TSSI TSS Inc (QB)

Note 1 – Significant Accounting Policies

Description of Business

TSS, Inc. (‘‘TSS’’, the ‘‘Company’’, ‘‘we’’, ‘‘us’’ or ‘‘our’’) provides a comprehensive suite of services for the planning, design, deployment, maintenance, refresh and take-back of end-user and enterprise systems, including the mission-critical facilities they are housed in. We provide a single source solution for enabling technologies in data centers, operations centers, network facilities, server rooms, security operations centers, communications facilities and the infrastructure systems that are critical to their function. Our services consist of technology consulting, design and engineering, project management, systems integration, systems installation, facilities management and IT procurement services. Our corporate offices and our integration facility are located in Round Rock, Texas.

Basis of Presentation

The accompanying consolidated balance sheet as of December 31, 2021, which has been derived from audited consolidated financial statements, and the unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial statements and pursuant to the rules and regulations of the SEC for interim reporting and include the accounts of the Company and its consolidated subsidiaries. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring items) necessary to present fairly the consolidated financial position of the Company and its consolidated results of operations, changes in stockholders’ equity and cash flows. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021.

Liquidity

As of September 30, 2022, the Company had an accumulated deficit of $65.2 million. We have recorded operating and net income in our two most recent quarters but have a history of annual operating losses over recent years which have been due, in part, to the effects of COVID-19 and related supply chain constraints. These factors may be indicative of doubt regarding the Company’s ability to continue as a going concern. Management has evaluated the significance of these conditions in relation to its ability to meet its ongoing obligations. Our primary sources of funds to meet our liquidity and capital requirements include cash on hand, funds generated from operations including the funds from our customer financing programs and trade credit extended to us by our vendors or under our revolving credit facilities with our bank. If our future results do not meet our expectations, management believes that we can implement reductions in selling, general and administrative expenses to better achieve profitability and therefore improve cash flows, or that we could take further steps such as the issuance of new equity or debt. We may also require additional capital if we seek to acquire additional businesses to increase the scale of our operations, or if there is a sudden increase in the level of reseller services. There can be no assurance as to the Company’s ability to continue to operate profitability or to scale its business operations on terms upon which additional financing might be available.

Management believes that we will be able to generate sufficient cash flows and liquidity as described above, as we have a significant backlog of projects which have been delayed due to COVID-19 and the related supply chain constraints. During the second and third quarters of 2022 we have been able to achieve operating and net profits as we saw improvements in delivery of products and components that allowed us to fulfil a large portion of our existing backlog. We anticipate that this will continue into the next quarter based on anticipated delivery of products and components as indicated by suppliers and vendors and that we will again be profitable in the fourth quarter and for the year ending December 31, 2022 and that we will be profitable in 2023. As a result, management has concluded that there is not substantial doubt about the Company’s ability to continue as a going concern. These financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern for a reasonable period of time.

Revenue Recognition

We recognize revenues when control of the promised goods or services is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services.

Some of our contracts with customers contain multiple performance obligations. For these contracts, we account for individual performance obligations separately if they are distinct. The transaction price is allocated to the separate performance obligations based on relative standalone selling prices.

Maintenance Services

We generate maintenance services revenues from fees that provide our customers with as-needed maintenance and repair services on modular data centers during the contract term. Our contract terms are typically one year in duration, are billed annually in advance, and are non-cancellable. As a result, we record deferred revenue (a contract liability) and recognize revenue from these services on a ratable basis over the contract term. We can mitigate our exposure to credit losses by discontinuing services in the event of non-payment, however our history of non-payments and bad debt expense has been insignificant.

Integration Services

We generate integration services revenues from fees that provide our customers with customized system and rack-level integration services. We recognize revenue upon shipment to the customer of the completed systems as this is when we have completed our services and when the customer obtains control of the promised goods. We typically extend credit terms to our integration customers based on their credit worthiness and generally do not receive advance payments. As such, we record accounts receivable at the time of shipment, when our right to the consideration becomes unconditional. Accounts receivable from our integration customers are typically due within 30-60 days of invoicing. An allowance for doubtful accounts is provided based on a periodic analysis of individual account balances, including an evaluation of days outstanding, payment history, recent payment trends, and our assessment of our customers’ credit worthiness. As of September 30, 2022, and December 31, 2021, our allowance for doubtful accounts was $7,000.

Equipment Sales

We generate revenues under fixed price contracts from the sale of data center and related ancillary equipment to customers in the United States. We recognize revenue when the product is shipped to the customer as that is when the customer obtains control of the promised goods. Typically, we do not receive advance payments for equipment sales; however, if we do, we record the advance payment as deferred revenues. Normally we record accounts receivable at the time of shipment, when our right to the consideration has become unconditional. Accounts receivable from our equipment sales are typically due within 30-45 days of invoicing.

Deployment and Other Services

We generate revenues from fees we charge our customers for other services, including repairs or other services not covered under maintenance contracts, installation and servicing of equipment, including modular data centers that we sold, and other fixed-price services, including repair, design and project management services. In some cases, we arrange for a third party to perform warranty and servicing of equipment, and in these instances, we recognize revenue as the amount of any fees or commissions that we expect to be entitled to receive. Other services are typically invoiced upon completion of services or completion of milestones. We record accounts receivable at the time of completion when our right to consideration becomes unconditional.

Reseller Services

We generate revenues from fees we charge our customers to procure third-party hardware, software and professional services on their behalf that are then used in our integration services as we integrate these components to deliver a completed system to our customer. We recognize our reseller services revenue upon completion of the procurement activity. In some cases, we arrange for the purchase of third-party hardware, software or professional services that are to be provided to our customers by another party and we have no control of the goods before they are transferred to the customer. In these instances, we are acting as an agent in the transaction and recognize revenue as the amount of any fee or commissions that we expect to be entitled to after paying the other party for the goods or services provided to the customer. Accounts receivable from our reseller activities are typically due within 30-60 days of invoicing.

