilized in prototyping where the Company’s technology offers a unique combination of high definition, large format prints, and abrasion resistance.

Products

The Company has four primary technology platforms: ultraviolet (UV) chemistry, film coating and construction, technical abrasive etching, and industrial inkjet printing. The Company’s traditional products and new initiatives are based on these platforms and their combinations. The Company’s Chromaline branded products for the screen printing industry and IKONICS Imaging products for the awards and recognition market are based on UV chemistry and film coating and construction capabilities; the AMS offering is a combination of UV chemistry, film coating and construction and technical abrasive etching capabilities; DTX is a combination of UV chemistry, film coating and construction, and industrial inkjet printing.  There is overlap and synergy in the market between the Domestic, Ikonics Imaging, AMS and DTX product offerings, and the Company offers ancillary products, including equipment to provide customers with a total solution.  The Company considers this combination of core technologies and product offerings to be unique.

Distribution and Customers

The Company currently has approximately 200 domestic and international distributors for its Chromaline and ImageMate screen printing emulsions and films.  The Company’s abrasive etching products are mainly sold directly to end users in the awards and recognition market under the Ikonics Imaging brand. AMS products are sold either directly to users or the Company offers AMS as a service. DTX includes the sales of consumable inks and films to customers that have purchased specialized industrial inkjet printers from the Company’s strategic partner. DTX sales are both direct to users and through distributors. The Company markets and sells its products through magazine advertising, trade shows and the internet.

The Company has a diverse customer base both domestically and abroad, with international sales accounting for 31.0% of total sales in 2017 and 28.0% of total sales in 2016, and does not depend on one or a few customers for a material portion of its revenues.  In 2017 and 2016, no one customer accounted for more than 10% of net sales.

Quality Control in Manufacturing

In March 1994, IKONICS became the first company in northern Minnesota to receive ISO 9001 certification.  ISO 9000 is a worldwide standard issued by the International Organization for Standardization that provides a framework for quality assurance.  The Company has been recertified every three years beginning in  

1997.  IKONICS’ quality function goal is to train all employees properly in both their work and in the importance of their work.  Internal records of quality, including related graphs and tables, are reviewed regularly and discussions are held among management and employees regarding how improvements might be realized.  The Company has rigorous materials selection procedures and also uses testing procedures to assure its products meet quality standards.

Research and Development and Intellectual Property

The Company incurred costs totaling 4.0% of sales, or $689,000, on research and development in 2017, and 3.7% of sales, or $647,000, in 2016.  In its research program, IKONICS has developed ultraviolet light-sensitive chemistries used in the manufacturing of screen print stencils, photoresists for abrasive etching and acid resist and prototyping ink jet fluids and ink jet receptive films.  The Company has a number of patents and patent applications on these chemistries and applications.  There can be no assurance that any patent granted to the Company will provide adequate protection to the Company’s intellectual property.  Within the Company, steps are taken to protect the Company’s trade secrets, including physical security, confidentiality and non-competition agreements with employees, non-disclosure agreements where applicable, and confidentiality agreements with vendors.  Over the past few years, the Company has directed a larger portion of it research and development resources towards industrial inkjettable fluids and ink jet receptive substrates along with dye sublimation films.  The Company has also invested significant resources for personnel and equipment to develop proprietary products and techniques for the etching of composite materials, industrial ceramics and electronic wafers.

In addition to its patents, the Company has various trademarks including the “IKONICS,” “Chromaline,” “IKONICS Imaging,” “Precision Abrasive Machining,” “SmartFlex,” “PhotoBrasive,” “AccuArt,”  “Nichols,” “image mate,” “Alpha FlexTrace,” “Alpha MicroCap,”, “DTX” and “SubTHAT!” trademarks.

Raw Materials

The primary raw materials used by IKONICS in its production are photopolymers, polyester films, polyvinylacetates, polyvinylalcohols and water.  The Company’s purchasing staff leads in the identification of both domestic and foreign sources for raw materials and negotiates price and terms for all domestic and foreign markets.  IKONICS’ involvement in foreign markets has given it the opportunity to become a global buyer of raw materials at lower overall cost.  The Company has a number of suppliers for its operations.  Some suppliers provide a significant amount of key raw materials to the Company, but the Company believes alternative sources are available for most materials.  For those raw materials where an alternative source is not readily available, the Company has contingency raw material replacement plans.  To date, there have been no significant shortages of raw materials.  The Company believes it has good supplier relations.

Competition

The Company competes in its markets based on product development capability, quality, reliability, availability, technical support and price.  Though the screen printing market is much larger than the awards and recognition market, IKONICS commands significantly more market share in the latter.  IKONICS has two primary domestic competitors in its screen printing film business.  They are larger than IKONICS and possess greater resources than the Company in many areas.  The Company has numerous competitors in the market for screen print emulsions, many of whom are larger than IKONICS and possess greater resources.  The market for the Company’s abrasive etching products in the awards and recognition market has one significant competitor.  IKONICS considers itself to be the leader in this market.  There are significant competitors, using different technologies in the new markets being entered by the Company. The primary competition for AMS is from other machining methods, most of which are well established. The primary competition for DTX comes from old, well-established technologies based on wax and screen printing and new competition from laser technologies.

Government Regulation

The Company is subject to a variety of federal, state and local industrial laws and regulations, including those relating to the discharge of material into the environment and protection of the environment.  The governmental authorities primarily responsible for regulating the Company’s environmental compliance are the Environmental Protection Agency, the Minnesota Pollution Control Agency and the Western Lake Superior Sanitary District.  Failure to comply with the laws promulgated by these authorities may result in monetary sanctions, liability for environmental

clean-up and other equitable remedies.  To maintain compliance, the Company may make occasional changes in its waste generation and disposal procedures.

These laws and regulations have not had a material effect upon the capital expenditures or competitive position of the Company.  The Company believes that it complies in all material respects with the various federal, state and local regulations that apply to its current operations.  Failure to comply with these regulations could have a negative impact on the Company’s operations and capital expenditures and such negative impact could be significant.

The Company also is subject to regulations from foreign governments covering the importation of certain chemicals. The Company believes that it complies in all material respects with these regulations that apply to its current products.  Failure to comply with these regulations could have a negative impact on the Company’s operations and capital expenditures and such negative impact could be significant.

Employees

As of February 23, 2018, the Company had 83 full-time employees, 78 of whom are located at the Company’s two facilities in Duluth, Minnesota and five of whom are outside technical sales representatives in various locations in the United States.  None of the Company’s employees are subject to a collective bargaining agreement and the Company believes that its employee relations are good.

Item 1A.  Risk Factors

The Company’s DTX and AMS initiatives involve new technologies that might not be executed successfully and might not achieve market acceptance.

