GVP GSE Systems Incorporated

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations

GSE is a leading provider of professional and technical engineering, staffing services, and simulation software to clients in the power and process industries. We provide customers with simulation, engineering and plant services that help clients reduce risks associated with operating their plants, increase revenue through improved plant and employee performance, and lower costs through improved operational efficiency. In addition, we provide professional services that systematically help clients fill key vacancies in the organization on a short-term basis, primarily in procedures, engineering, technical support, and training focused on regulatory compliance and certification in the nuclear power industry. Our operations also include interactive computer-based tutorials and simulation software for the refining, chemical, and petrochemical industries.

On May 11, 2018, GSE acquired True North Consulting, LLC, now a wholly-owned subsidiary of GSE Performance Solutions, Inc., for $9.75 million (subject to customary pre- and post-closing working capital adjustments). True North is a provider of technical engineering solutions to nuclear and fossil fuel power plants with an emphasis on regulatory-driven ASME code programs. Located in Montrose, Colorado, True North is a well-regarded service provider to leading companies in the power industry. The acquisition of True North is expected to broaden our engineering services offering, expand our relationships with several of the largest nuclear energy providers in the United States, and add a highly specialized, complimentary talent pool to our employee base.

Cautionary Statement Regarding Forward-Looking Statements

This report and the documents incorporated by reference herein contain "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, as amended (the "Exchange Act") that are based on management's assumptions, expectations and projections about us, and the industry within which we operate, and that have been made pursuant to the Private Securities Litigation Reform Act of 1995 reflecting our expectations regarding our future growth, results of operations, performance and business prospects and opportunities. Wherever possible, words such as "anticipate", "believe", "continue", "estimate", "intend", "may", "plan", "potential", "predict", "expect", "should", "will" and similar expressions, or the negative of these terms or other comparable terminology, have been used to identify these forward-looking statements. These forward-looking statements may also use different phrases. These statements regarding our expectations reflect our current beliefs and are based on information currently available to us. Accordingly, these statements by their nature are subject to risks and uncertainties, including those listed under Item 1A - Risk Factors in our most recent annual report on Form 10-K, which could cause our actual growth, results, performance and business prospects and opportunities to differ from those expressed in, or implied by, these forward-looking statements. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements we make. Except as otherwise required by federal securities law, we are not obligated to update or revise these forward looking statements to reflect new events or circumstances. We caution you that a variety of factors, including but not limited to the factors described under Item 1A - Risk Factors in our most recent annual report on Form 10-K, could cause our business conditions and results to differ materially from what is contained in forward-looking statements.

Other factors and assumptions not identified above were also involved in the formation of these forward-looking statements and the failure of such other assumptions to be realized, as well as other factors, may also cause actual results to differ materially from those projected.  Most of these factors are difficult to predict accurately and are generally beyond our control. You should consider the areas of risk described in Item 1A - Risk Factors in our most recent annual report on Form 10-K in connection with any forward-looking statements that may be made by us. You should not place undue reliance on any forward-looking statements. New factors emerge from time to time, and it is not possible for us to predict which factors will arise.

We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any additional disclosures we make in proxy statements, quarterly reports on Form 10-Q and current reports on Form 8-K filed with the SEC.

General Business Environment

We operate through two reportable business segments: Performance Improvement Solutions and Nuclear Industry Training and Consulting. Each segment focuses on delivering solutions to customers within our targeted markets - primarily the power and process industries. Marketing and communications, accounting, finance, legal, human resources, information systems and other administrative services are organized at the corporate level. Business development and sales resources are generally aligned with each segment to support existing customer accounts and new customer development.  The following is a description of our business segments:

Performance Improvement Solutions (approximately 44% of revenue)

Our Performance Improvement Solutions segment primarily encompasses our power plant high-fidelity simulation solutions and interactive computer based tutorials/simulation focused on the process industry. This segment includes various simulation products, engineering services, and operation training systems delivered across the industries we serve: primarily nuclear and fossil fuel power generation, as well as the process industries. Our simulation solutions include the following: (1) simulation software and services, including operator training systems, for the nuclear power industry, (2) simulation software and services, including operator training systems, for the fossil power industry, and (3) simulation software and services for the process industries used to teach fundamental industry processes and control systems to newly hired employees and for ongoing workforce development and training. GSE and its predecessors have been providing these services since 1976.