The following table shows our revenues disaggregated by reportable segment and by product or service type (in ’000’s, unaudited):

Judgments

We consider several factors in determining that control transfers to the customer upon shipment of equipment or upon completion of our services. These factors include that legal title transfers to the customer, we have a present right to payment, and the customer has assumed the risks and rewards of ownership at the time of shipment or completion of the services.

Sales Taxes

Sales (and similar) taxes that are imposed on our sales and collected from customers are excluded from revenues.

Shipping and Handling Costs

Costs for shipping and handling activities, including those activities that occur subsequent to transfer of control to the customer, are recorded as cost of revenues and are expensed as incurred. We accrue costs for shipping and handling activities that occur after control of the promised good or service has transferred to the customer.

Remaining Performance Obligations

Remaining performance obligations include deferred revenue and amounts we expect to receive for goods and services that have not yet been delivered or provided under existing, non-cancellable contracts. For contracts that have an original duration of one year or less, we have elected the practical expedient applicable to such contracts and we do not disclose the transaction price for remaining performance obligations at the end of each reporting period and when we expect to recognize this revenue. As of September 30, 2022, deferred revenue of $4,274,000 includes $2,630,000 of our remaining performance obligations for our maintenance contracts, all of which are expected to be recognized within one year, and $1,644,000 relating to procurement and integration services where we have yet to complete our services for our customers, all of which are expected to be recognized within one year. Contract liabilities consisting of deferred revenue were $4,061,000 at December 31, 2020.

Concentration of Credit Risk

We are currently economically dependent upon our relationship with a large US-based IT OEM. If this relationship is unsuccessful or discontinues, our business and revenue will suffer. The loss of or a significant reduction in orders from this customer or the failure to provide adequate products or services to it would significantly reduce our revenue.

The following customer accounted for a significant percentage of our revenues for the periods shown (unaudited):

No other customers represented more than 10% of our revenues for any periods presented. Our US-based IT OEM customer represented 91% and 51% of our trade accounts receivable at September 30, 2022 and December 31, 2021, respectively. A US-based data center equipment customer represented 29% of our trade accounts receivable at December 31, 2021. No other customer represented more than 10% of our accounts receivable at September 30, 2022, or at December 31, 2021.

Non-recourse factoring

We have entered into a factoring agreement with a financial institution to sell certain of our accounts receivables from a US-based IT OEM customer under a non-recourse agreement. Under the arrangement, we sell certain trade receivables on a non-recourse basis and account for the transaction as a sale of the receivables. The financial institution assumes the full risk of collection, without recourse to the Company in the event of a loss. Debtors are directed to send payments directly to the financial institution. The applicable receivables are removed from our consolidated balance sheet when the cash proceeds are received by us. We do not service any factored accounts after the factoring has occurred. We utilize this factoring arrangement as part of our financing for working capital. The aggregate gross amount factored under this arrangement was approximately $27.4 million and $9.3 million for the three-month periods ended September 30, 2022 and 2021, respectively. We paid financing fees under this arrangement of approximately $237,000 and $43,000 for the three-month periods ended September 30, 2022 and 2021, respectively, which was recorded as interest expense in our consolidated statements of operations. The aggregate gross amount factored under this arrangement was approximately $53 million and $22.2 million for the nine-month periods ended September 30, 2022 and 2021, respectively. We paid financing fees under this arrangement of approximately $393,000 and $100,000 for the nine-month periods ended September 30, 2022 and 2021, respectively, which was recorded as interest expense in our consolidated statements of operations.

Recent Accounting Guidance

Recently Issued Accounting Pronouncements

In June 2016, FASB issued Accounting Standards Update ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). The standard’s main goal is to improve financial reporting by requiring earlier recognition of credit losses on financing receivables and other financial assets. Among the provisions of ASU 2016-13 is a requirement that assets measured at amortized cost, which includes trade accounts receivable, be presented at the net amount expected to be collected. This pronouncement requires that an entity reflect all of its expected credit losses based on current estimates which will replace the current standard requiring that an entity need only consider past events and current conditions in measuring an incurred loss. We are subject to this guidance effective with the consolidated financial statements we issue for the year ending December 31, 2023, and the quarterly periods during that year. We are currently evaluating the adoption date and the impact of the adoption of this guidance on our consolidated financial statements and disclosures.

In May 2019, FASB issued Accounting Standards Update 2019-15, Financial Instruments – Credit Losses (Topic 326), (AASU 2019-15”). ASU 2019-15 provides guidance that allows entities to make an irrevocable one-time election upon adoption of the new credit loss standard to measure financial assets at amortized cost (except held-to-maturity securities) using the fair value option. The effective date and transition methodology are the same as in ASU 2016-13.

Contract assets consisting of accounts receivable and costs in excess of billings were $1,721 as of December 31, 2020.

Goodwill attributable to reporting units (in ‘000’s):

At September 30, 2022 and December 31, 2021, both the facilities unit and the systems integration unit had negative carrying amounts on our records.

We recognized amortization expense related to intangibles of approximately $23,000 for each of the three-month periods ended September 30, 2022 and 2021, respectively. We recognized amortization expense related to intangibles of approximately $67,000 for each of the nine-month periods ended September 30, 2022 and 2021, respectively.