The Company’s DTX and AMS initiatives involve new technologies that might never achieve market acceptance.  During 2017 and 2016, the Company generated operating losses in its AMS segment while DTX realized operating income for the first time in 2015 and was profitable again in 2016 and 2017.  The Company’s ability for generating profits from these initiatives will depend on its products gaining market acceptance among customers, which cannot be guaranteed.  The degree of market acceptance of any new products the Company develops will depend on a number of factors, including:

If new products that the Company develops do not have the capabilities the Company expects or fail to achieve an adequate level of acceptance by customers for any reason, then the Company’s AMS and DTX business units could fail to generate the revenues the Company expects and may not become profitable or sustain profitability.

If the Company’s new products and technologies do not achieve market acceptance, the Company will not realize a return on its investments in its new business initiatives.

The Company has invested, and plans to continue to invest, significant resources in its research and development efforts to develop technology for its AMS and DTX business units.  The Company spent 4.0% of sales, or $689,000, on research and development in 2017 and 3.7% of sales, or $647,000, in 2016.  A substantial portion of these investments was in the Company’s AMS and DTX initiatives.  The Company plans to continue to invest significant resources in research and development on these initiatives for the foreseeable future.  The Company believes successful

execution of these initiatives is important for its ability to grow its revenues and profits.  However, if the Company fails to generate its projected revenues in these business units, the Company’s investments in these areas would not generate the profits the Company expects and its results of operations, financial condition and prospects would be materially and adversely affected.

Adverse changes to global economic conditions generally, and to the aerospace and automotive industries in particular, may harm the Company’s business.

The prospects for economic growth in the United States and other countries remain uncertain and major economies where the Company conducts business could continue or return to recessionary conditions.  Economic concerns and issues such as reduced access to capital for businesses may cause the Company’s customers to delay or reduce purchases of the Company’s products.  Given the continued uncertainty concerning the global economy, the Company also faces risks that may arise from financial difficulties experienced by suppliers and customers, such as an inability to collect receivables or the continued operation of suppliers.

The Company’s AMS segment focuses primarily on customers in the aerospace industry, and its DTX segment focuses primarily on customers in the automotive industry.  The aerospace and automotive industries have experienced volatility in prior years in a manner similar to or greater than the global economy generally.  If either or both these industries experiences difficulties that reduce demand for their products generally, the Company’s results of operations, financial condition and prospects would suffer.

The Company faces significant competition and expects to face increasing competition in many aspects of its businesses, which could cause operating results to suffer.

The Company operates in highly competitive industries that experience rapid technological and market developments, changes in customer needs, and frequent product introductions and improvements, particularly with respect to the AMS and DTX businesses.  If the Company is unable to anticipate and respond to these developments, its products or technologies could become uncompetitive or obsolete.  Most of the Company’s competitors in the AMS and DTX fields are larger and better capitalized than the Company with longer operating histories.  These advantages could allow the Company’s competitors to invest more resources in research and development and sales and marketing than the Company, which could make the competitive products more attractive or better known to consumers than the Company’s products.  In addition, because there is potential for rapid technological change in fields in which the Company operates, the Company could face competition from new sources in the future that customers find more attractive.

The Company also could face increased competition in its traditional Domestic and IKONICS Imaging units.  Capital costs for machinery necessary to operate in these industries have decreased in recent years, increasing the possibility that the Company will face new competitors.  An increase in the amount of competition the Company faces, or a loss of competitiveness in any of the Company’s business units for any reason, could adversely affect its revenues and gross margins.

The Company’s failure to comply with environmental laws and regulations could harm its business and results of operations.

The manufacturing of the Company’s products requires the use of hazardous materials that are subject to a broad array of environmental laws and regulations.  The Company’s failure to comply with these laws or regulations could result in:

The Company’s failure to manage the use, transportation, emissions, discharge, storage, recycling or disposal of hazardous materials could lead to increased costs or future liabilities.  Environmental laws and regulations also could require the Company to acquire pollution abatement or remediation equipment, modify product designs or incur other expenses.

Third parties may claim the Company infringes their intellectual property rights, which could harm the Company’s business.

The Company may face claims that it infringes other parties’ intellectual rights.  Regardless of a claim’s merit, claims that the Company’s products or processes infringe the intellectual property rights of others could cause the Company to incur large costs to respond to, defend, and resolve the claims, and they may divert the efforts and attention of management and technical personnel.  As a result of any intellectual property rights infringement claims, the Company could be required to:

These actions could harm the Company’s competitive position, result in additional expenses, or require the Company to impair its assets.  If the Company alters or stops production of affected items, its ability to generate revenue could be harmed.

The Company may be unable to enforce or protect its intellectual property rights, which may harm its ability to compete and may harm its business.

The Company’s ability to enforce its patents, trademarks and other intellectual property rights is subject to general litigation risks, as well as uncertainty as to the enforceability of the Company’s intellectual property rights in various countries.  If the Company seeks to enforce its rights, it could become subject to claims that its intellectual property rights are invalid, not enforceable, or licensed to the opposing party.  The Company’s assertion of intellectual property rights also could result in the other party seeking to assert claims against the Company, which could harm the Company’s business.  The Company’s inability to enforce its intellectual property rights for any reason could harm its competitive position and business.

If the Company is unable to protect the confidentiality of its proprietary information and know-how, the value of its technology could be adversely affected.

In addition to patented technology, the Company relies on unpatented proprietary technology, trade secrets, processes and know-how.  The Company generally seeks to protect this information by confidentiality agreements with employees, consultants, advisors and third parties.  These agreements may be breached, and the Company may not have adequate remedies for any such breach.  In addition, the Company’s trade secrets may otherwise become known or be independently developed by competitors.  To the extent that the Company’s employees, consultants or contractors use intellectual property owned by others in their work for the Company, disputes may arise as to the rights in related or resulting know-how and inventions.

The Company operates a global business that exposes it to additional risks.

The Company operates throughout the world, including in the United States, Europe and China.  These international operations create a variety of risks and uncertainties, including:

The occurrence of any one of these risks could negatively affect the Company’s international business and, consequently, its results of operations generally.

The Company faces risks related to sales through distributors and other third parties.

During 2017, a significant portion of the Company’s sales, including nearly all sales of its Domestic products and nearly all of its International sales, were conducted through third parties.  Using third parties for distribution exposes the Company to many risks, including competitive pressure, concentration, credit risk and compliance risks.  Distributors may sell products that compete with the Company’s products, and the loss of a distributor could reduce the Company’s revenue.  Distributors may face financial difficulties, including bankruptcy, which could harm the Company’s collection of accounts receivable and financial results.  Violations of the FCPA or similar laws by distributors or other third-party intermediaries could have a material impact on the Company’s business.  Failing to manage risks related to the Company’s use of distributors may reduce sales, increase expenses, and weaken its competitive position.

