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, 2023. 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, intense competition in the market segments in which we operate, changes in the U.S. Tax laws, the impact of the Ukrainian-Russian military and Israeli-Hamas conflict on global trade and financial markets, and the impact of pandemics 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, 2023.
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 ongoing basis, we evaluate our estimates, including those related to the allowance for credit losses for accounts receivable and financing 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, 2023 in the “Critical Accounting Policies” section contained in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations. Management believes there have been no significant changes for the three months
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ended December 31, 2023 to the items that we disclosed as our critical accounting estimates in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of our Annual Report on Form 10-K for the fiscal year ended September 30, 2023 except for the estimation for credit losses. See Note 1 Basis of presentation in Item 1 to this Quarterly Report on Form 10-Q for details of the new policy.
Recent trends affecting our financial performance
As of December 31, 2023, the Russian/Ukrainian military conflict and the Israeli-Hamas conflict has not had a direct significant impact on revenue as we do not have any recurring customers in either region. However, we do have customers and suppliers in surrounding regions which may be affected and further escalation of both conflicts and geopolitical tensions related to such conflicts could adversely affect our business, financial condition and results of operations, by among other things, cyberattacks, supply disruptions, lower consumer demand, and changes to foreign exchange rates and financial markets. It is not possible at this time to predict the size of the impact or consequences of the conflicts on the Company and our customers or suppliers.
Results of Operations.
Overview of the three months ended December 31, 2023
Our sales decreased by approximately $2.9 million, or 16%, to $15.4 million for the three months ended December 31, 2023 as compared to $18.3 million for the three months ended December 31, 2022. The decrease in sales is the result of a decrease of $1.2 million in our TS segment combined with approximately a $1.7 million decrease in our HPP segment. Our gross margin percentage as a percentage of sales decreased to 27% for the three months ended December 31, 2023 as compared to 32% for the three months ended December 31, 2022. For the three months ended December 31, 2023 there was an operating loss of $(0.3) million compared to operating income of $1.4 million for the three months ended December 31, 2022. Other income (expense), net increased $0.6 million for the three months ended to December 31, 2023 as compared to the three months ended December 31, 2022. An income tax expense of $13 thousand was recorded for the three months ended December 31, 2023 compared to an income tax expense of $133 thousand in the same period of fiscal year 2023.
The following table details our results of operations in dollars and as a percentage of sales for the three months ended December 31, 2023 and 2022:
%
%
December 31, 2023
of sales
December 31, 2022
of sales
(Dollar amounts in thousands)
Sales
$
15,375
100
%
$
18,344
100
%
Costs and expenses:
Cost of sales
11,280
73
%
12,527
68
%
Engineering and development
700
5
%
836
5
%
Selling, general and administrative
3,738
24
%
3,617
20
%
Total costs and expenses
15,718
102
%
16,980
93
%
Operating income
(343)
(2)
%
1,364
7
%
Other income (expense), net
283
2
%
(270)
(1)
%
Income before income taxes
(60)
—
%
1,094
6
%
Income tax expense
13
—
%
133
1
%
Net (loss) income
$
(73)
—
%
$
961
5
%
Sales
Our sales decreased by approximately $2.9 million to $15.4 million for the three months ended December 31, 2023 as compared to $18.3 million for the same prior year period.
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TS segment sales change was as follows for the three months ended December 31, 2023 and 2022:
December 31,
Decrease
2023
2022
$
%
(Dollar amounts in thousands)
Products
$
10,935
$
12,059
$
(1,124)
(9)
%
Services
3,728
3,796
(68)
(2)
%
Total
$
14,663
$
15,855
$
(1,192)
(8)
%
The decrease in TS segment product sales of $1.1 million during the period is primarily attributable to the U.S. division due to decreased sales to several major customers. Service sales for the three months ended December 31, 2023 decreased $0.1 million from the prior year period, which is attributable to the U.S. division. The decrease in service sales included decreased third party maintenance sales of $0.3 million, partially offset by increased managed services sales of $0.2 million.
HPP segment sales change was as follows for the three months ended December 31, 2023 and 2022:
December 31,
Decrease
2023
2022
$
%
(Dollar amounts in thousands)
Products
$
472
$
2,162
$
(1,690)
(78)
%
Services
240
327
(87)
(27)
%
Total
$
712
$
2,489
$
(1,777)
(71)
%
The HPP product sales decreased by $1.7 million for the three months ended December 31, 2023 as compared to the same prior year period primarily as a result of one large Myricom product order in the first quarter of fiscal year 2023 which did not reoccur in fiscal year 2024. The HPP services sales decreased $0.1 million for the three months ended December 31, 2023 compared to the prior year period as a result of decreased royalties on high-speed processing boards related to the E2D program.
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, 2023 and 2022:
December 31,
Increase (decrease)
2023
%
2022
%
$
%
(Dollar amounts in thousands)
Americas
$
14,552
95
%
$
17,940
97
%
$
(3,388)
(19)
%
Europe
451
3
%
288
2
%
163
57
%
Asia
372
2
%
116
1
%
256
221
%
Totals
$
15,375
100
%
$
18,344
100
%
$
(2,969)
(16)
%
The $3.4 million decrease in sales to the Americas was primarily the result of a decrease in the TS segment’s U.S. division of $1.7 million, a decrease in the TS segment’s U.K. division of $0.1 million, and a decrease in the HPP segment of $1.6 million. The $0.2 million increase in sales to Europe was primarily the result of increased sales by our TS segment’s U.K. division of $0.2 million and U.S. division of $0.1 million, partially offset with a $0.1 million decrease in the HPP segment. The sales to Asia increased $0.3 million due to an increase of sales in the TS segment’s U.S. division of $0.4 million, partially offset with a decrease in the U.K. division of $0.1 million.
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Gross Margins
Our gross margin ("GM") decreased $1.7 million for the three months ended December 31, 2023 as compared to the same prior year period. The GM as a percentage of sales decreased to 27% for the three months ended December 31, 2023 as compared to the prior year period of 32%.
December 31,
2023
2022
Decrease
GM$
GM%
GM$
GM%
GM$
GM%
(Dollar amounts in thousands)
TS
$
3,757
26
%
$
4,164
26
%
$
(407)
—
%
HPP
338
47
%
1,653
66
%
(1,315)
(19)
%
Total
$
4,095
27
%
$
5,817
32
%
$
(1,722)
(5)
%
The impact of product mix within our TS segment on gross margin for the three months ended December 31, 2023 and 2022 was as follows:
December 31,
2023
2022
Decrease
GM$
GM%
GM$
GM%
GM$
GM%
(Dollar amounts in thousands)
Products
$
1,897
17
%
$
2,029
17
%
$
(132)
—
%
Services
1,860
50
%
2,135
56
%
(275)
(6)
%
Total
$
3,757
26
%
$
4,164
26
%
$
(407)
—
%
The overall TS segment GM as a percentage of sales remained flat at 26% for the three month period ended December 31, 2023 compared to the prior year period. Product GM as a percentage of product sales remained flat at 17% for the three months ended December 31, 2023 compared to 17% for the prior year period. There were not any significant changes in GM for any individual products sold. Service GM as a percentage of service sales decreased to 50% for the three months ended December 31, 2023 compared to the prior year period of 56% due to decreased third party maintenance sales in which the sale is recorded “net” meaning gross profit is recorded in the services sales financial statement line item. This “net” recording increases GM as a percentage of sales.