We have elected to use December 31 as our annual date to test goodwill and intangibles for impairment. As circumstances change that could affect the recoverability of the carrying amount of the assets during an interim period, we will evaluate goodwill and other long-lived intangible assets for impairment. We performed a quantitative analysis of our goodwill and intangibles at December 31, 2021 as part of our annual testing for impairment and concluded that there was no impairment. We considered relevant matters, including macroeconomic conditions and the effects of COVID-19 on our operations, and there was no identified material triggering events or circumstances that occurred during the three or nine-month periods ended September 30, 2022 or 2021 that indicated the carrying value of our goodwill and other long-lived intangible assets was impaired.

Depreciation of property and equipment and amortization of leasehold improvements and software totaled $46,000 and $110,000 for the three-month periods ended September 30, 2022 and 2021, respectively. Depreciation of property and equipment and amortization of leasehold improvements and software totaled $180,000 and $338,000 for the nine-month periods ended September 30, 2022 and 2021, respectively.

In February 2015, we entered into a multiple advance term loan agreement and related agreements with MHW SPV II, LLC (‘‘MHW’’), an entity affiliated with the Chairman of our Board of Directors, for a loan in the maximum amount of $2 million. We borrowed $945,000 under this loan agreement on February 3, 2015, and executed a promissory note to evidence this loan and the terms of repayment which requires interest-only payments until maturity.

In July 2017, we amended and restated the terms of this multiple advance term loan agreement whereby we increased the maximum principal amount of loans to $2.5 million for up to sixty days, and $2 million thereafter. The term of the loan was modified to be five years from the date of modification, thereby extending the term of the $945,000 loan to July 19, 2022. As part of this modification, the interest rate on the $945,000 loan remained at a fixed annual rate of 12%, however it was changed so that 6% was paid in cash monthly in arrears, and 6% was payable in kind, to be evidenced by additional promissory notes having an aggregate principal amount equal to the accrued but unpaid interest. At June 30, 2022 there was approximately $267,000 in accrued interest in-kind outstanding on this loan which was paid in full in July 2022.

In conjunction with entering into the loan agreement, the Company and MHW also entered into a warrant granting MHW the right to purchase up to 1,115,827 shares of the Company’s common stock. As part of the July 2017 modification, we also modified the warrant to change the exercise price of the shares and to extend the term of the warrant to July 19, 2022. The warrant was exercisable for a period of five years from July 19, 2017 at an exercise price of $0.10 for the first 390,539 shares, $0.20 for the next 390,539 shares and $0.30 for the final 334,749 shares. The exercise price and number of shares of common stock issuable on exercise of the warrant was subject to adjustment in the event of any stock split, reverse stock split, recapitalization, reorganization or similar transaction. The fair value of the modified warrant was determined to be approximately $167,000 and the incremental value of the warrant compared to the original warrant was approximately $6,000. This amount was added to the remaining unamortized value of the original warrant such that approximately $93,000 was amortized to interest expense using the straight-line method (which approximates the effective interest rate method) over the term of the loan. Approximately $9,000 and $12,000 was amortized for this warrant during each of the nine-month periods ended September 30, 2022 and 2021, respectively.

On July 19, 2017, we borrowed an additional $650,000 from MHW Partners, an entity affiliated with MHW. This loan ranked parri-passu with the $945,000 promissory notes held by MHW and was subject to the same loan agreement. Similar to the notes held by MHW, this note issued to MHW Partners bore interest at 12% per annum payable in cash monthly in arrears at a rate of 6% per annum and payable in kind at a fixed rate of 6% per annum and had a maturity date of July 19, 2022. At June 30, 2022 there was approximately $182,000 in accrued interest in-kind outstanding on this loan, which was paid in full during July 2022.

The obligations under the loan to MHW and MHW Partners were secured by substantially all of the Company’s assets pursuant to the terms of a security agreement.

In conjunction with entering into the loan with MHW Partners, we entered into a warrant granting MHW Partners the right to purchase up to 767,500 shares of our common stock. The warrant was exercisable for a period of 5 years from July 19, 2017, at an exercise price of $0.10 for the first 268,625 shares, $0.20 for the next 268,625 shares and $0.30 for the final 230,250 shares. The exercise price and number of shares of common stock issuable upon exercise of this warrant were subject to adjustment in the event of any stock split, reverse stock split, recapitalization, reorganization or similar transactions. The fair value of the warrant granted was approximately $115,000. Using the relative-fair value allocation method, the debt proceeds were allocated between the debt value and the fair value of the warrants, resulting in a recognition of a discount on the loan of approximately $98,000 and a corresponding increase to additional paid-in capital. This discount was amortized to interest expense using the effective interest rate method over the term of the loan. Approximately $5,000 was amortized during the three-month periods ended September 30, 2021. Approximately $10,000 and $15,000 was amortized during each of the nine-month periods ended September 30, 2022 and 2021, respectively.

Peter H. Woodward, the Chairman of our Board of Directors, is a principal of MHW Capital Management LLC, which is the investment manager of MHW and MHW Partners. MHW Capital Management LLC is entitled to a performance related fee tied to any appreciation in the valuation of the common stock in excess of the applicable strike price under the warrant.

On July 1, 2022, we repaid in full the remaining amounts outstanding under multiple advance term loan agreements with MHW SPV II, LLC and MHW Partners L.P, including the accrued interest-in-kind outstanding on the loans. The outstanding amounts due under such loans were payable on or before July 19, 2022. Under their terms, the Company was permitted to prepay such loans without penalty.

On July 19, 2022, MHW and MHW Partners exercised their outstanding warrants and purchased 1,883,326 shares of common stock of the Company. The warrants were granted in connection with the multiple advance term loan agreements with MHW SPV II, LLC and MHW Partners, LP. The Company received approximately $367,000 from the aggregate exercise price of the warrants.