Increases in prices and declines in the availability of raw materials could negatively impact the Company’s financial results.

Certain raw materials needed to manufacture products are obtained from a limited number of suppliers and many of the raw materials are petroleum-based.  Under normal market conditions, these raw materials are generally available on the open market from a variety of producers.  While alternate supplies of most key raw materials are available, supplier production outages may lead to strained supply-demand situations for certain raw materials.  The substitution of key raw materials could require the Company to identify new supply sources, or reformulate and retest products or processes.  From time to time, the prices and availability of these raw materials may fluctuate, which could impair the Company’s ability to procure necessary materials, or increase the cost of manufacturing products.  If the prices of raw materials increase in a short period of time, the Company may be unable to pass these increases on to its customers in a timely manner or at all, which could reduce its gross margins.  Like most companies in the Company’s industries, the Company does not have long-term supply contracts for most of its key raw materials, which exacerbates the foregoing risks to the Company.

If any of the Company’s present single or limited source suppliers become unavailable or inadequate, its customer relationships, results of operations and financial condition may be adversely affected.

The Company acquires certain of its materials that are critical to its operations from a limited number of third parties.  Should any of the Company’s current single or limited source suppliers become unavailable or inadequate, or impose terms unacceptable to the Company such as increased pricing terms, the Company could be required to spend a significant amount of time and expense to develop alternate sources of supply, and may not be successful in doing so on acceptable terms or at all.  If the Company is unable to find a suitable supplier for a particular material, it could be required to modify its existing business processes or offerings to accommodate the situation.  As a result, the loss of a single or limited source supplier could adversely affect the Company’s relationship with its customers and its results of operations and financial condition.

The Company depends on one manufacturer to make and sell DTX printers. If the manufacturer ceased to make or sell DTX printers, or failed to meet quality standards, the Company’s financial results and prospects would be adversely affected.

The Company relies on one company to manufacture and sell DTX printers.  If the manufacturer ceased to produce or devote resources to selling DTX printers, due to a change in company strategy, to focus on alternative initiatives, or for any other reason, the Company would need to find an alternative manufacturer and seller of DTX printers.  Finding an alternative manufacturer and seller of DTX printers could result in additional costs and delays in growing the Company’s DTX business unit, which would adversely affect the Company’s financial results and prospects.

In addition, if these manufacturers failed to produce DTX printers that satisfy the Company’s quality standards, the Company’s reputation with end users could be harmed and the Company could be forced to find a new manufacturer.  Either of these results also would harm the Company’s business and prospects.

The inability to attract and retain qualified personnel could adversely impact the Company’s business.

Sustaining and growing the Company’s business depends on the recruitment, development and retention of qualified employees, including management and research and development personnel.  The inability to recruit and retain key personnel or the unexpected loss of key personnel may adversely affect the Company’s operations.

An active trading market for the Company’s shares of common stock may not develop.

The Company’s common stock has been listed for trading on the Nasdaq Capital Market since 1999 and persistently has experienced limited trading volume.  There can be no assurance that an active public market for the Company’s shares will develop or be sustained.  The lack of an active trading market could adversely affect the price and liquidity of the Company’s common stock.

The Company’s directors and officers own a large percentage of the Company’s common stock, which may allow them to collectively exert significant influence over substantially all matters requiring shareholder approval.

As of December 31, 2017, the Company’s directors and officers collectively beneficially owned approximately 14.0% of its common stock outstanding as of that date.  As a result, the Company’s directors and officers could exert significant influence over all matters requiring a shareholder vote, including the election of directors, amendments to the Company’s articles of incorporation, and extraordinary transactions such as mergers or going private transactions.  These ownership positions may have the effect of delaying, deterring or preventing a change in control or a change in the composition of the Company’s board of directors.  In addition, substantial sales of shares beneficially owned by our directors or officers could be viewed negatively by third parties and have a negative impact on the Company’s stock price.

The price of the Company’s common stock may fluctuate significantly.

The price of the Company’s common stock has, and could continue to, fluctuate substantially in a short period of time.  The price of the Company’s common stock could vary for many reasons, including the following:

In addition, stock markets in general have experienced price and volume fluctuations in recent years, fluctuations that sometimes have been unrelated to the operating performance of the affected companies.  These broad market fluctuations may adversely affect the market price of the Company’s common stock.  The market price of the Company’s common stock could decline below its current price and the market price of the Company’s shares may fluctuate significantly in the future.  These fluctuations may be unrelated to the Company’s performance.

The terms of our financing agreement contain certain financial ratio covenants that may impair our ability to conduct our business.

On April 1, 2016, we entered into a financing agreement with the Duluth Economic Development Authority and Wells Fargo Bank, N.A. to borrow $3.4 million. The proceeds from the loan were used to finance the construction of a 27,300-square foot building, as well as related equipment for use in our manufacture of sound deadening technology used in the aerospace industry and products consisting of etched composites, ceramics, glass and silicon wafers, to be located in Duluth, Minnesota. We are subject to certain customary covenants set forth in the associated covenant agreement, including a requirement that we maintain a debt service coverage ratio as of the end of each calendar quarter of not less than 1.25 to 1.00 on a rolling four-quarter basis. In the event of a breach of a covenant, we would need to obtain a waiver from the lender or the lender may cancel the financing agreement and accelerate the full amount of outstanding indebtedness.  We were in compliance with the covenants, including the debt service ratio covenant, as of December 31, 2017, but our ability to comply with these covenants in the future will depend on future operating performance and we may not meet them. In the event that we fall out of compliance with these covenants and we are unable to obtain a waiver and the indebtedness is accelerated, it would have an adverse effect on our financial condition and future operating performance and could limit our ability to invest in other business activities.

We heavily rely on our information technology systems and are vulnerable to damage and interruption.

We rely on our information technology systems and infrastructure to process transactions and manage our business, including maintaining employee, client and supplier information.  We have also engaged third parties, including cloud providers, to store, transfer and process data.  Our information technology systems, as well as the systems of our customers, suppliers and other partners, are vulnerable to outages and an increasing risk of deliberate intrusions to gain access to and exploit company sensitive information. Similarly, data security breaches by employees and others with or without permitted access to our systems pose a risk that sensitive data may be exposed to unauthorized persons or to the public. We may be unable to prevent outages or security breaches in our systems that could adversely affect our results of operations and cause reputational harm.

The Company’s operating results and financial condition may fluctuate on a quarterly and annual basis.