The impact of product mix within our HPP segment on gross margin for the three months ended December 31, 2023 and 2022 was as follows:
December 31,
2023
2022
Decrease
GM$
GM%
GM$
GM%
GM$
GM%
(Dollar amounts in thousands)
Products
$
282
60
%
$
1,421
66
%
$
(1,139)
(6)
%
Services
56
23
%
232
71
%
(176)
(48)
%
Total
$
338
47
%
$
1,653
66
%
$
(1,315)
(19)
%
The overall HPP segment GM as a percentage of sales decreased to 47% for the three months ended December 31, 2023 from 66% for the three months ended December 31, 2022. The 6% decrease in product GM as a percentage of product revenue for the three months ended December 31, 2023 compared to the same prior year period is primarily due to one major order, which had relatively high GM as a percentage of sales, which did not reoccur in the current year period. The 48% decrease in service GM as a percentage of services revenue from the prior year was due to decreased royalty sales, which are nearly all GM.
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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, 2023 to $0.7 million when compared to the prior year period due to decreased consulting and labor expenses. The current period expenses were primarily for product engineering expenses incurred in connection with the continued development of the ARIA Zero Trust Gateway 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, 2023 and 2022:
Three months ended December 31,
$
%
% of
% of
Increase
Increase
2023
Total
2022
Total
(Dollar amounts in thousands)
By Operating Segment:
TS segment
$
2,755
74
%
$
2,703
75
%
$
52
2
%
HPP segment
983
26
%
914
25
%
69
8
%
Total
$
3,738
100
%
$
3,617
100
%
$
121
3
%
SG&A expenses of $3.7 million for the three months ended December 31, 2023 increased $0.1 million as compared to the prior year period. The TS segment G&A expenses increased by approximately $0.1 million due to increased salaries and stock compensation expense when compared to the prior year period. The HPP segment SG&A expenses increased approximately $0.1 million for the three months ended December 31, 2023 as compared to the prior year period due to increased consulting expenses.
Other Income/Expenses
The following table details Total other income (expense), net for the three months ended December 31, 2023 and 2022:
Three months ended
Increase
December 31, 2023
December 31, 2022
(Decrease)
(Amounts in thousands)
Foreign exchange loss
$
(174)
$
(501)
$
327
Interest expense
(49)
(64)
15
Interest income
496
261
235
Other income, net
10
34
(24)
Total other income (expense), net
$
283
$
(270)
$
553
The approximately $0.6 million increase in total other income (expense), net for the three months ended December 31, 2023 as compared to the same prior year period is primarily due to a net decrease in foreign exchange loss of $0.3 million combined with an increase in interest income of $0.2 million.
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 (loss) on the income statement and the foreign exchange gain is primarily from the U.S. Dollar bank account. The US dollar weakened relative to the British Pound for the three months ended December 31, 2023 causing a foreign exchange loss, but to a much lesser extent than the same prior year period.
The interest income increase of $235 thousand for the three months ended December 31, 2023 as compared to the prior year period is primarily due to higher interest income from our cash and cash equivalents from increased interest rates.
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The interest expense decrease of $15 thousand for the three months ended December 31, 2023 as compared to the prior year period is related to the TS U.S. division entering into multi-year contracts in prior years, which incur less interest expense as time elapses due to principal payments being made. Payments on these agreements contain both principal and interest expense. See Note 8 Accounts payable and accrued expenses, and Other noncurrent liabilities in Item 1 to this Quarterly Report on Form 10-Q for details. Additionally, the last payment on the only note payable outstanding as of September 30, 2023 was made the first day of the quarter and no interest expense was incurred during the first three months of December 31, 2023.
Income Taxes
An income tax expense of $13 thousand was recorded for the three months ended December 31, 2023 compared to an income tax expense of $133 thousand in the same period of 2022. The estimated annualized effective income tax rate for the three months ended December 31, 2023 was 23%, excluding the impacts of the UK entity which continues to experience losses and maintains a full valuation allowance. The difference between our effective income tax rate and the U.S. federal statutory rate is the impact of state taxes and tax credits that we expect to be able to utilize against federal and state taxes.
The effective tax rate for the three months ended December 31, 2023 was also 23%, excluding the UK as previously mentioned, as there were no discrete tax items recorded during the period. The income tax expense for the three months ended December 31, 2022 was primarily driven by minimum state tax expenses and the required capitalization of R&D expenses under IRC Section 174, offset by the use of federal NOL and R&D credits. For the three months ended December 31, 2022, we used the discrete method to arrive at tax expense due to the full valuation allowance against our deferred tax assets and cumulative loss position.
While the Company had maintained a full valuation allowance, we had been using the discrete effective tax rate method to calculate income taxes for the purposes of quarterly reporting. Now that the valuation allowance has been reduced, the Company has resumed using the annualized effective tax rate method to calculate income taxes as prescribed under ASC 740 and has done so for the period ending December 31, 2023.
Liquidity and Capital Resources
Our primary source of liquidity is our cash and cash equivalents and our line of credit.
Cash and cash equivalents increased by $0.4 million to $25.6 million as of December 31, 2023 from $25.2 million as of September 30, 2023.
The following is a summary of our cash flows for the three months ended December 31, 2023 and 2022:
For the Three months ended December 31,
(Dollar amounts in thousands)
2023
2022
(Dollar amounts in thousands)
Net cash provided by (used in):
Operating activities
$
1,673
$
(4,227)
Investing activities
(126)
(95)
Financing activities
(1,182)
(125)
Effect of exchange rate changes on cash
29
50
Increase (decrease) in cash and cash equivalents
$
394
$
(4,397)
Operating Activities
Cash provided by operating activities was $1.7 million for the three months ended December 31, 2023 compared to $4.2 million used in operating activities in the prior year. The increase from the prior year is primarily related to
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increased accounts payable and accrued expenses of $10.4 million, partially offset with increased purchases of inventory of $4.7 million. Inventory fluctuations are dependent on when orders are received and shipped. Accounts payable and accrued expenses fluctuations are dependent on when vendor invoices are received as well as the related timing of the payments. The remaining differences are primarily related to timing differences in operating assets and liabilities.
Investing Activities
Cash used in investing activities was $126 thousand for the three months ended December 31, 2023 compared to $95 thousand used in investing activities for the prior year. The increase in cash used from the prior year is primarily related to an increase in purchases of property, equipment, and improvements.
Financing Activities
Cash used in financing activities was $1.2 million for the three months ended December 31, 2023 compared to $0.1 million for the prior year. The primary difference was the timing in the net borrowing on the line-of-credit, which for the three months ended December 31, 2023 we had a net payment of $0.8 million compared to a net borrowing of $0.1 million in the prior year.
Other Liquidity and Capital Resources Items
Our cash held by our foreign subsidiary in the United Kingdom totaled approximately $4.9 million as of December 31, 2023, which consisted of 0.2 million Euros, 0.3 million British Pounds, and 4.3 million U.S. Dollars. This cash is included in our total cash and cash equivalents reported within our financial statements. Due to the pension obligation in the U.K., we maintain a large balance of cash in the U.K.
As of December 31, 2023 and September 30, 2023, 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. Amounts of $14.2 million and $13.5 million were available as of December 31, 2023 and September 30, 2023, respectively. As of December 31, 2023 and September 30, 2023 there were no cash withdrawals outstanding. For further discussion of the Company’s line of credit, including its financial covenants, see Item 1, Note 9 Note Payable and Line of Credit.
We have multi-year agreements in which we sell certain customers goods and services with financing. This is on the Consolidated Balance Sheets as Financing receivables, net of allowances and Financing receivables due after one year, net of allowances. In the remainer of fiscal year 2024 we are scheduled to receive $5.7 million related to the financing receivables.
We also have multi-year agreements with vendors related to some of the financing agreements we have for customers, which are on the Consolidated Balance Sheets in Accounts payable and accrued expenses and Other noncurrent liabilities payables (long-term portion in other noncurrent liabilities). In the remainder of fiscal year 2024 we are scheduled to pay $1.5 million related to the payables.
Our last payment on the only note payable outstanding as of September 30, 2023 was made in the first fiscal quarter and we no longer have any note payable outstanding as of December 31, 2023.
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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Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.