Note 4 – Revolving Line of Credit

In May 2022, we entered into a revolving line of credit (the “credit facility”) with Susser Bank (“Lender”) pursuant to a Business Loan Agreement (Asset Based) (the “Loan Agreement”), dated effective May 5, 2022. The obligations under the credit facility are secured by substantially all of our assets. Our wholly-owned subsidiaries, Vortech L.L.C., and VTC, L.L.C. jointly and severally guarantee our obligations under the credit facility.

The maximum amount of the credit facility is $1,500,000. The credit facility is subject to a borrowing base of the lesser of $1,500,000 and 80% of eligible accounts receivables, subject to customary exclusions and limitations. Certain accounts receivables subject to a vendor payment program with a customer are excluded from the definition of eligible accounts receivables under the credit facility. Borrowings under the credit facility will bear interest based on the U.S. Prime Rate as published in the Money Rates section of The Wall Street Journal (effective rate of 6.25% at September 30, 2022) and such interest rate shall not be less than 3.50% per annum. In addition to interest payable on the principal amount of indebtedness outstanding from time to time under the credit facility, we paid a loan origination fee of 0.5%, payable in advance upon entering into the credit facility. The credit facility matures on May 5, 2023.

The credit facility requires that we maintain a minimum liquidity of $1,500,000 at all times.

The Loan Agreement and ancillary documents include customary affirmative covenants for secured transactions of this type, including maintaining adequate books and records, periodic financial reporting, compliance with laws, maintenance of insurance, maintenance of assets, timely payment of taxes, and notices of adverse events. The Loan Agreement and ancillary documents include customary negative covenants, including incurrence of other indebtedness, mergers, consolidations and transfers of assets and liens on our assets. The Loan Agreement and ancillary documents also include customary events of default, including payment defaults, failure to perform or observe terms, covenants or agreements included in the Loan Agreement and ancillary documents, insolvency and bankruptcy defaults, judgment defaults, material adverse chance defaults, and change of ownership defaults.

The maximum amount we would have been eligible to borrow at September 30, 2022 was approximately $163,000. There were no amounts outstanding under this credit facility at September 30, 2022.

Note 5- Leasing Arrangements

We have operating leases for our office and integration facilities as well as for certain equipment and vehicles. Our leases have remaining lease terms of 1 month to 7 years. As of September 30, 2022, we have not entered into any lease arrangement classified as a finance lease.

We determine if an arrangement is a lease at inception. Operating leases are included in lease right-of-use assets, current lease liabilities and lease liabilities, non-current, on our consolidated balance sheet. We have elected an accounting policy to not recognize short-term leases (one year or less) on the balance sheet. We also elected the package of practical expedients which applies to leases that commenced before the adoption date. By electing the package of practical expedients, we did not need to reassess whether any existing contracts are or contain leases, the lease classification for any existing leases and initial direct costs for any existing leases.

Right-of-use assets and operating lease liabilities are recognized based on the present value of future minimum lease payments over the lease term at commencement date. When the implicit rate of the lease is not provided or cannot be determined, we use our incremental borrowing rate based on the information available at the commencement date to determine the present value of future payments. Lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise those options. Lease expense for minimum lease payments is recognized on a straight- line basis over the lease term. Components of lease expense and other information is as follows (in ‘000’s):

The following presents information regarding the Company's operating leases as of September 30:

Future minimum lease payments under non-cancellable leases as of September 30, 2022 were as follows (in ‘000’s):

Note 6 - Net Income (Loss) Per-Share

Basic and diluted income (loss) per share are based on the weighted average number of shares of common stock and potential common stock outstanding during the period. Potential common stock, for the purposes of determining diluted income (loss) per share, includes the effects of dilutive unvested restricted stock, options to purchase common stock and convertible securities. The effect of such potential common stock is computed using the treasury stock method or the if-converted method, as applicable.

The following table presents a reconciliation of the numerators and denominators of the basic and diluted income (loss) per share computations for net income (loss). In the table below, net income (loss) represents the numerator and shares represents the denominator (in thousands except per share amounts; unaudited).

688,000 and 936,000 restricted shares were excluded from the calculation of dilutive shares for the three-month and nine-month periods ended September 30, 2022, respectively, as they did not result in any shares being dilutive as more shares could have been repurchased with the unrecognized compensation expense. For the nine-month period ended September 30, 2021, 4,953,000 potentially dilutive shares were excluded from the calculation of dilutive shares because their effect would have been anti-dilutive.

Related party transactions: (in $’000)

Peter H. Woodward, the Chairman of our Board of Directors, is a principal of MHW Capital Management, LLC, which is the investment manager of MHW and MHW Partners.

Note 8 - Segment Reporting

Segment information reported in the tables below represents the operating segments of the Company organized in a manner consistent with which separate information is available and for which segment results are evaluated regularly by our chief operating decision-maker in assessing performance and allocating resources. Our activities are organized into two major segments: facilities and systems integration. Our facilities unit is involved in the design, project management and maintenance of data center and mission-critical business operations. Our systems integration unit integrates IT equipment for OEM vendors and customers to be used inside data center environments, including modular data centers, and also includes our reseller services where we procure equipment to be used in our integration activities. All revenues are derived from the U.S. market. Segment operating results reflect earnings before acquisition related expenses, other expenses, net, and provision for income taxes.

Revenue and operating results by reportable segment reconciled to reportable net income (loss) for the three and nine-month periods ended September 30, 2022 and 2021 and other segment-related information is as follows (in ‘000’s, unaudited):

Other consolidated activities include assets not specifically attributable to each business segment including cash and cash equivalents, prepaid expenses and other assets that are managed at a corporate level.