The Company’s operating results and financial condition may fluctuate from quarter to quarter and year to year, and could vary due to a number of factors, some of which are outside of the Company’s control.  In addition, the Company’s actual or projected operating results may fail to match its past performance.  The Company’s operating results and financial condition may fluctuate due to a number of factors, including those listed below and those identified throughout this “Risk Factors” section:

Due to all of the foregoing factors and the other risks discussed in this “Risk Factors” section, you should not rely on quarter-to-quarter or year-to-year comparisons of the Company’s operating results as an indicator of future performance.

Item 1B. Unresolved Staff Comments

None

Item 2.  Property

The Company primarily conducts its operations in Duluth, Minnesota.  The administrative, sales, research and development, quality and most of the manufacturing activities are housed in a 60,000 square-foot, four-story building, including a basement level.  The building is approximately seventy years old and has been maintained in good condition.  The Company also utilizes a 5,625 square-foot warehouse adjacent to the existing plant building that was constructed in 1997.  These facilities are owned by the Company with no existing liens or leases.  The Company also owns an approximately 11-acre property with a 62,300 square-foot manufacturing and warehouse facility.  The 62,300 square-foot facility is comprised of a 35,000 square-foot warehousing and manufacturing facility constructed in 2008 and a 27,300 square-foot expansion completed in 2016 to accommodate the Company’s AMS business. The entire facility on the 11-acre property is collateral on the Company’s $3.4 million loan.

Item 3.  Legal Proceedings

None.

Item 4.  Mine Safety Disclosures

Not applicable.

PART II

Item 5.  Market for Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The Company’s Common Stock is traded on the Nasdaq Capital Market under the symbol IKNX.  The following table sets forth, for the fiscal quarters indicated, the high and low sales prices for the Company’s Common Stock as reported on the Nasdaq Capital Market for the periods indicated.

As of February 23, 2018, the Company had 534 shareholders.  The Company has not declared cash dividends in the past two years and does not currently have plans to pay any cash dividends in the future. Any future declaration and payment of dividends is within the sole discretion of the Company’s board of directors.

 The Company repurchased shares as indicated in the table below during the fourth quarter of  2017(1): 

Item 6. Selected Financial Data

Not applicable

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following management discussion and analysis focuses on those factors that had a material effect on the Company’s financial results of operations and financial condition during 2017 and 2016 and should be read in conjunction with the Company’s audited financial statements and notes thereto for the years ended December 31, 2017 and 2016, included herein.

Critical Accounting Policies and Estimates

The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America.  Therefore, the Company is required to make certain estimates, judgments and assumptions that the Company believes are reasonable based upon the information available.  These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented.  The accounting policies and estimates which IKONICS believes are the most critical to aid in fully understanding and evaluating its reported financial results include the following:

Revenue Recognition.  The Company recognizes revenue on sales of products when title passes, which can occur at the time of shipment, or when the goods arrive at the customer location depending on the agreement with the customer.  The Company sells its products to both distributors and end-users.  Sales to distributors and end-users are recorded based upon the criteria governed by the sales, delivery, and payment terms stated on the invoices from the Company to the purchaser.  In addition to transfer of title / risk of loss, all revenue is recorded in accordance with the criteria outlined within SAB 104 and FASB ASC 605, Revenue Recognition:

(a) persuasive evidence of an arrangement (principally in the form of customer sales orders and the Company’s sales invoices);

(b) delivery and performance (evidenced by proof of delivery, e.g. the shipment of film and substrates with bill of lading used for proof of delivery for FOB shipping point terms, and the carrier booking confirmation report used for FOB destination terms).  Once the finished product is shipped and physically delivered under the terms of the invoice and sales order, the Company has no additional performance or service obligations to complete;

(c) a fixed and determinable sales price (the Company’s pricing is established and is not based on variable terms, as evidenced in either the Company’s invoices or the limited number of distribution agreements; the Company rarely grants extended payment terms and has no history of concessions); and

(d) a reasonable likelihood of payment (the Company’s terms are standard, and the Company does not have a substantial history of customer defaults or non-payment).

Sales are reported on a net basis by deducting credits, estimated normal returns and discounts.  The Company’s return policy does not vary by geography.  The customer has no rotation or price protection rights and the Company is not under a warranty obligation.  Freight billed to customers is included in sales.  Shipping costs are included in cost of goods sold.

Trade Receivables.  The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history and the customer’s current credit worthiness, as determined by review of the current credit information.  The Company continuously monitors collections and payments from its customers and maintains a provision for estimated credit losses based upon historical experience and any specific customer collection issues that have been identified.  While such credit losses have historically been within expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same collection history that has occurred in the past.  The general payment terms are net 30-45 days for domestic customers and net 30-90 days for foreign customers.  A small percentage of the trade receivables balance is denominated in a foreign currency with no concentration in any given country.  At the end of each reporting period, the Company analyzes the receivable balance for customers paying in a foreign currency.  These balances are adjusted to each quarter or year-end spot rate.  The Company also maintains a provision based upon historical experience and any specifically identified issues for any customer related returns, refunds or credits.

Inventories.  Inventories are valued at the lower of cost or market value using the last in, first out (LIFO) method.  The Company monitors its inventory for obsolescence and records reductions from cost when required.

Income Taxes.  Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are

recognized for taxable temporary differences.  Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. 

Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. 

The Tax Cut and Jobs Act of 2017 (the “Tax Reform Act”) was enacted December 22, 2017.  This legislation makes significant changes in U.S. tax law including a reduction in the corporate tax rates, changes to net operating loss carryforwards and carrybacks and a repeal of the corporate alternative minimum tax. The legislation reduced the U.S. corporate tax rate from the current rate of 34% and 35% to 21%. As a result of the enacted law, the Company was required to revalue deferred tax assets and liabilities at the newly enacted rate. This revaluation resulted in a benefit of $115,000 to income tax expense in continuing operations and a corresponding reduction in the deferred tax liability. The other provisions of the Tax Reform Act did not have a material impact on the 2017 consolidated financial statements.

Results of Operations

Year Ended December 31, 2017 Compared to Year Ended December 31, 2016

Sales.  Sales decreased 1.9% in 2017 to $17.2 million, compared to $17.6 million in 2016.  A more competitive market for artwork film sales along with overall soft market conditions resulted in a decrease in Domestic sales from $7.4 million in 2016 to $6.9 million in 2017.  Compared to 2016, IKONICS Imaging sales decreased by $231,000 to $4.0 million in 2017 as sales were negatively affected by some customers moving to competing technologies.  The IKONICS Imaging sales variance was also impacted by a large initial order from a new customer received in 2016.  Partially offsetting these sales decreases in 2017, IKONICS Imaging realized sales of $258,000 for its newly introduced SubTHAT!™ film.  AMS sales decreased by $296,000, or 28.4%, in 2017 versus 2016 due to the temporary decrease in orders from AMS’s largest customer during the second quarter of 2017.  Beginning in the third quarter of 2017, the customer resumed its normal order pattern, which is expected to continue in 2018.   Partially offsetting these sales decreases was a $413,000, or 101.9% increase in DTX due to the sale of two DTX printers and improved consumable sales.  Export sales also realized a $214,000, or 4.8%, sales increase in 2017 compared to 2016 due to improved sales to Asia.

