Item 2. Management’s Discussion and Analysis
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
The discussion below contains certain forward-looking statements including, but not limited to, among others, statements concerning future revenues and future business plans. Forward-looking statements include statements in which we use words such as “expect”, “believe”, “anticipate”, “intend”, “project”, “estimate”, “should”, “could”, “may”, “plan”, “potential”, “predict”, “project”, “will”, “would” and similar expressions. Although we believe the expectations reflected in such forward-looking statements are based on reasonable assumptions, the forward-looking statements are subject to significant risks and uncertainties, and thus we cannot assure you that these expectations will prove to have been correct, and actual results may vary from those contained in such forward-looking statements. We discuss many of these risks and uncertainties in Item 1A under the heading “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended September 30, 2020, and in this Form 10-Q. Factors that may cause such variances include, but are not limited to, our dependence on a small number of customers for a significant portion of our revenue, our high dependence on contracts with the U.S. federal government, our reliance in certain circumstances on single sources for supply of key product components, intense competition in the market segments in which we operate, the recent changes in the U.S. Tax laws, and the impact of the novel coronavirus (COVID-19) on our business, results of operations and financial condition. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our estimates and assumptions only as of the date of this document. Except as required by law, we do not undertake any obligation to publicly update or revise any forward-looking statements contained in this report, whether as a result of new information, future events or otherwise. This management’s discussion and analysis of financial condition and results of operations should be read in conjunction with our financial statements and the related notes included elsewhere in this filing and in our Annual Report on Form 10-K for the fiscal year ended September 30, 2020.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates, including those related to uncollectible receivables, inventory valuation, impairment assessment of intangibles, income taxes, deferred compensation and retirement plans, as well as estimated selling prices used for revenue recognition and contingencies. We base our estimates on historical performance and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. A description of our critical accounting policies is contained in our Annual Report on Form 10-K for the fiscal year ended September 30, 2020 in the “Critical Accounting Policies” section contained in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Observations on effects of novel coronavirus (COVID-19)
On March 11, 2020, the World Health Organization characterized the novel coronavirus (COVID-19) outbreak as a pandemic. The outbreak has and continues to adversely affect the economies of the U.S., U.K., and other international markets and economies in which we operate. As a result of the World Health Organization characterizing the COVID-19 outbreak as a pandemic, national, state, and local governments have and continue to take actions such as declaring a state of emergency, implementing social distancing and other guidelines, and shutting down and/or limiting the opening or operation of certain businesses which are not considered essential. The Company continues to comply with such actions
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causing most employees to work remotely in all locations. Our revenue decreased significantly for the three months ended December 31, 2020 due to the pandemic. This is largely the result of customers reducing their budgets. The pandemic has also had an adverse effect on our ability to transact one-on-one business. Due to the uncertainty of the pandemic, including but not limited to, regulatory measures or voluntary actions that have and may be put in place to limit the spread of COVID-19 and the duration of such measures, the impact of any further spread of COVID-19, or the resurgence of COVID-19 in a given geographic region after it has hit its “peak,” at this time, we cannot make a reasonable estimate on the extent or duration of the impacts on our business.
Results of Operations
Overview of the three months ended December 31, 2020
Our revenues decreased by approximately $5.5 million, or 33%, to $11.4 million for the three months ended December 31, 2020 as compared to $16.9 million for the three months ended December 31, 2019. The decrease in revenue is the result of a decrease of $6.0 million in our TS segment, partially offset by a $0.5 million increase in our HPP segment. Our gross margin percentage increased to 30% of revenues for the three months ended December 31, 2020 from 24% for the three months ended December 31, 2019. The increase is primarily attributed to the HPP segment. For the three months ended December 31, 2020 there was an operating loss of $0.5 million compared to an operating loss of $0.4 million for the three months ended December 31, 2019, primarily as a result of decreased sales. Other income, (expense) net increased approximately $2.0 million for the three months ended December 31, 2020 to income of $1.8 million as compared to expense of $0.2 million for the three months ended December 31, 2019. The primary components of Other income, (expense) include an increase from debt forgiveness of loans taken out at each operating segment under the Payroll Protection Program totaling 2.2 million, partially offset by a foreign exchange loss of $0.5 million. The income tax provision was $0.1 million for the three months ended December 31, 2020, as compared to income tax benefit of $0.1 million for the three months ended December 31, 2019. The effective tax rate for the current quarter was 8.7%. The effective tax expense rate was primarily driven by an increase in tax expense. This is primarily related to the write off of a deferred tax asset as a result of the change in tax law, allowing for the immediate deduction of covered expenses incurred through the Paycheck Protection Program (“PPP”) loan along with the associated change in valuation allowance against deferred tax assets from the prior period, offset by the forgiveness of the PPP Loans for which the income is excluded for tax purposes. This additional expense was recorded discretely during the quarter. In the prior period, the Company established a deferred tax asset for these expenses that were expected to be deductible in a future period.
The following table details our results of operations in dollars and as a percentage of sales for the three months ended December 31, 2020 and 2019:
%
%
December 31, 2020
of sales
December 31, 2019
of sales
(Dollar amounts in thousands)
Sales
$
11,388
100
%
$
16,858
100
%
Costs and expenses:
Cost of sales
8,010
70
%
12,827
76
%
Engineering and development
729
6
%
672
4
%
Selling, general and administrative
3,186
28
%
3,761
22
%
Total costs and expenses
11,925
105
%
17,260
102
%
Operating loss
(537)
(5)
%
(402)
(2)
%
Other income, (expense) net
1,798
16
%
(208)
(1)
%
Income (loss) before income taxes
1,261
11
%
(610)
(3)
%
Income tax expense (benefit)
110
1
%
(70)
—
%
Net income (loss)
$
1,151
10
%
$
(540)
(3)
%
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Revenues
Our revenues decreased by approximately $5.5 million to $11.4 million for the three months ended December 31, 2020 as compared to $16.9 million of revenues for the three months ended December 31, 2019. TS segment revenues decreased by $6.0 million and HPP segment revenues increased by approximately $0.5 million.
TS segment revenue change was as follows for the three months ended December 31, 2020 and December 31, 2019:
Decrease
2020
2019
$
%
(Dollar amounts in thousands)
Products
$
7,232
$
12,792
$
(5,560)
(43)
%
Services
2,600
3,025
(425)
(14)
%
Total
$
9,832
$
15,817
$
(5,985)
(38)
%
The decrease in TS segment product revenues of approximately $5.6 million during the period is primarily the result of a decrease of $6.4 million in our U.S. division, partially offset by an increase in the U.K. division of $0.8 million. The $6.4 million decrease in the U.S. division is primarily the result of decreased sales to several major customers during the period. The $0.8 million increase in the U.K. division product revenues is primarily the result of higher sales volume to one major customer during the period as compared to the prior year period. There was a decrease in TS segment service revenues of $0.4 million during the period as compared to the prior year period, which is primarily due to a decrease in the U.S. division service revenues consisting of a decrease of $0.6 million in internal service and third party service revenues, partially offset by a $0.1 million increase in managed service contract revenues and a $0.1 million increase in third party maintenance revenues.
HPP segment revenue change was as follows for the three months ended December 31, 2020 and 2019:
Increase
2020
2019
$
%
(Dollar amounts in thousands)
Products
$
1,176
$
767
$
409
53
%
Services
380
274
106
39
%
Total
$
1,556
$
1,041
$
515
49
%
The HPP product revenues increased by $0.4 million for the three months ended December 31, 2020 as compared to the three months ended December 31, 2019, primarily as a result of a $0.4 million increase in Multicomputer product sales. The HPP services revenues increased $0.1 million for the three months ended December 31, 2020 as compared to the three months ended December 31, 2019 due to $0.3 million of increased royalties on high-speed processing boards related to the E2D program, partially offset by a decrease of $0.2 million from repairs from the prior year period.
Our revenues by geographic area, which is based on the customer location to which the products were shipped or services rendered, were as follows for the three months ended December 31, 2020 and 2019:
Increase (decrease)
2020
%
2019
%
$
%
(Dollar amounts in thousands)
Americas
$
9,750
85
%
$
16,125
96
%
$
(6,375)
(40)
%
Europe
1,541
14
%
663
4
%
878
132
%
Asia
97
1
%
70
—
%
27
39
%
Totals
$
11,388
100
%
$
16,858
100
%
$
(5,470)
(32)
%
The $6.4 million decrease in revenue to the Americas is primarily the result of decreased sales by our TS segment division of $6.9 million, partially offset by an increase in the HPP segment of $0.5 million. The $0.9 million increase in
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revenue to Europe is primarily the result of increased sales by our TS segment consisting of $0.8 million from the U.K. division and $0.1 million from the U.S. division. The revenue to Asia remained stable from the prior period.
Gross Margins
Our gross margin ("GM") decreased by approximately $0.6 million to $3.4 million for the three months ended December 31, 2020 as compared to a gross margin of approximately $4.0 million for the three months ended December 31, 2019. The GM as a percentage of revenue increased to 30% for the three months ended December 31, 2020, from 24% for the three months ended December 31, 2019. The increase in GM as a percentage of revenue is primarily attributed the HPP segment.
2020
2019
Increase (decrease)
GM$
GM%
GM$
GM%
GM$
GM%
(Dollar amounts in thousands)
TS
$
2,436
25
%
$
3,524
22
%
$
(1,088)
3
%
HPP
942
61
%
507
52
%
435
9
%
Total
$
3,378
30
%
$
4,031
24
%
$
(653)
6
%
The impact of product mix within our TS segment on gross margin for the three months ended December 31, 2020 and 2019 was as follows:
2020
2019
Increase (decrease)
GM$
GM%
GM$
GM%
GM$
GM%
(Dollar amounts in thousands)
Products
$
885
12
%
$
1,678
13
%
$
(793)
(1)
%
Services
1,551
60
%
1,846
62
%
(295)
(2)
%
Total
$
2,436
25
%
$
3,524
23
%
$
(1,088)
2
%
The overall TS segment GM as a percentage of sales increased to 25% for the three month period ended December 31, 2020 from 23% for the three month period ended December 31, 2019. This is due to a significant increase of services gross margin relative to products gross margin. However, individually both product and service GM as percentage of revenue slightly decreased.
The impact of product mix within our HPP segment on gross margin for the three months ended December 31, 2020 and 2019 was as follows:
2020
2019
Increase
GM$
GM%
GM$
GM%
GM$
GM%
(Dollar amounts in thousands)
Products
$
575
49
%
$
277
36
%
$
298
13
%
Services
367
97
%
230
84
%
137
13
%
Total
$
942
61
%
$
507
49
%
$
435
12
%
The overall HPP segment GM as a percentage of sales increased to 61% for the three months ended December 31, 2020 from 49% for the three months ended December 31, 2019. The 12% increase in gross margin as a percentage of sales in the HPP segment for the three months ended December 31, 2020 as compared to the prior year period is attributed to increased GM from increased services revenue including a $280 thousand increase of royalty revenues, which is all margin. The GM as a percentage of sales from products increased primarily due to increased E2D parts sold, which carry a higher GM as a percentage of revenue than other products sold.
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Operating Expenses
Engineering and Development Expenses
The engineering and development expenses incurred by our HPP segment remained stable at $0.7 million for the three months ended December 31, 2020 when compared to the three months ended December 31, 2019. The current period expenses were primarily for product engineering expenses incurred in connection with the continued development of the ARIA SDS cyber security products.
Selling, General and Administrative Expenses
The following table details our selling, general and administrative (“SG&A”) expense by operating segment for the three months ended December 31, 2020 and 2019:
For the three months ended December 31,
% of
% of
$ Decrease
% Decrease
2020
Total
2019
Total
(Dollar amounts in thousands)
By Operating Segment:
TS segment
$
2,119
67
%
$
2,663
71
%
$
(544)
(20)
%
HPP segment
1,067
33
%
1,098
29
%
(31)
(3)
%
Total
$
3,186
100
%
$
3,761
100
%
$
(575)
(15)
%
SG&A expenses overall decreased approximately $0.6 million for the three months ended December 31, 2020 as compared to the three months ended December 31, 2019. The approximate $0.6 million decrease in TS segment SG&A expenses compared to the prior year period is primarily the result of a decrease of variable compensation of $0.2 million and a decrease of payroll related expenses of $0.4 million. The HPP segment SG&A expenses for the three months ended December 31, 2020 as compared to the three months ended December 31, 2019 remained relatively stable.
Other Income/Expenses
The following table details other income (expense) for the year ended December 31, 2020 and 2019:
For the three months ended
Increase
December 31, 2020
December 31, 2019
(Decrease)
(Amounts in thousands)
Interest expense
$
(38)
$
(57)
$
19
Interest income
98
173
(75)
Foreign exchange loss
(467)
(335)
(132)
Gain on debt forgiveness
2,196
—
2,196
Other income, net
9
11
(2)
Total other income (expense), net
$
1,798
$
(208)
$
2,006
The $2.0 million increase in total other income (expense), net for the three months ended December 31, 2020 as compared to the three months ended December 31, 2019 is primarily driven by a gain on debt forgiveness of $2.2 million, which did not occur in the prior year. This debt forgiveness is related to two loans (one at each operating segment) taken out under the Payroll Protection Program. The largest offset was an increase in expense of $0.1 million in a foreign exchange loss. In consolidation, U.S. dollars and Euros are remeasured into the functional currency, British Pounds, of our U.K. subsidiary. This non-cash remeasurement is included in foreign exchange gain or loss on the income statement and the foreign exchange loss is primarily from a Euro and U.S. Dollar bank account.
The interest income decrease of $0.1 million for the three months ended December 31, 2020 as compared to the three months ended December 31, 2020 is primarily related to agreements that have payment terms in excess of one year (see Note 6 in Item 1 to this Quarterly Report on Form 10-Q) from the TS-US segment.
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Income Taxes
The income tax provision was $0.1 million for the three months ended December 31, 2020, as compared to income tax benefit of $0.1 million for the three months ended December 31, 2019. The effective tax rate for the current quarter was 8.7%. The effective tax expense rate was primarily driven by an increase in tax expense. This is primarily related to the write off of a deferred tax asset as a result of the change in tax law, allowing for the immediate deduction of covered expenses incurred through the Paycheck Protection Program (“PPP”) loan along with the associated change in valuation allowance against deferred tax assets from the prior period, offset by the forgiveness of the PPP Loans for which the income is excluded for tax purposes. This additional expense was recorded discretely during the quarter. In the prior period, the Company established a deferred tax asset for these expenses that were expected to be deductible in a future period.
Generally, fluctuations in the effective tax rate are primarily due to changes in our geographic pretax income resulting from our business mix and changes in the tax impact of permanent differences, other special items, and other discrete tax items, which may have unique tax implications depending on the nature of the item.
Liquidity and Capital Resources
Our primary source of liquidity is our cash and cash equivalents, which increased by $0.6 million to $19.9 million as of December 31, 2020 from $19.3 million as of September 30, 2020.
Our significant sources of cash for the year ended December 31, 2020 included a decrease in accounts receivable of $1.3 million, an increase in accounts payable and accrued expenses of $0.4 million, and an increase in deferred revenue of $0.3 million.
Our significant uses of cash for the year ended December 31, 2020 included net payment on our line of credit of $0.8 million and an increase in inventories of $0.6 million.
Our cash held by our foreign subsidiary in the United Kingdom totaled approximately $8.9 million as of December 31, 2020 consisted of 0.8 million Euros, 0.3 million British Pounds, and 7.4 million U.S. Dollars. This cash is included in our total cash and cash equivalents reported within the financial statements.
As of December 31, 2020 and September 30, 2020 the Company maintained a line of credit with a capacity of up to $15.0 million for inventory accessible to both the HPP and TS segments. This line of credit also includes availability of a limited cash withdrawal of up to $1.0 million. An amount of $14.2 million and $13.4 million were available as of December 31, 2020 and September 30, 2020, respectively. As of December 31, 2020 and September 30, 2020 there were no cash withdrawals outstanding.
If cash generated from operations is insufficient to satisfy working capital requirements, we may need to access funds through bank loans or other means. If we are unable to secure additional financing, we may not be able to complete development or enhancement of products, take advantage of future opportunities, respond to competition, retain key employees, or continue to effectively operate our business.
On April 17, 2020, the Company and Modcomp, Inc., its wholly owned subsidiary each received a loan (“SBA Loans”) in the form of a promissory note from Paragon Bank in the amounts of $827,000 and $1,353,600, respectively under the Paycheck Protection Program, which was established under the recently enacted Coronavirus Aid, Relief, and Economic Security Act (CARES Act) administered by the U.S. Small Business Administration. The SBA loans had a two-year term and carried an annual fixed interest rate of 1%. The SBA Loans were forgiven in full by the SBA in the first quarter of fiscal year 2021.
Based on our current plans and business conditions, management believes that the Company’s available cash and cash equivalents, the cash received from the SBA loans, the cash generated from operations, and availability on our line of credit will be sufficient to provide for the Company’s working capital and capital expenditure requirements for at least 12 months from the date of this report.
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