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, 2021, 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, 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, 2021.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our condensed 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, 2021 in the “Critical Accounting Policies” section contained in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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Observations on effects of novel coronavirus
On March 11, 2020, the World Health Organization characterized the novel coronavirus 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.
In these times of pandemic, our top priorities are to protect the health, well-being, and safety of our employees and partners, while still focusing on the key drivers of our business. To that end, and to insure we continue to operate safely and cautiously while also meeting our public health responsibilities, the Company has adopted flexible business practices including allowing most employees to work remotely in all locations.
COVID-19 has adversely affected the distribution channel leading to significantly longer lead times when ordering product. Manufacturers are not producing as much product as prior to the pandemic due to disruptions, resulting in supply shortages. Additionally, recent global shipping delays have exacerbated this problem. The TS segment has many vendors it transacts with and supply shortages are pervasive with many of them. The HPP segment has also experienced shortages with their vendors as well. The HPP segment secured a $1.8 million contract for real-time networking monitoring for cyber attack detection in the first quarter of fiscal year 2022, but due to the delays by manufacturers the sale is anticipated to be recognized in revenue over the next two years when we can obtain the product from the manufacturers. Related to the supply shortage and potentially inflation, we have experienced price increases for our products, which we try to pass on to the customer.
We recognize the pandemic has created a dynamic and uncertain situation in the national economy, and we continue to closely monitor the latest information to make timely, informed business decisions and public disclosures regarding the potential impact of the pandemic on our operations. Despite reduced infection rates and ever-increasing vaccination rates in the United States, many nations and certain pockets within the United States are still battling various strains/variants of the novel coronavirus, creating ongoing uncertainties as to when economies will return to business as usual and what that will look like, what regulatory measures or voluntary actions will be further implemented to limit the spread of COVID-19 and its variants and the duration of any such measures. The extent, severity and impact of any further spread of COVID-19 variants or resurgence of COVID-19 in a given geographic region after it has hit its “peak,” and the extent to which herd immunity will be achieved through the vaccination process is still uncertain. In summary, the scope of this pandemic and its effects are unprecedented, and we cannot at this time 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, 2021
Our sales increased by approximately $1.0 million, or 9%, to $12.4 million for the three months ended December 31, 2021 as compared to $11.4 million for the three months ended December 31, 2020. The increase in sales is the result of an increase of $1.5 million in our TS segment, partially offset by a $0.5 million decrease in our HPP segment. Our gross margin percentage slightly decreased to 29% of sales for the three months ended December 31, 2021 as compared to 30% for the three months ended December 31, 2020. For the three months ended December 31, 2021 there was an operating loss of $0.4 million compared to an operating loss of $0.5 million for the three months ended December 31, 2020, primarily as a result of increased sales from the TS segment, partially offset by the HPP segment. Other income, (expense) net decreased $1.8 million for the three months ended to December 31, 2021 as compared to the three months ended December 31, 2020. This is primarily due to forgiveness of the Payroll Protection Program loans being forgiven in the prior year, partially offset with a lower foreign exchange rate loss in the current period. An income tax expense of $12 thousand was recorded for the three months ended December 31, 2021 compared to an income tax expense of $110 thousand in the same period of 2020. The income tax expense for the three months ended December 31, 2021 is primarily driven by minimum state tax expenses, as the Company continues to maintain a full valuation allowance on its operations. The income tax expense for the three months ended December 31, 2020 was driven by an increase in the valuation allowance against
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deferred tax assets in the period, offset by a benefit recorded for a change in tax law, allowing for the immediate deduction of covered expenses incurred through the Paycheck Protection Program.
The following table details our results of operations in dollars and as a percentage of sales for the three months ended December 31, 2021 and 2020:
%
%
December 31, 2021
of sales
December 31, 2020
of sales
(Dollar amounts in thousands)
Sales
$
12,369
100
%
$
11,388
100
%
Costs and expenses:
Cost of sales
8,755
71
%
8,010
71
%
Engineering and development
627
5
%
729
6
%
Selling, general and administrative
3,383
27
%
3,186
28
%
Total costs and expenses
12,765
103
%
11,925
105
%
Operating loss
(396)
(3)
%
(537)
(5)
%
Other income, (expense) net
42
—
%
1,798
16
%
Income (loss) before income taxes
(354)
(3)
%
1,261
11
%
Income tax expense
12
—
%
110
1
%
Net income (loss)
$
(366)
(3)
%
$
1,151
10
%
Sales
Our sales increased by approximately $1.0 million to $12.4 million for the three months ended December 31, 2021 as compared to $11.4 million for the prior year period. The increase in sales was the result of an increase of $1.5 million in our TS segment, partially offset by a $0.5 million decrease in our HPP segment.