Gross Profit.    Gross profit was $5.7 million, or 33.2% of sales, in 2017 compared to $6.2 million, or 35.5% of sales, in 2016.  The gross profit as a percentage of sales decreased due to lower sale volumes and a less favorable sales mix.  Low margin Export sales comprised 27.4% of total 2017 sales compared to 25.7% of total sales in 2016 while higher margin IKONICS Imaging sales comprised 23.3% of total sales in 2017 versus 24.2% of total sales in 2016.  The gross margin percentage in 2017 was also unfavorably impacted by the sale of two low margin DTX printers and the temporary decrease in AMS sales in 2017.

Selling, General and Administrative Expenses.  Selling, general and administrative expenses were $5.5 million, or 31.9% of sales, in 2017 compared to $5.6 million, or 31.9% of sales, in 2016.  The decrease in selling, general and administrative expenses reflects lower health insurance expenses in 2017. IKONICS utilizes a self-funded medical insurance plan and can experience fluctuations in medical insurance costs.  The Company mitigates part of the risk under this self-funded plan by purchasing both specific and aggregate stop-loss insurance coverage.  The decrease in selling, general and administrative expenses also reflects lower travel expenses.  These expense decreases were partially offset by increased trade show expenses along with higher international sales consulting expenses.

Research and Development Expenses.  Research and development expenses in 2017 were $689,000, or 4.0% of sales, versus $647,000, or 3.7% of sales in 2016. The increase in expenses in 2017 was due to patent-related legal expenses along with increased production trial expenses.

Income Taxes.  During 2017, the Company realized an income tax benefit of $298,000, or an effective rate of 56.8%, compared to income tax benefit of $4,000, or an effective rate of 5.8%, for the same period in 2016.  The increase  to income tax benefit in 2017 from 2016 is primarily due to a benefit of $115,000 related to the favorable impact of a revaluation of the Company’s deferred tax liability as a result of the Tax Reform Act as well as a higher pre-tax book loss generated in 2017 compared to the pre-tax book loss generated in 2016.  Additionally, differences between effective tax rate and the statutory tax rate are related to credits for research and development, and other non-deductible items.

Liquidity and Capital Resources

Outside of the 2016 building expansion, for which $3.4 million in financing was obtained, the Company has financed its operations principally with funds generated from operations.  These funds have been sufficient to cover the Company’s normal operating expenditures, annual capital requirements, and research and development expenditures.

Cash and cash equivalents were $930,000 and $1.0 million at December 31, 2017 and 2016, respectively.  In addition to its cash, the Company held $2.9 million and $3.2 million of short-term investments as of December 31, 2017 and 2016, respectively.  The Company generated $205,000 in cash from operating activities during 2017, compared to generating $917,000 of cash from operating activities in 2016.  Cash provided by operating activities is primarily the result of the net loss adjusted for non-cash depreciation and amortization, deferred taxes, and certain changes in working capital components discussed in the following paragraph.

During 2017, improved collections resulted in a $146,000 trade receivables decrease.  Inventories increased by $100,000 related to an increase in finished goods inventories compared to 2016.  Accounts payable decreased from 2016 to 2017 by $409,000 due to the timing of payments to and purchases from vendors, mainly related to raw materials.  Prepaid expenses and other assets decreased $194,000 from 2016 to 2017.  The decrease is mainly related to 2016 prepayments on equipment being manufactured that was sold in 2017.  Compared to 2016, accrued expenses decreased $33,000 reflecting the timing of compensation payments.  Income taxes receivables decreased $64,000 due to the timing of estimated 2017 tax payments compared to the calculated 2017 tax liability.

During 2016, inventories decreased by $134,000 related to a decrease in raw material inventories compared to 2015.  The timing of collections resulted in a $171,000 trade receivables increase in 2016 versus 2015.  Accounts payable increased from 2015 to 2016 by $310,000 due to the timing of payments to and purchases from vendors.  Prepaid expenses and other assets increased $276,000 from 2015 to 2016.  The increase is mainly related to prepayments on equipment manufactured in 2016 that were completed and sold in 2017.  Compared to 2015, accrued expenses increased $74,000 reflecting the timing of compensation payments and an increase in the accrual for medical expenses.  Income taxes receivable decreased $37,000 due to the timing of estimated 2016 tax payments compared to the calculated 2016 tax liability.

During 2017, cash provided by investing activities was $115,000.  The Company purchased 16 certificates of deposits totaling $3.9 million.  Eighteen certificates of deposits totaling $4.2 million matured during 2017.  The Company’s purchases of property and equipment of $230,000 in 2017 were mainly for improvements to production and process capabilities and two vehicles. Also, during 2017, the Company incurred $39,000 in patent application costs that the Company has recorded as an asset and will amortize upon successful completion of the application process.  In addition, the Company sold three vehicles for $33,000. 

During 2016, cash used in investing activities was $5.3 million.  The Company purchased 19 certificates of deposits totaling $4.4 million.  Five certificates of deposits totaling $1.1 million matured during 2016.  The Company’s cash purchases of property and equipment were $2.1 million in 2016.  Total building expansion expenditures for 2016 were $1,393,000.  Expenditures on the new ERP system in 2016 were $281,000.  The remaining capital expenditures were mainly for upgrades to improve AMS production and process capabilities. Also during 2016, the Company incurred $27,000 in patent application costs that the Company records as an asset and amortizes upon successful completion of the application process.  In addition, the Company sold equipment for $21,000. 

Related to the Company’s loan, the Company made principal payments of $140,000 in 2017.  During 2017, the Company received $2,000 from financing activities from the issuance of 250 shares of common stock due to the exercise of stock options, while the Company repurchased 35,450 shares of its own stock for $300,000. 

During 2016, the Company received $3.2 million from financing activities.   The Company secured a loan of $3.4 million in which the proceeds were used to finance the expansion of its AMS facility.  Related to securing the loan, the Company paid $139,000 in debt issuance costs and made principal payments of $79,000.   During 2016, the Company received $4,000 from the issuance of 500 shares of common stock pursuant to the exercise of stock options. 

On April 1, 2016, the Company entered into a financing agreement to borrow $3.4 million.  The proceeds from the loan were used to finance the construction of a 27,300-square foot building, as well as related equipment for use in the Company’s manufacture of sound deadening technology used in the aerospace industry and products consisting of

etched composites, ceramics, glass and silicon wafers, to be located in Duluth, Minnesota.  The Loan requires monthly payments of approximately $18,000, including interest. The Loan bears interest at a rate of 2.14% per year, subject to change based upon changes to the maximum federal corporate tax rate, payable monthly, and matures on April 1, 2041.  The Loan is subject to mandatory purchase provisions, under which any owners of the Bonds (the “Owners”) may tender the Bonds to the Issuer on April 1, 2021, which would result in the Company repaying the outstanding loan principal and any outstanding accrued and unpaid interest to the Issuer at that time. If in the event the Bonds are not repurchased on April 1, 2021, the Bonds shall be subject to the interest rate and redemption provisions set forth in the associated covenant agreement.  Including debt costs of approximately $139,000, the Loan’s effective annual interest rate was 2.77% at December 31, 2017.  As a result of the Tax Reform Act described above, the Company estimates the future effective interest rate will be approximately 3.23% beginning in March 2018, resulting in an approximate $15,000 increase in interest payments annually.  The Company is subject to certain customary covenants set forth in the associated covenant agreement, including a requirement that the Company maintain a debt service coverage ratio as of the end of each calendar quarter of not less than 1.25 to 1.00 on a rolling four-quarter basis.  The Company was in compliance with the required debt service coverage ratio as of December 31, 2017 and 2016.

A bank line of credit exists providing for borrowings of up to $2,050,000 and expires on June 30, 2019.  The line of credit is collateralized by the Company’s assets and bears interest at 1.8 percentage points over the 30‑day LIBOR rate.  The Company did not utilize this line of credit during 2017 or 2016, and there were no borrowings outstanding as of December 31, 2017 and 2016.  There are no financial covenants related to the line of credit. 

The Company believes that current financial resources, its line of credit, cash generated from operations and secured through debt financing, and short term investments, along with the Company’s capacity for additional debt and/or equity financing will be sufficient to fund current and anticipated business operations.  The Company also believes that it is unlikely that a decrease in demand for the Company’s products would impair the Company’s ability to fund operations given its excess cash and available line of credit.

Capital Expenditures

In 2017, the Company incurred $230,000 of capital expenditures which were mainly for improvements to production and process capabilities and two vehicles. In 2016, the Company incurred $1.7 million of capital expenditures.  A majority of the expenditures were related to the AMS building expansion.  The remaining capital expenditures were for upgrades to improve AMS production and process capabilities, as well as for a new ERP system. 

The Company expects capital expenditures in 2018 of approximately $658,000.  The planned expenditures primarily will be to upgrade the heating, cooling and ventilation system at the Company’s main facility and manufacturing equipment to improve processes and capabilities.  These commitments are expected to be funded with cash generated from operating activities.

International Activity

The Company markets its products in numerous countries in various regions of the world, including North America, Europe, Latin America, and Asia.  The Company’s 2017 foreign sales of $5.4 million were approximately 30.5% of total sales, compared to the 2016 foreign sales of $4.9 million, which were 28.0% of total sales.  The Company realized an increase in foreign sales due to the sale of two DTX printers into Europe and improved consumable sales to Asia.

The Company’s foreign transactions are primarily negotiated, invoiced and paid in U.S. dollars, though a portion is transacted in Euros.  IKONICS has not implemented an economic hedging strategy to reduce the risk of foreign currency translation exposures, which management does not believe to be significant based on the scope and geographic diversity of the Company’s foreign operations.  Furthermore, the impact of foreign exchange on the Company’s balance sheet and operating results was not material in either 2017 or 2016.

Future Outlook

IKONICS has spent an average of approximately 4.0% of annual sales in research and development and has made capital expenditures related to new products and programs.  The Company plans to maintain its efforts in these

areas to expedite internal product development as well as to form technological alliances with outside entities to commercialize new product opportunities.

The Company continues to make progress on its AMS business initiative.  Although AMS experienced a short-term drop in sales during 2017 due to temporary inventory overstocking by a major customer, these sales have returned to expected levels, and the Company anticipates continued growth over the long term.  The Company has two long-term sales agreements in place for its technology with major aerospace companies and is negotiating a third.  In anticipation of this growing business, the Company increased its AMS capacity with a 27,300 square foot expansion at its Morgan Park site in 2016.

The Company is also continuing to pursue DTX-related business initiatives and expects increased consumable sales as a result of the sale of two DTX printers in 2017.  In addition to making efforts towards growing the inkjet technology business, the Company offers a range of products for creating texture surfaces and has introduced a fluid for use in prototyping.  The Company is currently working on production improvements to enhance its customer offerings.  The Company has been awarded European, Japanese, and United States patents on its DTX technologies.  The Company has also modified its DTX technology to facilitate entry into the market for prototyping. 

Both the Domestic and IKONICS Imaging units remain profitable in mature markets. Although these business units require aggressive strategies to grow market share, both are developing new products and business relationships that we believe will contribute to growth.  In October 2017, the Company introduced SubTHAT!™, a patent-pending product for the dye-sublimation market.  Response to SubTHAT!™ has been very encouraging, with the Company realizing SubTHAT!™ sales of $258,000 in the fourth quarter of 2017.  In addition to its traditional emphasis on domestic markets, the Company will continue efforts to grow its business internationally by attempting to develop new markets and expanding market share where it has already established a presence. However, the strong U.S. dollar has made this challenging.

Other future activities undertaken to expand the Company’s business may include acquisitions, building improvements, equipment additions, new product development and marketing opportunities.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements.

Recent Accounting Pronouncements

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers.  ASU 2014‑09 supersedes the revenue recognition requirements in Revenue Recognition (Topic 605), and requires entities to recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services.  In August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers: Deferral of the Effective Date, which defers the adoption of ASU 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. The standard permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the modified retrospective method).  The standard also requires expanded disclosures relating to the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Additionally, qualitative and quantitative disclosures are required about customer contracts, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. 

The Company will adopt the provisions of ASU 2014-09 on January 1, 2018 using the modified retrospective method.  While most of the Company’s revenue is contracted with customers through one-time purchase orders and short-term contracts, the Company does have long-term contracts with certain customers.  The Company is nearly complete with its evaluation of the effect of adoption on its financial statements, and will expand its financial statement disclosures in future periods in order to comply with the new standard.  For the revenue streams assessed, the Company does not anticipate any adjustments regarding the timing of recognizing revenue as a result of the adoption.  The

Company does not incur upfront costs to obtain a contract and, upon adoption, the Company will elect to treat delivery costs as a fulfillment activity that are expensed as incurred. 