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

The following discussion should be read in conjunction with, and is qualified in its entirety by reference to, the consolidated financial statements and notes thereto included in Item 1 of this Form 10-Q and the consolidated financial statements and notes thereto and our Management’s Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2021 included in our 2021 Annual Report on Form 10-K. This report contains forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that involve risks and uncertainties. Our expectations with respect to future results of operations that may be embodied in oral and written forward-looking statements, including any forward-looking statements that may be included in this report, are subject to risks and uncertainties that must be considered when evaluating the likelihood of our realization of such expectations. Our actual results could differ materially. The words “believe,” “expect,” “intend,” “plan,” “project,” “will” and similar phrases as they relate to us are intended to identify such forward-looking statements. In addition, please see the “Risk Factors” in Part 1, Item 1A of our 2021 Annual Report on Form 10-K for a discussion of items that may affect our future results. 

Overview

TSS, Inc. (‘‘TSS’’, the ‘‘Company’’, ‘‘we’’, ‘‘us’’ or ‘‘our’’) provides comprehensive services for the planning, design, deployment, maintenance, and refurbishment of end-user and enterprise systems, including the mission-critical facilities they are housed in. We provide a single source solution for enabling technologies in data centers, operations centers, network facilities, server rooms, security operations centers, communications facilities and the infrastructure systems that are critical to their function. Our services include technology consulting, design and engineering, project management, systems integration, systems installation, facilities management and IT procurement and reseller services. Our headquarters and our integration facility are in Round Rock, Texas.

Our business is concentrated in the data center infrastructure and services market. This market continues to be highly competitive as commerce moves to cloud-based solutions and as data storage requirements continue to escalate for many industries. These underlying macroeconomic trends are continuing to drive demand for more information technology equipment and more efficient data center design and operation, resulting in continued growth in this market. We compete against many larger competitors who have greater resources than we do, which may affect our competitiveness in the market. We rely on several large customers to win contracts and to provide business to us under ‘‘Master Service Agreements’’, and the loss of such customers or a material decline in volume from such customers would have a material negative effect on our results.

Almost all of the components used in our systems integration business are consigned to us by our original equipment manufacturer (OEM) or their end-user customers, thus our revenue reflects only the services we perform, and the consigned components are not reflected in our balance sheet. We also offer our customers the ability to procure third-party hardware, software and services on their behalf that are then used in our integration services as we integrate these components to deliver a completed system to our customer. In some cases, we also act as an agent and arrange for the purchase of third-party hardware, software or services that are to be provided to our customers by another party and we have no control of the goods or services before they are transferred to the customer. In these instances, we are acting as an agent in the transaction. These procurement and reseller services allow us to develop relationships with new hardware, software and professional service providers and allow us to generate higher profits on integration projects by broadening our revenue and customer base.

In March 2020, the coronavirus disease 2019 ("COVID-19") was declared a pandemic by the World Health Organization and a national emergency by the U.S. Government. The pandemic has negatively affected the U.S. and global economy, disrupted global supply chains and financial markets, and resulted in governments around the world implementing increasingly stringent measures to help control the spread of the virus, including quarantines, “shelter in place” and “stay at home” orders, travel restrictions, business curtailments, school closures, and other measures. In addition, governments and central banks in several parts of the world have enacted fiscal and monetary stimulus measures to counteract the impacts of COVID-19.

The COVID-19 pandemic had both an immediate and an ongoing impact on our operations in both our facilities segment and our systems integration segment since it began. Travel restrictions and other customer-actions that restricted physical access to customer sites negatively impacted our facilities segment because we were unable to access customer locations to provide our services. We also experienced supply-chain disruptions beginning in the second half of 2021 until early 2022 that delayed the delivery of equipment needed for both integration and for deployments, further delaying customer projects. Overall, these travel restrictions and supply chain challenges directly impacted our operating results though the first quarter of 2022 for our facilities segment, and up to and including our most recent quarter for our systems integration business. Additionally, as our customers deferred or cancelled the deployment of new modular data centers (MDCs) in 2021 they instead maintained and updated their existing MDCs. As supply chain issues continued to improve in 2022, we have been able to source needed equipment and complete MDC deployments. Revenues from MDC deployments have increased during 2022 by $4.2 million or 433% compared to the same period in 2021, helping drive the increase in our facilities revenues.

Our systems integration business has also been negatively impacted due to logistical and supply-chain issues that have continued to affect component supply to us and negatively impact our revenue through the pandemic. Safety and other measures that we had to implement in our systems integration facility so that we could continue to operate safely despite the pandemic materially increased the cost of operating and providing our integration services, particularly at the onset of the pandemic. As time has passed and with knowledge gained, we have been able to significantly reduce these incremental operating costs. The supply-chain disruptions have prevented our customers from providing product to us for use in our integration business, preventing us from providing our services, and negatively impacting our revenue. We continued to experience delays in obtaining needed components during the most recent quarter, causing us to defer integration projects and revenues as a result. Despite these ongoing challenges, overall there has been an improvement in supply chain issues during 2022 that has helped our integration services revenues grow by 22% year to date in 2022 same compared to the same period in 2021.

At this point we do not know how long this pandemic and its associated impact on our business will continue, or if it will worsen or improve. To the extent these travel restrictions and customer delays continue, the pandemic worsens, or we have further supply chain challenges, our business will continue to be negatively impacted.

RESULTS OF OPERATIONS

Revenue

Revenue consists of fees earned from the planning, design and project management for mission-critical facilities and information infrastructures, as well as fees earned from providing maintenance services for these facilities. We also earn revenue from providing system configuration and integration services, including procurement and reseller services, to IT equipment vendors. Currently we derive all our revenue from the U.S. market.

We contract with our customers under five primary contract types: fixed-price service and maintenance contracts, time and material contracts, cost-plus-fee, guaranteed maximum price and fixed-price contracts. Cost-plus-fee and guaranteed maximum price contracts are typically lower risk arrangements, and thus yield lower profit margins than time-and-materials and fixed-price arrangements which generate higher profit margins generally, relative to their higher risk. Certain of our service and maintenance contracts provide comprehensive coverage of all the customers’ equipment (excluding IT equipment) at a facility during the contract period. Where customer requirements are clear, we prefer to enter into comprehensive fixed-price arrangements or time-and-materials arrangements rather than cost-plus-fee and guaranteed maximum price contracts.

Most of our revenue is generated based on services provided either by our employees or subcontractors. To a lesser degree, the revenue we earn includes reimbursable travel and other costs to support the project. Since we earn higher profits from the labor services that our employees provide compared with use of subcontracted labor and other reimbursable costs, we seek to optimize our labor content on the contracts we are awarded to maximize our profitability.

We have been concentrating our sales efforts towards maintenance and integration services where we have traditionally earned higher margins. Historically we performed design and project-management services in a concentrated number of high-value contracts for the construction of new data centers. In addition to contributing to large quarterly fluctuations in revenue depending upon project timing, these projects required higher levels of working capital and generated lower margins than our maintenance and integration services. We re-focused our design and project management services towards smaller scaled jobs typically connected with addition/move/retrofit activities rather than new construction, to obtain better margins. We have also focused on providing maintenance services for modular data center applications as this market continues to expand. We continue to focus on increasing our systems integration revenues through more consistent revenue streams that will better utilize our assets in that business, and through adding services such as procurement and reseller services, to help drive volume through the integration facility.

Revenues of $8.1 million for the three-month period ended September 30, 2022 increased by $3.5 million or 76% compared to the third quarter of 2021. The increase was across both operating segments, and revenues from our facilities segment increased by $0.8 million or 34% compared to the third quarter of 2021 driven by a $1.6 million increase in revenues from deployment of MDCs as supply chain constraints eased and we were able to deliver against our backlog of deployment projects, offset by a decrease in MDC upgrade/refurbishment revenues of $0.7 million. Our systems integrations segment saw revenues of $4.8 million, an increase of $2.7 million, or 125% compared to the third quarter of 2021 as an improvement in supply chain constraints enabled our customers to procure parts needed to complete integration projects, and allowed us to increase revenues, in our procurement and reselling activities compared to the third quarter of 2021.

On a year-to-date basis, for the nine-month period ended September 30, 2022, our total revenues of $19.7 million have increased by $6.9 million or 54% compared to the first nine months of 2021 when we recorded revenue of $12.8 million. This was driven by $3.3 million or 59% growth in our facilities segment attributable to a higher level of MDC deployments, and $3.5 million or 49% growth in our systems integration segment, driven by higher integration business from our OEM partner as global supply-chain disruptions have started to dissipate and from an increase in our procurement and reseller activities.

Although we have seen an improvement in the current quarter in the supply chain constraints that we have been experiencing that prevent our partners and customers from delivering all of the products needed for us to complete and perform integration services, there are still ongoing supply issues that persist. These supply chain disruptions cause delays in the timing of systems integration revenue for us as we await delivery of required components, and our vendors and partners expect these supply-chain issues to continue for at least the next several quarters.

Our reseller and procurement revenues involve us procuring third-party hardware, software and services on our customers’ behalf that are then typically used in our integrated services as we integrate those components to deliver a completed system to our customer. In some cases, we also act as an agent and arrange for the purchase of third-party hardware, software or services that are to be provided to our customers by another party and we have no control of the goods or services before they are transferred to the customer. In these instances, we are acting as an agent in the transaction and recognize revenue as the amount of any fee or commission that we expect to be entitled to after paying the other party for the goods or services provided to the customer. During the third quarter of 2022 we had more agent-type transactions allowing our total revenues from reseller and procurement services to increase by $2.4 million or 347% compared to the third quarter of 2021, and allowing the gross profits from this business to increase by approximately $0.6 million compared to the third quarter of 2021. For the nine-month period ended September 30, 2021 our total revenue from reseller and procurement activity of $5.6 million had increased by $2.6 million or 88% compared to the same period in 2021, and allowing the gross profits from this business to increase by approximately $0.9 million.

Cost of Revenue

Cost of revenue includes the cost of component parts for our products, labor costs expended in the production and delivery of our services, subcontractor and third-party expense, equipment and other costs associated with our test and integration facilities, excluding depreciation of our manufacturing property and equipment, shipping costs, and the costs of support functions such as purchasing, logistics and quality assurance. The cost of revenue as a percentage of revenue was 66% for the three-month period ended September 30, 2022 compared to 58% for the third quarter of 2021. This increase from the third quarter of 2021 reflects the increased activity in our facilities segment as the number of MDC deployment projects increased compared to 2021 and from higher costs including labor costs, in our integration business compared to the prior year. We earn much lower margins on product purchase/resell services, unless we are acting as an agent in the transaction, than we do with our traditional integration and maintenance services. As the percentage of our total revenue derived from reseller services increases, we would anticipate that cost of revenue as a percentage of sales will increase. Absent the reseller business, the profit margin from our core integration and maintenance services was 42% in the third quarter of 2022 compared to 44% in the third quarter of 2021.

For the nine-month period ended September 30, 2022, our cost of revenue as a percentage of revenue was 64%. This compares to 64% for the comparable period of 2021.

The level of expected revenue from our reseller services has and will continue to fluctuate significantly on a quarterly basis. As a result, our cost of revenue as a percentage of total revenue will also fluctuate significantly. Cost of revenue for reseller services is higher than cost of revenue for our integration and maintenance services.

Since we earn higher profits when using our own labor services, we expect gross margins to improve when our labor services mix increases relative to the use of subcontracted labor or third-party labor. Our direct labor costs are relatively fixed in the short-term, and the utilization of direct labor is critical to maximizing our profitability. As we continue to bid and win contracts that require specialized skills that we do not possess, we would expect to have more third-party subcontracted labor to help us fulfill those contracts. In addition, we can face hiring challenges in internally staffing larger contracts. While these factors could lead to a higher ratio of cost of services to revenue, the ability to outsource these activities without carrying a higher level of fixed overhead improves our overall profitability by increasing income, broadening our revenue base and generating a favorable return on invested capital. As we increase the level of IT reseller services in the future, we anticipate that our overall gross margin will decrease as the normal margins on reseller activities are lower than the margins from our traditional facilities and systems integration services.

A large portion of our revenue is derived from fixed price contracts. Under these contracts, we set the price of our services and assume the risk that the costs associated with our performance may be greater than we anticipated. Our profitability is therefore dependent upon our ability to estimate accurately the costs associated with our services. These costs may be affected by a variety of factors, such as lower than anticipated productivity, conditions at the work sites differing materially from what was anticipated at the time we bid on the contract, and higher than expected costs of materials and labor. Certain agreements or projects could have lower margins than anticipated or losses if actual costs for contracts exceed our estimates, which could reduce our profitability and liquidity.

Gross Profit

Our gross profit margin for the three-month period ended September 30, 2022 was 34% compared to a gross profit margin of 42% in the third quarter of 2021. This decrease in margin as a percentage of revenues compared to the third quarter of 2021 was primarily attributable to an increase in costs, particularly labor costs, in our integration business and from an increase in the volume of reseller and procurement activities. Our reseller and procurement revenues were 38% of total revenues in the third quarter of 2022 compared to 15% of our total revenues in the third quarter of 2021. We earn much lower margins on product purchase/resell services, unless we are acting as an agent in the transaction, than what we earn from our core integration and maintenance activities. As reseller and procurement revenues grow as a percentage of our total revenues, we would expect our overall gross profit margin to decrease. The growth in our total revenues compared to 2021 allowed us to increase our overall gross profit by $0.8 million or 44%, to $2.8 million in the third quarter of 2022 compared to $1.9 million gross profit in the third quarter of 2021. The 54% growth in total revenue in 2022 has allowed us to increase our gross profit for the nine-month period ended September 30, 2022 by $2.4 million or by 51% compared to the first nine months of 2021.

Selling, General and Administrative Expenses

Selling, general and administrative expenses primarily consist of compensation and related expenses, including variable sales compensation, for our executive, administrative and sales and marketing personnel, as well as related travel, selling and marketing expenses, professional fees, facility costs, insurances and other corporate costs. For the three-month period ended September 30, 2022, our selling, general and administrative expenses increased by $266,000 or 17% compared to the third quarter of 2021 primarily due to higher compensation costs including incentive-based compensation due to our improved operating results, and from higher professional fees. For the nine-month period ended September 30, 2022, our selling, general and administrative expenses increased by $156,000 or 3% compared to the first nine months of 2021, primarily due to higher compensation costs.

Income (Loss) from Operations

For the three-month period ended September 30, 2022, we recorded operating income of $871,000. This compares to an operating income of $228,000 that we had in the third quarter of 2021. For the nine-month period ended September 30, 2022, we recorded operating income of $1,637,000, compared to an operating loss of $730,000 that we recorded in the first nine months of 2021.

Interest expense

For the three-month period ended September 30, 2022, we recorded interest expense, net of interest income of $255,000. This compares to $83,000 in the three-month period ended September 30, 2021. The increase in interest expense was due to the higher number of agent-type transactions that were factored in our procurement and reseller business compared to 2021. For the nine-month period ended September 30, 2022, we recorded interest expense, net of interest income, of $537,000, compared to $271,000 in the same period of 2021. This increase was due to $314,000 of interest expense attributable to agent-type reseller transactions in 2022 offset by a reduction in interest expense due to the maturity and repayment of long-term debt in 2022.

Net Income (Loss)

After net interest expense and income taxes we recorded net income of $605,000 or $0.03 per share for the three-month period ended September 30, 2022. This compares to net income of $123,000 or $0.01 per share for the three-month period ended September 30, 2021. For the nine-month period ended September 30, 2022 we recorded net income of $1,068,000 or $0.05 per share. This compares to a net loss of $(1,032,000) or $(0.06) per share that we recorded in the comparable period of 2021.

LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity at September 30, 2022 are our cash and cash equivalents on hand, funds available to us under our revolving line of credit, vendor trade-credit and projected cash flows from operating activities.

As of September 30, 2022, the Company had an accumulated deficit of $65.2 million. We have recorded operating and net income in our two most recent quarter but have a history of annual operating losses over recent years which have been due, in part, to the effects of COVID-19 and related supply chain constraints. These factors may be indicative of doubt regarding the Company’s ability to continue as a going concern. Management has evaluated the significance of these conditions in relation to its ability to meet its obligations. Our primary sources of funds to meet our liquidity and capital requirements include cash on hand, funds generated from operations, including the funds from our customer financing programs, funds available under our bank revolving credit facility and trade credit extended to us by our vendors. If our future results do not meet expectations, management believes that we can implement reductions in selling, general and administrative expenses to better achieve profitability and therefore improve cash flows, or that would take further steps such as the issuance of new equity or debt. We may also require additional capital if we seek to acquire additional businesses as a way to increase the scale of our operations, of there is a sudden increase in the level of reseller and procurement services. There can be no assurance as to the Company’s ability to scale its business operations or terms upon which additional financing may be available.

Management believes that we will be able to generate sufficient cash flows and liquidity as described above, as we have a significant backlog of projects which have been delayed due to COVID-19 and the related supply-chain constraints. During the second and third quarters of 2022 we were able to achieve operating and net profits as we saw improvement in delivery of products and components that allowed us to fulfil a large portion of our existing backlog. We anticipate that this will continue into the next quarter based on anticipated delivery of products and components as indicated by suppliers and vendors and that we will again be profitable in the fourth quarter and for the year ending December 31, 2022 and that we will be profitable in 2023. We were also able to repay all of the Company’s long-term debt during the third quarter of 2022 from existing liquidity and we now have no long-term debt apart from lease obligations. As a result, management has concluded that there is not substantial doubt about the Company’s ability to continue as a going concern. 

If we continue to meet the cash flow projections in our current business plan, we expect that we will have adequate capital resources necessary to continue operating our business and meet our debt obligations for at least the next twelve months. Our business plan and our assumptions around the adequacy of our liquidity are based on estimates regarding expected revenues and future costs. However, there are potential risks, including that our revenues may not meet our projections, our costs may exceed our estimates, or our working capital needs may be greater than anticipated. Further, our estimates may change, and future events or developments may also affect our estimates. Any of these factors may change our expectation of cash usage in 2022 and beyond or significantly affect our level of liquidity, which may limit our opportunities to grow our business.

At September 30, 2022 and December 31, 2021, we had cash and cash equivalents of $9.6 million and $8.0 million, respectively.

Significant Uses of Cash

Operating Activities:

Cash provided by operating activities was $3.6 million for the nine-month period ended September 30, 2022 compared to cash used in operating activities of $6.5 million for the nine-month period ended September 30, 2021. This change was primarily attributable to the timing and financial impacts of our procurement and reseller services. At the end of calendar year 2020 we were able to be paid by our customers for a number of large procurement projects, but we had yet to pay our vendors for these same projects. This drove an increase of $10 million in cash and accounts payable at the end of 2020. During the first quarter of 2021 we paid those vendors and both our cash balances and our accounts payable decreased by over $10 million, resulting in the decrease in our cash on hand compared to December 31, 2020 and resultant use of cash in operations during 2021. We have been able to structure our procurement and reseller activities in such a way as to minimize their overall impact on our liquidity by using trade creditors as the primary way to finance these activities. However due to timing it is possible to see fluctuations on a quarterly basis for reseller contracts in progress at the end of a particular reporting period. We believe that we will have adequate trade credit available to us to continue financing our reseller activities as we grow this business during 2022 and beyond. Otherwise, the change in cash provided by operating activities was primarily due to the improvement in our operating and net income in 2022 compared to the first nine months of 2021.

Investing Activities:

Cash used in investing activities was $213,000 in the nine-month period ended September 30, 2022 for the purchase of property and equipment for our integration facility, compared to cash used in the same period of 2021 of $60,000 for purchases of property and equipment.

Financing Activities:

Cash used in financing activities was $1,727,000 in the nine-month period ended September 30, 2022 compared to cash used in financing activities of $488,000 in the nine-month period ended September 30, 2021. During the third quarter of 2022 we repaid outstanding interest and principle on our notes payable of $2,045,000, and used $80,000 in the purchase of stock related to tax obligations around vesting of restricted stock by our employees. We received $31,000 from the exercise of employee stock options, and we also received $367,000 in proceeds from the exercise of warrants that had been issued in connection with our notes payable. In 2021 we received $20,000 from the exercise of employee stock options and $156,000 was used in 2021 for the purchase of stock related to tax obligations around the option exercises. We used $352,000 to retire a portion of our long-term debt in June 2021 following incentives from the lenders to repay this debt prior to maturity.

Future Uses of Cash

Our business plans and our assumptions around the adequacy of our liquidity are based on estimates regarding future revenues and costs and our ability to secure sources of funding when needed. However, our revenues may not meet our expectations, or our costs may exceed our estimates. Further, our estimates may change, and future events or developments may also affect our estimates. Any of these factors may change our expectations of cash usage during 2022 or beyond or significantly affect our level of liquidity, which may require us to take other measures to reduce our operating costs in order to continue operating. Any action to reduce operating costs may negatively affect our range of products and services that we offer or our ability to deliver such products and services, which could materially impact our financial results depending on the level of cost reductions taken.

Our primary liquidity and capital requirements are to fund working capital from current operations. Our primary sources of funds to meet our liquidity and capital requirements include cash on hand, funds generated from operations including the funds from our customer financing programs. We believe that if future results do not meet expectations, we can implement reductions in selling, general and administrative expenses to better achieve profitability and therefore improve cash flows, or that we could take further steps such as the issuance of new equity or debt. However, the timing and effect of these steps may not completely alleviate a material effect on liquidity. We may also require additional capital if we seek to introduce a new line of business or if we seek to acquire additional businesses as a way to increase the scale of our operations.

Off-Balance Sheet Arrangements

As of September 30, 2022 and December 31, 2021, we had no off -balance sheet arrangements.

Critical Accounting Policies and Pronouncements

There have been no material changes to our critical accounting policies and estimates as set forth in the Annual Report for the year ended December 31, 2021 on our consolidated financial statements and disclosures. See also Item 1. Financial Statements Note 1 – Significant Accounting Policies regarding Recent Accounting Pronouncements.