TS segment sales change was as follows for the three months ended December 31, 2021 and 2020:
December 31,
Increase
2021
2020
$
%
(Dollar amounts in thousands)
Products
$
8,000
$
7,232
$
768
11
%
Services
3,305
2,600
705
27
%
Total
$
11,305
$
9,832
$
1,473
15
%
The increase in TS segment product sales of $0.8 million during the period is attributable to an increase in the U.S. division of $2.1 million due to increased sales to several major customers, partially offset with decreased sales in the U.K. division of $1.3 million due to one customer not repeating a high volume of sales in the current period. Service sales for the three months ended December 31, 2021 increased $0.7 million from the prior year period. The changes in service sales included increased managed services sales of $0.4 million and increased internal and third party service sales of $0.3 million.
HPP segment sales change was as follows for the three months ended December 31, 2021 and 2020:
December 31,
Decrease
2021
2020
$
%
(Dollar amounts in thousands)
Products
$
720
$
1,176
$
(456)
(39)
%
Services
344
380
(36)
(9)
%
Total
$
1,064
$
1,556
$
(492)
(32)
%
The HPP product sales decreased by $0.5 million for the three months ended December 31, 2021 as compared to the prior year period, primarily as a result of a $0.5 million decrease in E2D part sales, partially offset with an increase of
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Myricom sales of $0.1 million. The HPP services sales remain relatively flat for the three months ended December 31, 2021 compared to the prior year period as royalties on high-speed processing boards related to the E2D program and repairs remained flat.
Our sales 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, 2021 and 2020:
December 31,
Increase (decrease)
2021
%
2020
%
$
%
(Dollar amounts in thousands)
Americas
$
11,625
94
%
$
9,750
85
%
$
1,875
19
%
Europe
635
5
%
1,541
14
%
(906)
(59)
%
Asia
109
1
%
97
1
%
12
12
%
Totals
$
12,369
100
%
$
11,388
100
%
$
981
9
%
The $1.9 million increase in sales to the Americas was primarily the result of an increase in the TS segment’s U.S. division of $2.6 million, partially offset by decreased sales by our HPP segment of $0.6 million and TS segment’s U.K. division of $0.1 million. The $0.9 million decrease in sales to Europe was primarily the result of decreased sales by our TS Segment’s U.K. division of $1.2 million due to a large volume by one customer in the prior year which did not reoccur in the current period, partially offset by an increase in the TS segment’s U.S. division of $0.1 million and an increase in the HPP segment of $0.1 million. The sales to Asia remained relatively flat consisting of an increase of $0.1 million from the TS segment’s U.S. division, offset by a $0.1 million decrease by our HPP segment.
Gross Margins
Our gross margin ("GM") increased $0.2 million for the three months ended December 31, 2021 as compared to the prior year period. The GM as a percentage of sales slightly decreased to 29% for the three months ended December 31, 2021 as compared to the prior year period of 30%. The GM as a percentage of sales slightly increased in the TS segment, but was more than offset by a decrease in the HPP segment.
2021
2020
Increase (decrease)
GM$
GM%
GM$
GM%
GM$
GM%
(Dollar amounts in thousands)
TS
$
2,992
26
%
$
2,436
25
%
$
556
1
%
HPP
622
58
%
942
61
%
(320)
(3)
%
Total
$
3,614
29
%
$
3,378
30
%
$
236
(1)
%
The impact of product mix within our TS segment on gross margin for the three months ended December 31, 2021 and 2020 was as follows:
2021
2020
Increase (decrease)
GM$
GM%
GM$
GM%
GM$
GM%
(Dollar amounts in thousands)
Products
$
1,144
14
%
$
885
12
%
$
259
2
%
Services
1,848
56
%
1,551
60
%
297
(4)
%
Total
$
2,992
26
%
$
2,436
25
%
$
556
1
%
The overall TS segment GM as a percentage of sales increased to 26% for the three month period ended December 31, 2021 compared to 25% for the prior year period. Product GM as a percentage of product sales increased to 14% for the three months ended December 31, 2021 from 12% for the prior year period. This was primarily due higher margin products being sold to several customers including a new customer having significant volume with relatively high margins. Service GM as a percentage of service sales decreased to 56% for the three months ended December 31, 2021 from 60% for the prior year period due to both the U.S. division having wage increases and additional hires to sustain the growth of managed services.
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The impact of product mix within our HPP segment on gross margin for the three months ended December 31, 2021 and 2020 was as follows:
2021
2020
Decrease
GM$
GM%
GM$
GM%
GM$
GM%
(Dollar amounts in thousands)
Products
$
299
42
%
$
575
49
%
$
(276)
(7)
%
Services
323
94
%
367
97
%
(44)
(3)
%
Total
$
622
58
%
$
942
61
%
$
(320)
(3)
%
The overall HPP segment GM as a percentage of sales decreased to 58% for the three months ended December 31, 2021 from 61% for the three months ended December 31, 2020. This 3% decrease was primarily attributed to lower margin product sold for the three months ended December 31, 2021 compared to the same prior year period. Additionally, the decrease in service GM was due to a lower service revenue while manufacturing overhead expenses remained relatively flat from prior year.
Operating Expenses
Engineering and Development Expenses
The engineering and development expenses incurred by our HPP segment decreased $0.1 million for the three months ended December 31, 2021 to $0.7 million when compared to the prior year period due to decreased headcount related expenses. 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, 2021 and 2020:
For the three months ended December 31,
$
%
% of
% of
Increase
Increase
2021
Total
2020
Total
(decrease)
(decrease)
(Dollar amounts in thousands)
By Operating Segment:
TS segment
$
2,383
70
%
$
2,119
67
%
$
264
12
%
HPP segment
1,000
30
%
1,067
33
%
(67)
(6)
%
Total
$
3,383
100
%
$
3,186
100
%
$
197
6
%
SG&A expenses of $3.4 million increased $0.2 million for the three months ended December 31, 2021 as compared to the prior year period. The approximately $0.3 million increase in TS segment SG&A expenses compared to the same prior year period is primarily the result of increased payroll. The HPP segment SG&A expenses decreased approximately $0.1 million for the three months ended December 31, 2021 as compared to the prior year period due to decreased headcount.
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Other Income/Expenses
The following table details other income (expense) for the three months ended December 31, 2021 and 2020:
For the three months ended
Increase
December 31, 2021
December 31, 2020
(Decrease)
(Amounts in thousands)
Foreign exchange loss
$
(17)
$
(467)
$
450
Interest expense
(105)
(38)
(67)
Interest income
145
98
47
Gain on debt forgiveness
—
2,196
(2,196)
Other income (expense), net
19
9
10
Total other income (expense), net
$
42
$
1,798
$
(1,756)
The $1.8 million decrease in total other income (expense), net for the three months ended December 31, 2021 as compared to the prior year period is primarily due to forgiveness of the Payroll Protection Program loans being forgiven in the prior year for a gain of $2.2 million, partially offset with a decreased foreign exchange rate loss of approximately $0.4 million in the current period.
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 US dollar and Euro weakened relative to the British Pound for the three months ended December 31, 2021, which caused the foreign exchange loss.
The interest income increase of $47 thousand for the three months ended December 31, 2021 as compared to the prior year period is primarily related to additional agreements that have payment terms in excess of one year (see Note 6 in Item 1 to this Quarterly Report on Form 10-Q for details) from the TS-US segment from the prior year period.
The interest expense increase of $67 thousand for the three months ended December 31, 2021 as compared to the prior year period is related to the TS U.S. division entering into multiple multi-year contracts starting in the second quarter of fiscal year 2021, which did not incur interest expense in the first fiscal quarter of the prior year. Payments on these agreements contain both principal and interest expense. See Note 10 in Item 1 to this Quarterly Report on Form 10-Q for details.
Income Taxes
An income tax expense of $12 thousand was recorded for the three months ended December 31, 2021 compared to an income tax expense of $110 thousand in the three months ended December 31, 2020. The income tax expense for the three months ended December 31, 2021 is primarily driven by minimum state tax expenses, as the Company continues to maintain a full valuation allowance on their operations. The income tax expense for the three months ended December 31, 2020 was driven by an increase in the valuation allowance against deferred tax assets in the period, offset by a benefit recorded for a change in tax law, allowing for the immediate deduction of covered expenses incurred through the Paycheck Protection Program.
We have in general historically calculated the provision for income taxes during interim reporting periods by applying an estimate of the annual effective tax rate for the full calendar year to ordinary income or loss for the reporting period. However, we used a discrete effective tax rate method to calculate income taxes for the quarter ended December 31, 2021 because we determined that our ordinary income or loss cannot be reliably estimated and small changes in estimated ordinary income would result in significant changes in the estimated annual effective tax rates.
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Liquidity and Capital Resources
Our primary source of liquidity is our cash and cash equivalents, which decreased by $0.7 million to $19.3 million as of December 31, 2021 from $20.0 million as of September 30, 2021.
Our significant source of cash for the three months ended December 31, 2021 included an decrease of a $1.5 million in accounts receivable and long-term receivable.
Our significant uses of cash for the three months ended December 31, 2021 were primarily related to an increase in other assets of $0.9 million, a decrease in accounts payable and accrued expenses of $0.8 million, and research development expenses of approximately $0.6 million.
Our cash held by our foreign subsidiary in the United Kingdom totaled approximately $9.0 million as of December 31, 2021 and consisted of 0.5 million Euros, 0.1 million British Pounds, and 8.2 million U.S. Dollars. This cash is included in our total cash and cash equivalents reported within our financial statements.
As of December 31, 2021 and September 30, 2021, 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 $13.9 million and $14.1 million were available as of December 31, 2021 and September 30, 2021, respectively. As of December 31, 2021 and September 30, 2021 there were no cash withdrawals outstanding. For a further discussion of the Company’s line of credit, including its financial covenants, see Item 1, Note 10 “Notes Payable and Line of Credit .”
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.
Based on our current plans and business conditions, management believes that the Company’s available cash and cash equivalents, 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 filing.
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