During February 2016, the FASB issued ASU No. 2016-02, Leases. ASU No. 2016-02 was issued to increase transparency and comparability among organizations by recognizing all lease transactions (with terms in excess of 12 months) on the balance sheet as a lease liability and a right-of-use asset (as defined). ASU No. 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with earlier application permitted.  Upon adoption, the lessee will apply the new standard retrospectively to all periods presented or retrospectively using a cumulative effect adjustment in the year of adoption. The Company does not expect the adoption of ASU No. 2016-02 to have a material impact on its financial statements.

In March 2016, the FASB issued ASU No. 2016-09, Compensation—Stock Compensation (Topic 718). This standard makes several modifications to Topic 718 related to the accounting for forfeitures, employer tax withholding on share-based compensation and the financial statement presentation of excess tax benefits or deficiencies. ASU 2016-09 also clarifies the statement of cash flows presentation for certain components of share-based awards. The standard is effective for interim and annual reporting periods beginning after December 15, 2016, although early adoption is permitted.  The Company adopted ASU No. 2016-09 in 2017 with minimal impact on the financial statements.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Not applicable

Item 8.  Financial Statements

Report of Independent Registered Public Accounting Firm

To the Stockholders and the Board of Directors of IKONICS Corporation

Opinion on the Financial Statements

We have audited the accompanying balance sheets of IKONICS Corporation (the Company) as of December 31, 2017 and 2016, the related statements of operations, stockholders' equity and cash flows for the years then ended, and the related notes to the financial statements (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

Basis for Opinion

These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion.

Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

IKONICS CORPORATION

BALANCE SHEETS

DECEMBER 31, 2017 AND 2016

See notes to financial statements.

IKONICS CORPORATION

STATEMENTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 2017 AND 2016

See notes to financial statements.

IKONICS CORPORATION

STATEMENTS OF STOCKHOLDERS’ EQUITY

YEARS ENDED DECEMBER 31, 2017 AND 2016

See notes to financial statements.

IKONICS CORPORATION

STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31, 2017 AND 2016

See notes to financial statements.

IKONICS CORPORATION

NOTES TO FINANCIAL STATEMENTS

YEARS ENDED DECEMBER 31, 2017 AND 2016

1.          SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business and Foreign Export Sales - IKONICS Corporation’s (the Company or IKONICS) traditional business has been the development and manufacturing of high-quality photochemical imaging systems for sale primarily to a wide range of printers and decorators of surfaces.  Customers’ applications are primarily screen printing and abrasive etching. These sales have been augmented with inkjet receptive films, ancillary chemicals and related equipment to provide a full line of products and services to its customers. Leveraging these technologies the Company is also diversifying and expanding its business to industrial markets. These efforts also include the Company’s Advanced Material Solutions (AMS) business unit which uses the Company’s proprietary process and photoresist film for the abrasive etching of composite materials, industrial ceramics, silicon wafers, and glass wafers. The customer base for AMS is primarily the aerospace and electronics industries. Based on its expertise in ultraviolet curable fluids and inkjet receptive substrates, the Company has also developed a patented digital texturing technology (DTX) for putting patterns and textures into steel molds for the plastic injection molding industry. The original equipment manufacturer (“OEM”) for the Company’s DTX technology is primarily the automotive industry. Industrial inkjet printers, which are integral to the DTX system, are manufactured and sold by a strategic partner. The Company’s business plan is to sell a suite of products including consumable fluids and transfer films. For most markets these sales are direct to the mold maker. The DTX technology is being expanded to prototyping where the Company’s technology offers a unique combination of high definition and large format prints. The Company’s principal markets are throughout the United States.  In addition, the Company sells to Europe, Latin America, Asia, and other parts of the world.  The Company extends credit to its customers, all on an unsecured basis, on terms that it establishes for individual customers.

Foreign sales approximated 31.0% and 28.0% of net sales in 2017 and 2016, respectively.  The Company’s trade receivables at December 31, 2017 and 2016 due from foreign customers were 25.5% and 23.6% of total trade receivables, respectively.  The foreign export receivables are comprised primarily of open credit arrangements with terms ranging from 30 to 90 days.  No single customer or foreign country represented greater than 10% of net sales in 2017 or in 2016.

The Company considers events or transactions that occur after the balance sheet date but before the financial statements are issued to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure.

A  summary of the Company’s significant accounting policies follows:

Cash Equivalents — The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents.  Cash equivalents consist of money market funds in which the carrying value approximates fair value because of the short maturity of these instruments.  The money market fund invests in United States dollar denominated securities that present minimal credit risk and consist of investments in debt securities issued or guaranteed by the United States government or by United States government agencies or instrumentalities, repurchase agreements fully collateralized by the United States Treasury, and United States government securities.

Short-Term Investments — Short-term investments consist of fully insured certificates of deposit with original maturities ranging from one to twelve months as of both December 31, 2017 and 2016. 

Trade Receivables — Trade receivables are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on an on-going basis.  Management determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customer’s financial condition, credit history, and current economic conditions.  Trade receivables are written off when deemed uncollectible.  Recoveries of trade receivables previously written off are recorded when received.  Accounts are considered past due if payment is not received according to agreed-upon terms.

A small percentage of the trade receivables balance is denominated in a foreign currency with no concentration in any given country.  At the end of each reporting period, the Company analyzes the receivable balance for customers paying in a foreign currency. These balances are adjusted to each quarter or year-end spot rate in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) No. 830, Foreign Currency Matters.  Foreign currency transactions and translation adjustments did not have a significant effect on the Balance Sheets or the Statements of Operations, Stockholders’ Equity and Cash Flows for 2017 and 2016.

Inventories — Inventories are stated at the lower of cost or market using the last-in, first-out (LIFO) method.  If the first-in, first-out (FIFO) cost method had been used, inventories would have been approximately $1,183,000 and $1,127,000 higher than reported at December 31, 2017 and 2016, respectively.  The inventory reserve for obsolescence was $7,000 and $5,000 at December 31, 2017 and 2016, respectively. The major components of inventories are as follows:

Property, Plant and Equipment — Major expenditures extending the life of the property, plant and equipment are capitalized. Repair and maintenance costs are expensed in the period in which they are incurred. Depreciation of property, plant and equipment is computed using the straight-line method over the following estimated useful lives:

Intangible Assets — Intangible assets consist of patents and licenses.  Intangible assets are amortized on a straight-line basis over their estimated useful lives or agreement terms.

As of December 31, 2017, the remaining estimated weighted average useful lives of intangible assets are as follows:

Impairment of Long-lived Assets — The Company reviews its long-lived assets, including property, plant and equipment and intangible assets, for impairment when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amount. Any impairment loss recorded is measured as the amount by which the carrying value of the assets exceeds the fair value of the assets.  To date, the Company has determined that no loss on impairment of long-lived assets exists.

Fair Value of Financial Instruments — The carrying amounts of financial instruments, including cash and cash equivalents, short-term investments, trade receivables, accounts payable, and accrued liabilities approximate fair value due to the short maturities of these instruments.  The fair value of long-term debt approximates its carrying value and has been estimated based on interest rates being offered for similar debt having the same or similar remaining maturities and collateral requirements.

Revenue Recognition — The Company recognizes revenue on sales of products when title passes which can occur at the time of shipment or when the goods arrive at the customer location depending on the agreement with the customer.  The Company sells its products to both distributors and end-users.  Sales to distributors and end-users are recorded based upon the criteria governed by the sales, delivery, and payment terms stated on the invoices from the Company to the purchaser.  In addition to transfer of title / risk of loss, all revenue is recorded in accordance with the criteria outlined:

Sales are reported on a net basis by deducting credits, estimated normal returns and discounts.  The Company’s return policy does not vary by geography.  The customer has no rotation or price protection rights and the Company is not under a warranty obligation.  Freight billed to customers is included in sales.  Shipping costs are included in cost of goods sold.

Deferred Taxes — Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences.  Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.  The Company classifies deferred tax assets and liabilities as noncurrent.  Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.  The Tax Cut and Jobs Act of 2017 (the “Tax Reform Act”) was enacted December 22, 2017.  This legislation makes significant changes in U.S. tax law including a reduction in the corporate tax rates, changes to net operating loss carryforwards and carrybacks and a repeal of the corporate alternative minimum tax. The legislation reduced the U.S. corporate tax rate from the current rate of 34% and 35% to 21%. As a result of the enacted law, the Company was required to revalue deferred tax assets and liabilities at the newly enacted rate. This revaluation resulted in a benefit of $115,000 to income tax expense in continuing operations and a corresponding reduction in the deferred tax liability. The other provisions of the Tax Reform Act did not have a material impact on the 2017 consolidated financial statements.

The Company follows the accounting standard on accounting for uncertainty in income taxes, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements.  Under this guidance, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement.  The guidance on accounting for uncertainty in income taxes also addresses derecognition, classification, interest and penalties on income taxes, and accounting in interim periods.

Earnings Per Common Share (EPS) — Basic EPS is calculated using net income (loss) divided by the weighted average of common shares outstanding.  Diluted EPS is similar to Basic EPS except that the weighted average number of common shares outstanding is increased to include the number of additional common shares, when

dilutive, that would have been outstanding if the potential dilutive common shares, such as those shares subject to options, had been issued.

Shares used in the calculation of diluted EPS are summarized below:

If the Company was in a net income position at December 31, 2017, 2,250 options with a weighted average exercise price of $8.91 would have been included as part of the weighted average common and common equivalent shares outstanding as the options would have been dilutive, while 15,918 options with a weighted average exercise price of $14.51 would have remained excluded as the options were anti-dilutive.

If the Company was in a net income position at December 31, 2016, 4,750 options with a weighted average exercise price of $10.58 would have been included as part of the weighted average common and common equivalent shares outstanding as the options would have been dilutive, while 11,418 options with a weighted average exercise price of $15.99 would have remained excluded as the options were anti-dilutive.

Employee Stock Plan - The Company accounts for employee stock options under the provision of ASC 718, Compensation — Stock Compensation.

Recent Accounting Pronouncements:

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers.  ASU 2014‑09 supersedes the revenue recognition requirements in Revenue Recognition (Topic 605), and requires entities to recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services.  In August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers: Deferral of the Effective Date, which defers the adoption of ASU 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. The standard permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the modified retrospective method).  The standard also requires expanded disclosures relating to the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Additionally, qualitative and quantitative disclosures are required about customer contracts, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. 

The Company will adopt the provisions of ASU 2014-09 on January 1, 2018 using the modified retrospective method.  While most of the Company’s revenue is contracted with customers through one-time purchase orders and short-term contracts, the Company does have long-term contracts with certain customers.  The Company is nearly complete with its evaluation of the effect of adoption on its financial statements, and will expand its financial statement disclosures in future periods in order to comply with the new standard.  For the revenue streams assessed, the Company does not anticipate any adjustments regarding the timing of recognizing revenue as a result of the adoption.  The Company does not incur upfront costs to obtain a contract and, upon adoption, the Company will elect to treat delivery costs as a fulfillment activity that are expensed as incurred. 

During February 2016, the FASB issued ASU No. 2016-02, Leases. ASU No. 2016-02 was issued to increase transparency and comparability among organizations by recognizing all lease transactions (with terms in excess of 12 months) on the balance sheet as a lease liability and a right-of-use asset (as defined). ASU No. 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with earlier application permitted.  Upon adoption, the lessee will apply the new standard retrospectively to all periods presented or retrospectively using a cumulative effect adjustment in the year of adoption. The Company is currently assessing the effect that ASU No. 2016-02 will have on its financial statements.

In March 2016, the FASB issued ASU No. 2016-09, Compensation—Stock Compensation (Topic 718). This standard makes several modifications to Topic 718 related to the accounting for forfeitures, employer tax withholding on share-based compensation and the financial statement presentation of excess tax benefits or deficiencies. ASU 2016-09 also clarifies the statement of cash flows presentation for certain components of share-based awards. The standard is effective for interim and annual reporting periods beginning after December 15, 2016, although early adoption is permitted. The Company adopted ASU No. 2016-09 in 2017 with minimal impact on the financial statements.

Use of Estimates — The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent 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.  Significant estimates include the allowance for doubtful trade receivables, the reserve for inventory obsolescence, and the valuation allowance for deferred tax assets.

2.          INCOME TAXES

Income tax expense (benefit) for the years ended December 31, 2017 and 2016 consists of the following:

The Tax Cut and Jobs Act of 2017 (the “Tax Reform Act”) was enacted December 22, 2017.  This legislation makes significant changes in U.S. tax law including a reduction in the corporate tax rates, changes to net operating loss carryforwards and carrybacks and a repeal of the corporate alternative minimum tax. The legislation reduced the U.S. corporate tax rate from the current rate of 34% and 35% to 21%. As a result of the enacted law, the Company was required to revalue deferred tax assets and liabilities at the newly enacted rate. This revaluation resulted in a benefit of $115,000 to income tax expense in continuing operations and a corresponding reduction in the deferred tax liability. The other provisions of the Tax Reform Act did not have a material impact on the 2017 consolidated financial statements.

The expected provision benefit for income taxes, computed by applying the U.S. federal income tax rate of 34% in 2017 and 2016 to income (loss) before taxes, is reconciled to income benefit as follows:

Net deferred tax liabilities consist of the following as of December 31, 2017 and 2016: