ITEM 2.
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Management’s Discussion and Analysis of Financial Condition and Results of Operations
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The following discussion of our results of operations and financial conditions should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q.
We are a leading provider of analytics and insights that facilitate measurement and improvement of the patient and employee experience while also increasing patient engagement and customer loyalty for healthcare organizations. Our solutions enable our clients to understand the voice of the customer with greater clarity, immediacy and depth. Our heritage, proprietary methods, and holistic approach enable our partners to better understand the people they care for and design experiences that inspire loyalty and trust, while also facilitating regulatory compliance and the shift to population-based health management. Our ability to measure what matters most and systematically capture, analyze and deliver insights based on self-reported information from patients, families and consumers is critical in today’s healthcare market. We believe that access to and analysis of our extensive consumer-driven information is becoming more valuable as healthcare providers increasingly need to more deeply understand and engage the people they serve to build customer loyalty.
Our portfolio of subscription-based solutions provides actionable information and analysis to healthcare organizations across a range of mission-critical, constituent-related elements, including patient experience, service recovery, care transitions, health risk assessments, employee engagement, reputation management, and brand loyalty. We partner with clients across the continuum of healthcare services. Our clients include integrated health systems, post-acute providers and payer organizations. We believe this cross-continuum positioning is a unique and an increasingly important capability as evolving payment models drive healthcare providers and payers towards a more collaborative and integrated service model.
The outbreak of COVID-19, and the associated responses, have impacted our business in a variety of ways. Governments have implemented business and travel restrictions, recommended social distancing and other guidelines, and temporarily suspended the requirement for certain healthcare organizations to periodically assess the performance of the care they provide (although many providers continue to do so). Many businesses, including many of our clients, have de-emphasized external business opportunities and restricted in-person meetings while shifting their attention toward addressing COVID-19 planning, business disruptions, higher costs, and revenue shortfalls. At NRC, our workforce remains intact and highly engaged. The vast majority of our associates are working remotely, and to date we have been capable of providing our services without significant disruption. Historically, we have relied on national travel as part of our sales efforts, but as a result of the pandemic we have placed an indefinite hold on all company related travel. The duration and severity of the COVID-19 pandemic and associated responses on our business, including the impact on our revenue, expenses, and cash flows, cannot be predicted at this time. Based on the foregoing, we do not expect our recent revenue and earnings growth to be indicative of future expectations. We do, however, expect to have adequate sources of liquidity to meet our current and expected needs for the foreseeable future.
We were the target of an external ransomware attack in February 2020 which resulted in a temporary suspension of our services to clients. Since then, we have fully restored our services. A forensic investigation conducted by outside security counsel and a cyber-security forensics expert also determined that there was low probability that any protected health information stored on our systems was compromised in connection with this event. Therefore, based on the investigation and in consultation with counsel we have concluded that this incident was not a reportable “breach” as defined by Health Insurance Portability and Accountability Act or various other state and provincial laws and regulations.
We recorded an insurance receivable of $2.8 million for incremental costs related to the cyber-attack that our insurer has confirmed as reimbursable. Due to the attack in the three-month period ended March 31, 2020, we also recognized revenue adjustments decreasing revenue by approximately $280,000 for our estimate of variable consideration related to subscription-based services that could not be performed. In addition, we incurred other expenses related to the incident including but not limited to professional fees and information technology costs amounting to approximately $285,000. These revenue adjustments and costs will be further evaluated and submitted as a loss claim to the insurer. We will record any insurance recovery when it is probable of collection. Due to insurance recoverability, we do not believe the cyber-attack will have a significant impact on our consolidated financial statements. However, our estimate of variable consideration related to the subscription-based services that could not be performed may change and the incident could adversely affect our retention and sales in the future.
Results of Operations
The following table and graphs set forth, for the periods indicated, selected financial information derived from our consolidated financial statements, including amounts expressed as a percentage of total revenue and the percentage change in such items versus the prior comparable period (please note that all columns may not add up to 100% due to rounding). The trends illustrated in the following table and graphs may not necessarily be indicative of future results. The discussion that follows the information should be read in conjunction with our consolidated financial statements.
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Three months ended
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March 31,
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2020
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2019
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Revenue:
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100.0
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%
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100.0
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%
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Operating expenses:
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Direct
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37.0
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37.0
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Selling, general and administrative
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25.8
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24.5
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Depreciation and amortization
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4.1
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4.5
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Total operating expenses
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66.9
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66.0
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Operating income
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33.1
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%
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34.0
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%
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Three Months Ended March 31, 2020, Compared to Three Months Ended March 31, 2019
Revenue. Revenue for the three-month period ended March 31, 2020, increased 7.6% to $33.9 million, compared to $31.5 million in the three-month period ended March 31, 2019. The increase was primarily due to new customer sales, as well as increases in sales to the existing client base net of reductions due to the temporary interruption of services resulting from the cyber-attack.
Direct expenses. Direct expenses increased 7.7% to $12.5 million for the three-month period ended March 31, 2020, compared to $11.7 million in the same period in 2019. This was due to decreased variable expenses of $559,000 and an increase in fixed expenses of $1.5 million. Variable expenses decreased due to less postage, printing, and paper costs, primarily resulting from changes in survey methodologies; and decreased contracted board portal costs due to decreased client usage; partially offset by higher conference expenses due to the timing of conferences. Fixed expenses increased primarily as a result of increased salary and benefit costs and contracted services in the customer service and information technology areas, including system restoration costs associated with the cyber-attack. Direct expenses as a percentage of revenue were 37.0% in the three-month periods ended March 31, 2020 and 2019.
Selling, general and administrative expenses. Selling, general and administrative expenses increased 13.5% to $8.7 million for the three-month period ended March 31, 2020, compared to $7.7 million for the same period in 2019, primarily due to an increase in salary and benefit costs of $516,000, increased software and platform hosting expenses of $177,000, additional legal and accounting costs of $168,000 primarily due to an insurance refund of legal expenses associated with litigation related to our April 2018 recapitalization (the "Recapitalization") in the same period in 2019, higher business insurance costs of $134,000, increased company incentive event costs of $103,000 and increased sales tax expense of $50,000. These were partially offset by lower travel and meals costs of $125,000 due to restricted travel associated with COVID-19. Selling, general and administrative expenses as a percentage of revenue were 25.8% in the three-month periods ended March 31, 2020 and 24.5% for the same period in 2019.
Depreciation and amortization. Depreciation and amortization was $1.4 million for the three-month period ended March 31, 2020 and 2019. Depreciation and amortization expense as a percentage of revenue was 4.1% for the three-month period ended March 31, 2019, and 4.5% for the same period in 2019.
Other income (expense). Other income, net increased to $176,000 for the three-month period ended March 31, 2020, compared to other expense, net of $844,000 for the same period in 2019, primarily due to decreased interest expense and foreign exchange rate changes. Interest expense decreased to $465,000 in 2020 from $570,000 for the same period in 2019 primarily due to the declining balance on our term loan and no borrowings on our line of credit in 2020. Other income increased to $630,000 in 2020 compared to other expense of $280,000 for the same period of 2019 primarily due to revaluation on intercompany transactions due to changes in the foreign exchange rate.
Income tax provision (benefit). Income tax provision (benefit) was ($385,000) for the three-month period ended March 31, 2020, compared to $1.7 million for the same period in 2019. The effective tax rate for the three-month period ended March 31, 2020 decreased to a (3.4)% benefit compared to 16.9% expense primarily due to increased tax benefits of $2.6 million from the exercise and vesting of share-based compensation awards partially offset by higher state income taxes due to the requirements to file in more states.
Liquidity and Capital Resources
We believe that our existing sources of liquidity, including cash and cash equivalents, borrowing availability, and operating cash flows, will be sufficient to meet our current and expected needs for the foreseeable future. We believe our working capital deficit has little impact on our liquidity. Cash dividends in the aggregate amount of $5.3 million declared on March 9, 2020 and paid in April 2020 were funded with cash on hand. Our board of directors considers whether to declare a dividend and the amount of any dividends declared on a quarterly basis. No determination has been made to date for the second quarter of 2020.
As of March 31, 2020, our principal sources of liquidity included $10.0 million of cash and cash equivalents, up to $15 million of unused borrowings under our line of credit and up to $15 million on our delayed draw term note. Of this cash, $3.1 million was held in Canada. The delayed draw term note can only be used to fund permitted future business acquisitions or repurchasing our Common Stock.
Working Capital
We had a working capital deficit of $4.9 million and $9.0 million on March 31, 2020 and December 31, 2019, respectively.
The change was primarily due to an increase in trade accounts receivable of $5.8 million, the addition of an insurance receivable of $2.8 million due to the cyber-attack, an increase in prepaid expenses of $570,000, an increase in income taxes receivable of $511,000, a decrease in accrued wages, bonus and profit sharing of $1.2 million and a decrease in accounts payable of $624,000. These were partially offset by an increase in deferred revenue of $2.8 million, an increase in accrued expenses of $900,000 and a decrease in cash and cash equivalents of $3.5 million.
Trade accounts receivable increased due to the timing of billings and collections on new and renewal contracts. Accrued wages, bonus and profit sharing decreased due to the payment of 2019 annual bonuses in the three-month period ended March 31, 2020. Income taxes receivable changed due to the timing of income tax payments. Accounts payable, accrued expenses and prepaid expenses changed due to timing of payment for services and supplies. Our working capital is significantly impacted by our large deferred revenue balances which will vary based on the timing and frequency of billings on annual agreements. The deferred revenue balances as of March 31, 2020, and December 31, 2019, were $19.2 million and $16.4 million, respectively.
The deferred revenue balance is primarily due to timing of initial billings on new and renewal contracts. We typically invoice clients for services before they have been completed. Billed amounts are recorded as billings in excess of revenue earned, or deferred revenue, on our consolidated financial statements, and are recognized as income when earned. In addition, when work is performed in advance of billing, we record this work as revenue earned in excess of billings, or unbilled revenue. Substantially all deferred revenue and all unbilled revenue will be earned and billed respectively, within 12 months of the respective period ends.
Cash Flow Analysis
A summary of operating, investing, and financing activities is shown in the following table:
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Three Months Ended March 31,
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2020
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2019
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(In thousands)
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Provided by operating activities
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$
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5,523
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$
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7,300
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Used in investing activities
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(590
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)
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(1,134
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)
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Used in financing activities
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(7,536
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)
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(16,820
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)
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Effect of exchange rate change on cash
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(893
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)
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(304
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)
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Net change in cash and cash equivalents
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(3,496
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)
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(10,350
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)
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Cash and cash equivalents at end of period
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$
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10,021
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$
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2,641
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Cash Flows from Operating Activities
Cash flows from operating activities consist of net income adjusted for non-cash items including depreciation and amortization, deferred taxes, share-based compensation and related taxes, reserve for uncertain tax positions and the effect of working capital changes.
Net cash provided by operating activities was $5.5 million for the three-month period ended March 31, 2020, which included net income of $11.8 million, plus non-cash charges (benefits) for deferred income taxes, depreciation and amortization, reserve for uncertain tax positions and share-based compensation and related taxes totaling $2.1 million. Net changes in assets and liabilities decreased cash flows from operating activities by $8.4 million, primarily due to increases in trade accounts receivable, prepaid and other current assets, deferred contract costs, net and insurance receivable due to the cyber-attack, as well as decreases in accounts payable, accrued expenses, wages, bonuses and profit sharing, and income taxes receivable and payable which fluctuate due to the timing of payments of prepaids, accounts payable and accrued expenses, direct and incremental costs directly related to sales and the timing of income tax payments. These decreases to cash flows were partially offset by increases in deferred revenue, which will vary based on the timing and frequency of billings on annual agreements.
Net cash provided by operating activities was $7.3 million for the three-month period ended March 31, 2019, which included net income of $8.2 million, plus non-cash charges (benefits) for deferred tax expense, depreciation and amortization, reserve for uncertain tax positions, totaling $1.7 million. Net changes in assets and liabilities decreased cash flows from operating activities by $2.6 million, primarily due to increases in trade accounts receivable and prepaid and other current assets, and decreases in accrued expense, wages, bonus and profit sharing, partially offset by increases in accounts payable, deferred revenue and income taxes payable and receivable which fluctuate with the timing of income tax payments.
Cash Flows from Investing Activities
Net cash of $590,000 and $1.1 million was used for investing activities in the three months ended March 31, 2020 and 2019, respectively. These expenditures consisted mainly of computer software classified in property and equipment. We expect similar capital expenditure purchases for the remainder of 2020 consisting primarily of computer software and hardware and other equipment to be funded through cash generated from operations.
Cash Flows from Financing Activities
Net cash used in financing activities was $7.5 million in the three months ended March 31, 2020. Cash was used to repay borrowings under the term notes totaling $959,000 and for finance lease obligations of $58,000. Cash was also used to pay $5.2 million of dividends
on our common stock, and to pay payroll tax withholdings related to share-based compensation of $1.3 million.
Net cash used in financing activities was $16.8 million in the three months ended March 31, 2019. Cash was used to repay borrowings on the line of credit of $6.8 million, repay borrowings under the note payable totaling $918,000, and for finance lease obligations of $57,000. Cash was also used to pay $17.1 million of dividends on common stock, and to pay payroll tax withholdings related to share-based compensation of $483,000. Cash was provided from proceeds of the line of credit of $8.5 million.
The effect of changes in foreign exchange rates decreased cash and cash equivalents by $893,000 in the three months ended March 31, 2020 and increased cash and cash equivalents by $304,000 in the three months ended March 31, 2019.
Capital Expenditures
Cash paid for capital expenditures was $590,000 for the three months ended March 31, 2020. These expenditures consisted mainly of computer software classified in property and equipment. We expect similar capital expenditure purchases for the remainder of 2020 consisting primarily of computer software and hardware and other equipment to be funded through cash generated from operations.
Debt and Equity
Our credit agreement (the “Credit Agreement”) with FNB provides for (i) a $15,000,000 revolving credit facility (the “Line of Credit”), (ii) a $40,000,000 term loan (the “Term Loan”) and (iii) a $15,000,000 delayed draw-down term facility (the “Delayed Draw Term Loan” and, together with the Line of Credit and the Term Loan, the “Credit Facilities”). The Delayed Draw Term Loan may be used to fund any permitted future business acquisitions or repurchasing our Common Stock and the Line of Credit will be used to fund ongoing working capital needs and other general corporate purposes.
The Term Loan is payable in monthly installments of $462,988 through April 2020 and $526,362 thereafter, with a balloon payment due at maturity in April 2023. The Term Loan bears interest at a fixed rate per annum of 5%.
Borrowings under the Line of Credit and the Delayed Draw Term Loan, if any, bear interest at a floating rate equal to the 30 day London Interbank Offered Rate (“LIBOR”) plus 225 basis points (3.61% at March 31, 2020). Interest on the Line of Credit accrues and is payable monthly. Principal amounts outstanding under the Line of Credit are due and payable in full at maturity, in April 2021. As of March 31, 2020, the Line of Credit did not have a balance. There were no borrowings on the line of credit for the three-month period ended March 31, 2020.
In the event that the Delayed Draw Term Loan is used, interest-only payments will be due through the calendar year in which the Delayed Draw Term Loan is drawn upon. After that, amortization will occur at the then current Term Loan rate and schedule with principal and accrued interest amounts outstanding under the Delayed Draw Term Loan due and payable monthly during the term of the Delayed Draw Term Loan, which expires on April 18, 2023. There have been no borrowings on the Delayed Draw Term Loan since origination.
We paid a one-time fee equal to 0.25% of the amount borrowed under the Term Loan at the closing of the Credit Facilities. We are also obligated to pay ongoing unused commitment fees quarterly in arrears pursuant to the Line of Credit and the Delayed Draw Term Loan facility at a rate of 0.20% per annum based on the actual daily unused portions of the Line of Credit and the Delayed Draw Term Loan facility, respectively.
All obligations under the Credit Facilities are to be guaranteed by each of our direct and indirect wholly owned domestic subsidiaries, if any, and, to the extent required by the Credit Agreement, direct and indirect wholly owned foreign subsidiaries (each, a “guarantor”).
The Credit Facilities are secured, subject to permitted liens and other agreed upon exceptions, by a first-priority lien on and perfected security interest in substantially all of our and our guarantors’ present and future assets (including, without limitation, fee-owned real property, and limited, in the case of the equity interests of foreign subsidiaries, to 65% of the outstanding equity interests of such subsidiaries).
The Credit Agreement contains customary representations, warranties, affirmative and negative covenants (including financial covenants) and events of default. The negative covenants include, among other things, restrictions regarding the incurrence of indebtedness and liens, repurchases of our Common Stock and acquisitions, subject in each case to certain exceptions. The Credit Agreement also contains certain financial covenants with respect to minimum fixed charge coverage ratio and maximum cash flow leverage ratio. Pursuant to the Credit Agreement, we are required to maintain a minimum fixed charge coverage ratio of 1.10x for all testing periods throughout the terms of the Credit Facilities. We are also required to maintain a maximum cash flow leverage ratio of 3.00x for all testing periods throughout the terms of the Credit Facilities. As of March 31, 2020, we were in compliance with our financial covenants.
LIBOR is currently expected to be phased out in 2021. We are required to pay interest on borrowings under our Line of Credit and Delayed Draw Term Loan at floating rates based on LIBOR. Future debt that we may incur may also require that we pay interest based upon LIBOR. Under the terms of our Credit Agreement with FNB, if LIBOR becomes unavailable during the term of the agreement, FNB may, in its reasonable discretion and in a manner consistent with market practice, designate a substitute index. We currently expect that the determination of interest under our Credit Agreement would be revised as to provide for an interest rate that approximates the existing interest rate as calculated in accordance with LIBOR. Despite our current expectations, we cannot be sure that if LIBOR is phased out or transitioned, the changes to the determination of interest under our agreements would approximate the current calculation in accordance with LIBOR. We do not know what standard, if any, will replace LIBOR if it is phased out or transitioned.
We have finance leases for computer equipment, office equipment, printing and inserting equipment. The balance of the finance leases as of December 31, 2020 was $726,000.
Shareholders’ equity increased $4.4 million to $37.3 million at March 31, 2020, from $32.9 million at December 31, 2019. The increase was mainly due to net income of $11.8 million and share-based compensation of $332,000. This was partially offset by dividends declared of $5.3 million, share repurchases exceeding the cost of stock options exercised of $1.3 million and changes in the cumulative translation adjustment of $1.1 million.
A sales tax accrual of $775,000 was recorded in 2019 after we became aware that a state sales tax liability was both probable and estimable as of December 31, 2019, due to sales taxes that should have been collected from customers in 2019 and certain previous years. We are working through voluntary disclosure agreements with certain states and will have procedures in place to start collecting and remitting sales tax in June or July of 2020. State and local jurisdictions have differing rules and regulations governing sales, use, and other taxes and these rules and regulations can be complex and subject to varying interpretations that may change over time. As a result, we could face the possibility of tax assessment and audits, and our liability for these taxes and associated interest and penalties could exceed our original estimates. In addition, we incurred additional sales tax expense in the first quarter of 2020 of $50,000 and will incur additional expense in the second quarter of 2020, since we will not start collecting sales tax from customers until June or July of 2020.
Contractual Obligations
We had contractual obligations to make payments in the following amounts in the future as of March 31, 2020:
Contractual Obligations(1)
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Total
Payments
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Less than
One Year
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|
|
One to
Three Years
|
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Three to
Five Years
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After
Five Years
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(In thousands)
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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Operating leases
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$
|
1,643
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|
|
$
|
410
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|
|
$
|
671
|
|
|
$
|
445
|
|
|
$
|
117
|
|
Finance leases
|
|
|
779
|
|
|
|
188
|
|
|
|
455
|
|
|
|
136
|
|
|
|
--
|
|
Uncertain tax positions(2)
|
|
|
--
|
|
|
|
--
|
|
|
|
--
|
|
|
|
--
|
|
|
|
--
|
|
Long-term debt
|
|
|
37,449
|
|
|
|
4,674
|
|
|
|
12,633
|
|
|
|
20,142
|
|
|
|
--
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|
Total
|
|
$
|
39,871
|
|
|
$
|
5,272
|
|
|
$
|
13,759
|
|
|
$
|
20,723
|
|
|
$
|
117
|
|
(1)
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Amounts are inclusive of interest payments, where applicable.
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(2)
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We have $679,000 in liabilities associated with uncertain tax positions. We are unable to reasonably estimate the expected cash settlement dates of these uncertain tax positions with the taxing authorities.
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We generally do not make unconditional, non-cancelable purchase commitments. We enter into purchase orders in the normal course of business, but these purchase obligations do not exceed one year.
Stock Repurchase Program
Our Board of Directors authorized the repurchase of up to 2,250,000 then-existing class A shares and 375,000 then-existing class B shares of common stock in the open market or in privately negotiated transactions under a stock repurchase program that was originally approved in February 2006 and subsequently amended in May 2013. In connection with the Recapitalization in April 2018, our Board of Directors further amended the stock repurchase program to eliminate the repurchase of the former class B common stock. As of March 31, 2020, the remaining number of shares of Common Stock that could be purchased under this authorization was 280,491 shares.
Critical Accounting Estimates
There have been no changes to our critical accounting estimates described in the Annual Report on Form 10-K for the year ended December 31, 2019 that have a material impact on our Condensed Consolidated Financial Statements and the related Notes.