Nuclear Industry Training and Consulting (approximately 56% of revenue)

Nuclear Industry Training and Consulting provides highly specialized and skilled nuclear operations instructors, procedure writers, technical engineers, and other consultants to the nuclear power industry. These employees work at our clients' facilities under client direction. Examples of these highly skilled positions are senior reactor operations instructors, procedure writers, project managers, work management specialists, planners and training material developers. This business is managed through our Hyperspring and Absolute subsidiaries. The business model, management focus, margins and other factors clearly separate this business line from the rest of the Company's product and service portfolio. GSE and its predecessors have been providing these services since 1997.

Business Strategy

Our objective is to provide a powerful technology-enabled engineering and training/consulting services platform focused primarily on the nuclear power industry. We offer our differentiated suite of products and services to adjacent markets such as fossil power and the process industries where our offerings are a natural fit with a clear and compelling value proposition for the market. Our primary growth strategy is twofold: (1) seek acquisitions to accelerate our overall growth in a manner that is complementary to our core business and (2) expand organically within our core markets by leveraging our market leadership position and drive increased usage and product adoption via new products and services. To accomplish this, we will pursue the following activities:

Pursue roll-up acquisition strategy. We intend to complement our organic growth strategy through selective acquisitions including, but not limited to, the following: technical engineering; training, staffing and consulting service businesses focused on the power industry particular nuclear; value added components for nuclear power plants; and software utilized in the power industry, both domestic and international. We are focusing our efforts on acquisitions that would enhance our existing portfolio of products and services, strengthen our relationships with our existing customers, and potentially expand our footprint to include new customers in our core served industries. We have made several acquisitions since 2011 and believe the opportunity exists to acquire businesses that are complementary to ours, allowing us to accelerate our growth strategy.

In November 2014, we acquired Hyperspring, which enabled GSE to offer highly skilled nuclear operations and consulting personnel with unique know-how to our client base of nuclear power plants. This deepened our relationship with existing clients and won business for us at new client sites in the nuclear industry. This acquisition has proven to be synergistic, enabling cross selling domestically, and in 2015, the expansion of these offerings to international customers for the first time. In September 2017, we acquired Absolute, a provider of technical consulting and staffing solutions to the global nuclear power industry, located in Navarre, Florida and in May 2018, we acquired True North, a leading provider of specialty engineering solutions to the nuclear power industry.  The acquisitions of Absolute and True North are expected to strengthen the Company's global leadership in the nuclear services area. The acquisitions add new capabilities to the GSE solution offering, and bring new highly complementary customers to GSE while deepening GSE relationships with existing clients. The acquisitions of Absolute and True North are a significant proof point of the thesis that GSE is a compelling platform for consolidating a fragmented vendor ecosystem for nuclear power. The acquisitions add significant scale and focus to the business, while positioning GSE as a "go to" provider of technical and consulting solutions to the power industry, in particular nuclear power.

Expand our total addressable market. Our focus on growth means introducing product capabilities or new product and service categories that create value for our customers and therefore expand our total addressable market. Currently we are working on initiatives to expand our solution offerings in both our business segments which may include, but not be limited to, the following: expanding our software product portfolio to the industries we serve with enhanced power and process simulation tools and systems that are complementary to our core offerings; delivering enhanced learning management systems/solutions; offering fully outsourced training solutions to our customers; adding work flow process improvement solutions; tailoring operational reporting and business intelligence solutions to address the unique need of our end user markets; and adding new services to broaden our market reach.

Initiatives such as these will broaden our scope and enable us to engage more deeply with the segments we serve. We have delivered a compelling solution, the GSE GPWR ^TM Generic Pressurized Water Reactor simulation technology, proving that our modeling technology can be sold via traditional license terms and conditions to the nuclear industry ecosystem. We have both upgraded and expanded the EnVision™ library of simulation and eLearning tutorials for the process industries with specific new products for training clients in the upstream segment of the oil and gas industry including launching a new cloud-based training platform, EnVision™ Learning On-Demand, that significantly extends the capabilities of its industry leading EnVision™ tutorials and simulations. We continue to provide cutting edge training systems by adapting our technology to systems to meet the specific needs of customers such as U.S. government laboratories.

Research and development (R&D).   We invest in R&D to deliver unique solutions that add value to our end-user markets. We have delivered nuclear core and Balance-of-Plant modeling and visualization systems to the industry. To address the nuclear industry's need for more accurate simulation of both normal and accident scenarios, we provide our DesignEP ^® and RELAP5-HD ^® solutions. Our entire JADE ^TM suite of simulation software, including industry leading JTOPMERET ^® and JElectric ^TM software, provides the most accurate simulation of Balance-of-Plant and electrical systems available to the nuclear and fossil plant simulation market. The significant enhancements we have made to our SimExec ^® and OpenSim ^TM platforms enables customers to be more efficient in the daily operation of their simulators. We are bringing SimExec ^® and OpenSim ^TM together into a next generation unified environment that will add new capabilities as requested by clients and driven by market need.

We intend to continue to make pragmatic and measured investments in R&D that first and foremost are driven by the market, and are complementary to advancing our growth strategy. Such investments in R&D may result in on-going enhancement of existing solutions as well as the creation of new solutions to serve our target markets, ensuring that we add greater value, in an easier to use fashion, at lower cost of ownership than any alternative available to customers. GSE has pioneered a number of industry standards over our lifetime and will continue to be one of the most innovative companies in our industry.

Strengthen and develop our talent . Our experienced employees and management team are our most valuable resources. Attracting, training, and retaining top talent is critical to our success. To achieve our talent goals, we intend to remain focused on providing our employees with entrepreneurial opportunities to increase client contact within their areas of expertise and to expand our business within our service offerings. We will also continue to provide our employees with training, personal and professional growth opportunities, performance-based incentives including opportunities for stock ownership, bonuses and competitive benefits as benchmarked to our industry and locations.

Continue to deliver industry-recognized high-quality services . We have developed a strong reputation for quality services based upon our industry-recognized depth of experience, ability to attract and retain quality professionals, and expertise across multiple service sectors. We have received industry certificates and awards including being recognized for outstanding work on projects by Bechtel's Nuclear, Security & Environmental global business unit (NS&E) at the Bechtel Supply Chain Recognition awards in April 2016. In addition, we have a recognized high-value brand as one of the most respected providers of software and services to the nuclear industry, as evidenced by our marquee client base and significant market wins over the past years. A recently conducted survey of clients with projects underway and/or just delivered validates our brand with a Net Promoter Score of +72, a compelling score for an industrial technology and services company.

Expand international operations in selected markets. We believe there are additional opportunities for us to market our software and services to international customers, and to do so in a cost-effective manner. For example, we believe partnerships with Value Added Resellers (VAR) could significantly expand our sales pipeline for the EnVision™ software suite. In 2016, we entered into a reseller agreement with an entity in the Middle East that has an established track record of success selling simulation and workforce development solutions to the process industries throughout the region. Such VARs may yield positive results for our pursuit of international nuclear opportunities globally (see industry trends below). We may explore the creation of appropriate joint ventures to target nuclear new-build and maintenance programs in key regions.

Employees.  As of June 30, 2018, we had approximately 467 employees, which includes approximately 195 in our Performance Improvement segment and 272 in our Nuclear Industry Training and Consulting segment. To date, we have been able to locate and engage highly qualified employees as needed and we expect our growth efforts to be addressed through attracting top talent.

Backlog.  As of June 30, 2018, we had approximately $68.1 million of total gross revenue backlog, which included $43.6 million of Performance Improvement Solutions backlog and $24.5 million of Nuclear Industry Training and Consulting backlog.   With respect to our backlog, it includes only those amounts that have been funded and authorized and does not reflect the full amounts we may receive over the term of such contracts. Our backlog includes future expected revenue at contract rates, excluding contract renewals or extensions that are at the discretion of the client.  We calculate backlog without regard to possible project reductions or expansions or potential cancellations unless and until such changes may occur.

Backlog is expressed in terms of gross revenue and, therefore, may include significant estimated amounts of third-party or pass-through costs to subcontractors and other parties.  Because backlog is not a defined accounting term, our computation of backlog may not necessarily be comparable to that of our industry peers.

Products and Services

Performance Improvement Solutions

To assist our clients in creating world-class internal training and engineering improvement processes, we offer a set of integrated and scalable products and services which provide a structured program focused on continuous skills improvement for experienced employees to engineering services, which include plant design verification and validation. We provide the right solutions to solve our clients' most pressing needs.

For workforce development and training, students and instructors alike must have a high degree of confidence that their power plant simulator truly reflects plant behavior across the entire range of operations. To achieve this, GSE's simulation solution starts with the most robust engineering approach possible. Using state-of-the-art modeling tools combined with our leading nuclear power modeling expertise, GSE provides simulation solutions that achieve unparalleled fidelity and accuracy. The solutions that GSE provides are also known for ease of use, resulting in increased productivity by end-users. For these reasons, GSE has delivered more nuclear power plant simulators than any other company in the world.

For virtual commissioning, designers of first-of-a-kind plants or existing plants need a highly accurate dynamic simulation platform to model a wide variety of design assumptions and concepts from control strategies to plant behavior to human factors. Because new builds and upgrades to existing plants result in new technology being deployed, often involving the integration of disparate technologies for the first time, a high-fidelity simulator allows designers to see the interaction between systems for the very first time. With our combination of simulation technology and expert engineering, GSE was chosen to build first-of-a-kind simulators for the AP1000, PBMR, and small modular reactors such as those being built by NuScale.

Examples of the types of simulators we sell include, but are not limited to, the following:

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Universal Training Simulators: These products complement the Self-Paced Training Tutorials by reinforcing what the student learned in the tutorial, putting it into practice on the Universal Simulator. The simulation models are high fidelity and engineering correct, but represent a typical plant or typical process, rather than the exact replication of a client's plant. We have delivered over 360 such simulation models to clients consisting of major oil companies and educational institutions.

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Part-Task Training Simulators:  Like the Universal Simulators, we provide other unique training solutions such as a generic nuclear plant simulator and VPanel ® displays, which replicate control room hardware and simulator solutions specific to industry needs such as severe accident models to train on and aid in the understanding of events like the Fukushima Daiichi accident.

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Plant-Specific Operator Training Simulators:  These simulators provide an exact replication of the plant control room and plant operations. They provide the highest level of realism and training and allow users to practice their own plant-specific procedures. Clients can safely practice startup, shutdown, normal operations, as well as response to abnormal events we all hope they never have to experience in real life. Since our inception, we have delivered over 480 plant-specific simulators to clients in the nuclear power, fossil power and process industries worldwide.

Nuclear Industry Training and Consulting

As our customers' experienced staff retire, access to experts that can help operate and train existing and new employees in how to operate their plants is essential to ensure safe ongoing plant operations. In addition, operating and training needs change over time and sometimes our clients require fixed priced discrete projects or specialized courses in contrast to straight staff augmentation. The industry needs operating personnel, including procedure writers, engineers, operators and instructors who can step in and use as well as update the client's operating methods, procedures, training material and more. Finding technical professionals and instructors, who know the subject, can perform the work or teach it to others and can adapt to the client's culture, is critical. GSE provides qualified professionals, instructors and turnkey projects/courses that work within the client's system and complement the operating or training methods they already have in place. Examples of our training program courses include senior reactor operator certification, generic fundamentals training, and simulation supervisor training. In addition, we also provide expert support through consulting or turnkey projects for procedure writing, technical engineers, project managers, training material upgrade and development, outage execution, planning and scheduling, corrective actions programs, and equipment reliability.

We   bring together the collection of skills we have amassed over more than 40 years beginning with its traditional roots in custom high-fidelity simulation and training solutions for the power industries, extended through the acquisition of specialized engineering capabilities, enhanced by the entry and intermediate level training solutions of EnVision and the extensive nuclear industry training and consulting services of Absolute and Hyperspring.

Results of Operations - Three and six months ended June 30, 2018, versus three and six months ended June 30, 2017

Revenue . Total revenue for the three months ended June 30, 2018, increased 44.2% compared to the three months ended June 30, 2017. For the six months ended June 30, 2018, revenue increased 42.2% compared to the six months ended June 30, 2017. The increase in revenue was primarily driven by the year over year increase in revenue in the Nuclear Industry Training and Consulting segment, as described below.

Performance Improvement Solutions revenue decreased approximately $0.8 million or 7.0% during the three months ended June 30, 2018, compared to the same period in the prior year. Total new orders for this segment were $8.6 million during the three months ended June 30, 2018, an increase of $4.4 million when compared to the $4.2 million in the new orders during the three months ended June 30, 2017. The decrease in revenue was primarily due to the following: a decline of $1.8 million in revenue from our Performance Solutions subsidiary due to timing differences, as some of the 2017 major projects completed in late 2017 or early 2018; the fact that some major projects from new orders will start in the second half of 2018; and a decline of $0.3 million from foreign subsidiaries as a result of the winding down of the international subsidiaries. The decrease was partially offset by the acquisition of True North, which contributed $1.3 million of revenue to the segment since the acquisition on May 11, 2018.

For the six months ended June 30, 2018, Performance Improvement Solutions revenue was $20.8 million compared to $21.4 million for the six months ended June 30, 2017. We recorded total orders of $14.5 million during the six months ended June 30, 2018, an increase of $5.4 million compared to $9.1 million in the six months ended June 30, 2017. The decrease in revenue for the six months ended June 30, 2018 compared to the prior year was mainly driven by a decrease of $1.4 million in revenues from Performance Solutions subsidiary due to timing differences as discussed above, and a decrease of $0.5 million from foreign subsidiaries as a result of the winding down of the international subsidiaries. The decrease was partially offset by the acquisition of True North, which contributed $1.3 million of revenues to the segment since the acquisition.

For the three months ended June 30, 2018, Nuclear Industry Training and Consulting r evenue increased $8.4 million, or 154.3% compared to the three months ended June 30, 2017. Total orders for this segment were $7.4 million in the three months ended June 30, 2018, compared to $3.9 million in the prior year. The increase in the revenue was largely due to the acquisition of Absolute which contributed $7.5 million of revenues to the current year and an increase of $0.9 million from Hyperspring due to overall increased staff augmentation needs from its customers.

For the six months ended June 30, 2018, Nuclear Industry Training and Consulting revenue increased $14.7 million, or 121.5% compared to the six months ended June 30, 2017. We recorded total orders of $26.2 million in the six months ended June 30, 2018, compared to $18.8 million in the six months ended June 30, 2017. The $14.7 million increase was primarily attributable to the acquisition of Absolute, which contributed $14.9 million of revenues to the current year increase.

At June 30, 2018, backlog was $68.1 million: $43.6 million for the Performance Improvement Solutions business segment, $4.6 million of which was attributable to True North, and $24.5 million for Nuclear Industry Training and Consulting. At December 31, 2017, the Company's backlog was $71.4 million: $46.3 million for the Performance Improvement Solutions business segment and $25.1 million for Nuclear Industry Training and Consulting. The decrease in Performance Improvement Solutions business segment backlog was primarily due to 2017 backlog that was converted to revenues during 2018 and has only been partially backfilled by new orders.

Gross Profit . Gross profit totaled $6.3 million for the three months ended June 30, 2018, compared to $5.0 million for the same period in 2017.  As a percentage of revenue, gross profit decreased from 29.3% for the three months ended June 30, 2017, to 25.7% for the three months ended June 30, 2018.  For the six months ended June 30, 2018, gross profit was $11.2 million compared to $9.1 million for the same period in 2017.  As a percentage of revenue, gross profit decreased from 27.3% for the six months ended June 30, 2017, to 23.6% for the six months ended June 30, 2018.

The year over year increase in gross profit percentage for Performance Improvement Solutions during 2018 was primarily driven by cost savings realized in the second quarter of 2018 for a major project, which resulted in a revenue recognition of $0.7 million related to performance obligations satisfied in previous periods.

The gross profit percentage in Nuclear Industry Consulting and Training was lower during the three months ended June 30, 2017, as compared to other periods; this was mainly due to lower margin projects from a major customer in 2017. The minor fluctuations in gross profit percentage in other periods represented the normal changes in the mix of projects with different margins.

Selling, General and Administrative Expenses . Selling, general and administrative (SG&A) expenses totaled $4.8 million in the three months ended June 30, 2018, a 27.0% increase from the $3.8 million for the same period in 2017. For the six months ended June 30, 2018 and 2017, SG&A expenses totaled $9.3 million and $7.4 million, respectively. Fluctuations in the components of SG&A spending were as follows:

Corporate charges increased from $2.6 million for the three months ended June 30, 2017, to $3.4 million for the three months ended June 30, 2018. The increase was primarily driven by $0.5 million of acquisition expenses related to the True North acquisition; $0.1 million of corporate charges attributable to Absolute which was acquired in September 2017; higher labor costs of $0.1 million due to higher headcount and higher bonus of $0.1 million mainly due to a new post earnout bonus plan in 2018 for certain Hyperspring employees. For the six months ended June 30, 2018 and 2017, corporate charges increased from $5.0 million to $6.8 million. The increase was primarily due to $0.5 million of acquisition expenses related to the True North acquisition; higher bonus of $0.4 million mainly due to a new post earnout bonus plan in 2018 for certain Hyperspring employees; $0.3 million of corporate charges attributable to Absolute; higher professional fees of $0.2 million associated with the adoption of the new revenue standard (ASC 606) and the impact of the Tax Cuts and Jobs Act; and higher labor costs of $0.2 million due to higher headcount.

Business development expense increased $0.2 million and $0.4 million for the three and six months ended June 30, 2018, respectively, compared to the same periods in 2017. This was mainly due to acquisition of Absolute.

Facility O&M expenses increased $55,000 and $115,000 for the three and six months ended June 30, 2018, respectively, compared to the same periods in 2017. The increase in 2018 was mainly due to the lease of a new office building in Columbia location in March 2018.

Contingent consideration expense mainly reflected the fair value adjustments related to our November 2014 Hyperspring acquisition. The earnout period expired in November 2017, and the final payment was made in January 2018, therefore no contingent consideration adjustment was recorded for the current year.

Research and Development Expenses . Research and development (R&D) costs consist primarily of software engineering personnel and other related costs. R&D costs, net of capitalized software, totaled $0.2 million and $0.3 million for the three months ended June 30, 2018 and 2017, respectively. Before capitalization of software development costs, R&D costs totaled $0.4 million for each of the three months ended June 30, 2018 and 2017. R&D costs, net of capitalized software, totaled $0.5 million and $0.8 million for the six months ended June 30, 2018 and 2017, respectively. R&D expenses before capitalization of software development costs totaled $0.8 million for each of the six months ended June 30, 2018 and 2017. The decrease in R&D expenses in 2018 was mainly due to that more software projects had reached the development stage in current year.

Restructuring Charges . On December 27, 2017, the Board of GSE Systems, Inc. approved an international restructuring plan to streamline and optimize the Company's global operations and we announced we expected restructuring charges to total $2.0 million, excluding any tax impacts and cumulative translation adjustments. The Company recorded restructuring charges of $0.2 million and $1.1 million for the three and six months ended June 30, 2018, primarily consisted of lease termination costs, employee severance costs and other charges. As of June 30, 2018, we had recorded accumulated restructuring charges of $1.8 million, and we expect to record the remaining restructuring charges of approximately $0.2 million by the end of 2018. These restructuring charges exclude cumulative translation adjustment losses of approximately $1.6 million, assuming currency rates at June 30, 2018, and will be recorded as a charge against net income upon liquidation of the respective foreign subsidiaries. We also expect to recognize tax benefits related to the liquidation of these subsidiaries that may offset the majority of the currency translation adjustment losses. For the six months ended June 30, 2017 we recorded restructuring charges of $45,000, which represented true-up adjustments related to the restructuring plan initiated in 2015.

Depreciation . Depreciation expense increased $77,000 and $104,000 for the three and six months ended June 30, 2018, compared to the same periods in 2017. The increase in 2018 was largely driven by the acquisition of Absolute and the depreciation of additional leasehold improvements as we relocated most of our corporate functions to a new office building in Columbia Maryland in March 2018.

Amortization of Definite-lived Intangible Assets. Amortization expense related to definite-lived intangible assets totaled $0.3 million and $34,000 for the three months ended June 30, 2018 and 2017, respectively. For the six months ended June 30, 2018 and 2017, amortization expense related to definite-lived intangible assets totaled $0.5 million and $0.1 million, respectively. The increase in amortization of definite-lived intangible assets in 2018 was primarily due to acquisition of Absolute and True North. During the three and six months ended June 30, 2018, Absolute's amortization expenses totaled $167,000 and $286,000, respectively. During the three months ended June 30, 2018, True North's amortization expenses were $136,000.

Interest (expense) income, net . Interest expenses totaled $61,000 and $39,000 for the three and six months ended June 30, 2018, respectively. Interest income totaled $18,000 and $45,000 for the three and six months ended June 30, 2017, respectively. The Company issued a five-year term loan of $10.3 million in May 2018 to finance the acquisition of True North, and had recorded interest expenses of $64,000 related to the term loan for the three months ended June 30, 2018.

(Loss) gain on derivative instruments, net. In the normal course of business, our operations are exposed to fluctuations in foreign currency values and interest rate changes. We control a portion of these risks through a risk management program that includes the use of derivative instruments. (Loss) gain on derivative instruments relates to the Company's interest rate swap contracts, foreign exchange contracts and remeasurement of foreign currency denominated contract receivables, billings in excess of revenue earned, and subcontractor accruals. The following table summarizes the components of the (loss) gain recognized for the three and six months ended June 30, 2018 and 2017:

Other Income (Expense), Net .  For the three and six months ended June 30, 2018, the Company recognized other income, net, of $4,000 and other expense, net, of $29,000, respectively. For the three and six months ended June 30, 2017, the Company recognized other income, net, of $34,000 and $37,000, respectively.

(Benefit) provision for Income Taxes

Income tax expense (benefit) was $(0.4) million and $(0.2) million with effective income tax rates of (84.4)% and 27.0% for the three and six months ended June 30, 2018, respectively. This is compared to income tax expense of $0.2 million and $0.3 million with effective income tax rates of 22.1% and 35.4%, for the three and six months ended June 30, 2017, respectively. The Company's income tax (benefit) provision for interim periods is determined using an estimate of its annual effective tax rate, adjusted for discrete items arising in that quarter. Tax expense in 2018 is comprised mainly of federal income tax expense, foreign income tax expense, and state taxes. Tax expense in 2017 is comprised mainly of foreign income tax expense, Alternative Minimum Tax, state taxes, and deferred tax expense relating to the tax amortization of goodwill.

Our effective tax rates were (84.4)% and 27.0% for the three and six months ended June 30, 2018. For the three months ended June 30, 2018, the difference between our effective tax rate of 27.0% and the U.S. statutory federal income tax rate of 21% was primarily due to permanent differences, accruals related to uncertain tax positions for certain foreign tax contingencies, and discrete item adjustments for the foreign taxes. For the six months ended June 30, 2018, the difference between the effective tax rate of  (84.4)% and the U.S. statutory federal income tax rate of 21% was primarily due to changes in jurisdictional income and the inclusion of income from a new acquisition in the second quarter of 2018 .

Because of its net operating loss carryforwards, the Company is subject to U.S. federal and state income tax examinations from the year 1997 and forward. The Company is subject to foreign tax examinations by tax authorities for years 2011 forward for Sweden, 2014 forward for China, and 2015 forward for both India and the UK.

An uncertain tax position taken or expected to be taken in a tax return is recognized in the consolidated financial statements when it is more likely than not ( i.e. , a likelihood of more than 50%) that the position would be sustained upon examination by tax authorities that have full knowledge of all relevant information. A recognized tax position is then measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Interest and penalties related to income taxes are accounted for as income tax expense.

The Company has recorded full valuation allowance for its Chinese, U.K., and Swedish net deferred tax assets at June 30, 2018.

During the quarter ended June 30, 2018, the Company identified an immaterial error of $1.2 million, or $0.06 per share, in the December 31, 2017 financial statements related to the release of the valuation allowance against deferred tax assets attributable to windfall tax benefits recognized upon the adoption of ASU 2016-09. The portion relating to ASU 2016-09 should have been recorded to the consolidated statement of operations as an increase to our benefit for income taxes with a resulting increase to net income during the year ended December 31, 2017, however, the adjustment was recorded to accumulated deficit in the consolidated statement of changes in stockholders' equity. This had no impact to the ending accumulated deficit balance at December 31, 2017.

 

Additionally, the Company identified a $0.7 million classification error between deferred tax asset and deferred tax liability at December 31, 2017 due to improper netting of deferred taxes by jurisdiction. Accordingly, we reclassified $0.7 million of deferred tax liabilities, which was included in other liabilities to deferred tax assets in our December 31, 2017 consolidated balance sheet.

 

The Company evaluated the required changes and determined that their impact was not material. The financial statements for the year ended December 31, 2018 will reflect the correct comparative data.

Critical Accounting Policies and Estimates

In preparing the Company's consolidated financial statements, management makes several estimates and assumptions that affect the Company's reported amounts of assets, liabilities, revenues and expenses. The Company's most significant estimates relate to revenue recognition on contracts with customers, allowance for doubtful accounts, product warranties, valuation of goodwill and intangible assets acquired, valuation of long-lived assets to be disposed of, valuation of contingent consideration issued in business acquisitions, valuation of stock based compensation awards, and the recoverability of deferred tax assets. These critical accounting policies and estimates are discussed in the Management's Discussion and Analysis of Financial Condition and Results of Operations section in our most recent Annual Report on Form 10-K. For all of these policies, management cautions that future events rarely develop exactly as forecast, and the best estimates may require adjustment.

Liquidity and Capital Resources

As of June 30, 2018, the Company's cash, cash equivalents and restricted cash totaled $10.5 million compared to $20.1 million at December 31, 2017.

For the six months ended June 30, 2018 and 2017, net cash (used in) provided by operating activities was $(6.3) million and $2.9 million, respectively. The year over year change of $9.2 million in cash flows (used in) provided by operating activities was primarily driven by cash payments of $1.3 million for the restructuring expenses and the change in contract receivables, billing in excess of revenue earned and accounts payable and accrued expenses, which was mainly due to timing differences of cash collections and billing.

Net cash used in investing activities totaled $10.6 million and $0.1 million for the six months ended June 30, 2018 and 2017, respectively. The increase in cash outflow in 2018 was primarily driven by the acquisition of True North, the net cash consideration of which was $9.8 million; $0.4 million increase in fixed assets primarily due to increase in lease improvements and furniture and fixtures as we entered into a new lease agreement in December 2017 and relocated most of our corporate functions, including finance, legal, and R&D to a new office in Columbia, Maryland in March 2018; and $0.2 million increase in capitalized software development costs as more software reached development stage.

For the six months ended June 30, 2018 and 2017, cash provided by (used in) financing activities totaled $7.6 million and $(1.4) million, respectively. The increase in the cash inflow from financing activities was largely driven by the proceeds from issuance of term loan of $10.2 million, net of discount and issuance costs, a decrease of $0.6 million in the Company's withholding of RSUs in order to pay employees' payroll withholding taxes on vested RSUs; the increase was partially offset by repayments of $0.7 million on the term loan and an increase of $1.1 million in contingent consideration payments to the former Hyperspring owners as we paid off the earnout.

At June 30, 2018, the Company had cash, cash equivalents and restricted cash of $10.5 million. The Company believes that its (i) cash and cash equivalents and (ii) cash generated from normal operations will be sufficient to fund its working capital and other requirements for at least the next twelve months.

Credit Facilities

Citizens Bank

The Company entered into a three-year, $5.0 million revolving line of credit facility (RLOC) with Citizens Bank, National Association (the Bank) on December 29, 2016, to fund general working capital needs. On May 11, 2018, GSE and Performance Solutions (collectively, the  Borrower) entered into an Amended and Restated Credit and Security Agreement (the Credit Agreement) with the Bank, amending and restating the Company's existing Credit and Security Agreement with the Bank, which included a $5.0 million asset-based revolving credit facility between the Borrower and the Bank, to now include (a) a $5.0 million revolving credit facility not subject to a borrowing base, including a letter of credit sub-facility, and (b) a $25.0 million delayed draw term loan facility available to be drawn upon for up to 18 months and to finance certain permitted acquisitions by the Company.

On May 11, 2018, upon acquisition of True North, the Company drew down approximately $10.3 million to fund the transaction, $0.5 million of which was repaid to the Bank on the same day. At June 30, 2018, the outstanding balance of the long-term debt was $9.5 million.

At June 30, 2018, there were no outstanding borrowings on the RLOC and three letters of credit totaling $1.2 million. The amount available at June 30, 2018, after consideration of the letters of credit was approximately $3.8 million.

The credit facility agreement is subject to standard financial covenants and reporting requirements. At June 30, 2018, the Company was in compliance with its financial covenants.

BB&T Bank

At June 30, 2018, we had one letter of credit with BB&T totaling $0.5 million, which expired and is pending on release by the bank and customer. At June 30, 2018 and December 31, 2017, the cash collateral account with BB&T totaled $0.5 million and $1.0 million, respectively and were classified as restricted cash on the consolidated balance sheets.

Non-GAAP Financial Measures

EBITDA and Adjusted EBITDA are not measures of financial performance under generally accepted accounting principles (GAAP). Management believes EBITDA and Adjusted EBITDA, in addition to operating profit, net income and other GAAP measures, are useful to investors to evaluate the Company's results because each measure excludes certain items that are not directly related to the Company's core operating performance that may, or could, have a disproportionate positive or negative impact on our results for any particular period. Investors should recognize that EBITDA and Adjusted EBITDA might not be comparable to similarly-titled measures of other companies. Our management uses EBITDA and Adjusted EBITDA and other non-GAAP measures to evaluate the performance of our business and make certain operating decisions (e.g., budgeting, planning, employee compensation and resource allocation). This measure should be considered in addition to, and not as a substitute for or superior to, any measure of performance prepared in accordance with GAAP. A reconciliation of non-GAAP EBITDA and Adjusted EBITDA to the most directly comparable GAAP measure in accordance with SEC Regulation G is as follows:

( in thousands )

Adjusted Net Income and Adjusted EPS Reconciliation (in thousands, except per share amounts)

Adjusted Net Income and adjusted earnings (loss) per share ("adjusted EPS") are not measures of financial performance under GAAP.  Management believes adjusted net income and adjusted EPS, in addition to other GAAP measures, provide meaningful supplemental information regarding our operational performance. Our management uses Adjusted Net Income and other non-GAAP measures to evaluate the performance of our business and make certain operating decisions (e.g., budgeting, planning, employee compensation and resource allocation). This information facilitates management's internal comparisons to our historical operating results as well as to the operating results of our competitors. Since management finds this measure to be useful, we believe that our investors can benefit by evaluating both non-GAAP and GAAP results.  These measures should be considered in addition to, and not as a substitute for or superior to, any measure of performance prepared in accordance with GAAP. A reconciliation of non-GAAP adjusted net income and adjusted EPS to GAAP net income, the most directly comparable GAAP financial measure, is as follows: