Inuvo, Inc. 10-K

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our financial condition and results of operations for 2022 and 2021 should be read in conjunction with the consolidated financial statements and the notes to those statements that are included elsewhere in this report. Our discussion includes forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth under Cautionary Statements Regarding Forward-Looking Information, Part I. Item 1. Business and Item 1A. Risk Factors. We use words such as "anticipate," "estimate," "plan," "project," "continuing," "ongoing," "expect," "believe," "intend," "may," "will," "should," "could," and similar expressions to identify forward-looking statements. Company Overview Inuvo is a technology company that develops and sells information technology solutions for marketing and advertising. These solutions predictively identify and message online audiences for any product, service or brand across devices, formats, and channels including video, mobile, connected TV, linear TV, display, social, search and native. These solutions allow Inuvo’s clients to engage with their audiences in a manner that drives responsiveness. Inuvo facilitates the delivery of hundreds of millions of marketing messages to consumers every single month and counts among its clients numerous world-renowned names across industries. The Inuvo solution incorporates a proprietary form of artificial intelligence, or AI, branded the IntentKey. This patented machine learning technology uses interactions with Internet content as a source of information from which to predict consumer intent. The AI can identify and advertise to the reasons why consumers are purchasing products and services not to who those consumers are. In this regard, the technology is designed for a privacy conscious future and is focused on the components of the advertising value chain most responsible for return on advertising spend, the intelligence behind the advertising decision. Inuvo technology can be consumed both as a managed service and SaaS. For clients, Inuvo has also developed a collection of proprietary websites collectively branded as Bonfire Publishing where content is created specifically to attract qualified consumer traffic for clients through the publication of information across a wide range of topics including health, finance, travel, careers, auto, education and lifestyle. These sites also provide the means to market test various Inuvo advertising 14 technologies. Further, Inuvo also provides Search and Social advertising services through a proprietary set of technologies branded as CampSight. There are many barriers to entry associated with the Inuvo business model, including a proficiency in large scale information processing, predictive software development, marketing data products, analytics, artificial intelligence, integration to the internet of things ("IOT"), and the relationships required to execute within the IOT. Inuvo’s intellectual property is protected by 19 issued and eight pending patents. Hitachi Credit Agreement On March 12, 2020, we closed on the Loan and Security Agreement dated February 28, 2020 with Hitachi. Under the terms of the Loan and Security Agreement, Hitachi has provided us with a $5,000,000 line of credit commitment. We are permitted to borrow (i) 90% of the aggregate Eligible Accounts Receivable, plus (ii) the lesser of (A) 75% of the aggregate Unbilled Accounts Receivable or (B) 50% of the amount available to borrow under (i), up to the maximum credit commitment. The interest rate under the Hitachi agreement is 2% in excess of the Wall Street Journal Prime Rate, with a minimum rate of 6.75% per annum, on outstanding amounts. The principal and all accrued but unpaid interest are due on demand. In the event of a default under the terms of the Loan and Security Agreement, the interest rate increases to 6% greater than the interest rate in effect from time to time prior to a default. The Loan and Security Agreement contains certain affirmative and negative covenants to which we are also subject. We agreed to pay Hitachi a commitment fee of $50,000, with one half due upon the execution of the agreement and the balance due six months thereafter. We are obligated to pay Hitachi a commitment fee of $15,000 annually. We are also obligated to pay Hitachi a quarterly service fee of 0.30% on the monthly unused amount of the maximum credit line. In addition to a $2,000 document fee we have paid to Hitachi, if we had exited our relationship with Hitachi before March 1, 2022, we were obligated to pay Hitachi an exit fee of $50,000. On March 12, 2020, we drew $5,000,000 under this agreement, using $2,959,573 of these proceeds to satisfy all of our obligations under a credit agreement with Western Alliance Bank. The balance was used for working capital and was repaid in 2020. At December 31, 2022 and 2021, there were no outstanding balances due under the Loan and Security Agreement with Hitachi. 2022 Overview We grew revenue, added new clients, and increased awareness in 2022. Year-over-year (YOY) revenue was up 26%. Our strategy of bringing together the capabilities of both platforms to serve joint clients was successfully implemented throughout the year. Consequently, we were able to differentiate ourselves even further in the following ways: • through the development of data warehousing and reporting that serves multi-channel clients; • by conceiving, building and deploying AI based media-mix predictive technology; • by extending the AI targeting technology to cable television; • by incorporating AI based campaign decisions with CampSight; • through the use of AI for content creation within Bonfire Publishing; • through the development of a GUI that allows clients to visualize the AI targeting signals; • by augmenting the AI brain with new concept understanding; Gross margins declined in 2022 compared to 2021. We reported gross margins of 60% in 2022 compared to 73.4% in 2021, primarily due to change in revenue mix. The IntentKey and CampSight platforms provide a similar service to clients, where ultimately their purpose is the delivery of high converting consumers to maximize return on advertising spend. The distinction between the platforms is mostly related to the channels each platform serves, programmatic for the IntentKey and social and search for CampSight. As the number of joint clients grows, the need to distinguish between the platforms has diminished. 15 Results of Operations For the Years Ended December 31, 2022 2021 Change % Change Net Revenue $ 75,603,745 $ 59,830,688 $ 15,773,057 26.4 % Cost of Revenue 30,244,387 15,925,837 14,318,550 89.9 % Gross Profit $ 45,359,358 $ 43,904,851 $ 1,454,507 3.3 % Net Revenue We experienced 26% higher YOY revenue for the year ended December 31, 2022 as compared to the same period in 2021. The amount of business served exceeded the prior year across both platforms. Both platforms benefited from the acquisition of new customers, in part as a result of the 2021 agreement with a business development partner discussed in Note 9 to our Consolidated Financial Statements. During 2022, three material clients accounted for 29.1%, 24.1% and 12.9% of our revenue, respectively. In 2021, three separate material clients accounted for 14.3%, 15.6% and 33.0% of our revenue, respectively. In 2021 and throughout 2022 we onboarded several Direct clients that contributed to revenue growth. We have experienced churn in our Direct client base where some Direct clients that were material to 2021 were not served or only partially served in 2022 and some Direct clients that were material to 2022 are no longer being served. Historically, we have been able to replace lost clients with new clients or by expanding our relationship with existing clients, however, we would likely experience a significant decline in revenue and our business operations could be significantly harmed if we are unable to replace lost clients. Cost of Revenue Cost of revenue is primarily composed of payments to advertising exchanges that provide access to digital inventory where we serve advertisements using information predicted by the IntentKey platform. To a lesser extent, cost of revenue includes payments to website publishers and app developers that host advertisements we serve through CampSight. CampSight cost of revenue is relatively small and therefore generates a higher gross margin. In recent quarters, the components of the cost of revenue have shifted, as the IntentKey platform revenue becomes a greater percentage of Net Revenue. As CampSight revenue declines as a percent of total Net Revenue, one should expect total gross margin to decrease. Cost of revenue increased 90% in 2022 compared to the prior year due to this shift in revenue and to the acquisition of new customers as mentioned in the Net Revenue section above. Operating Expenses For the Year Ended December 31, 2022 2021 Change % Change Marketing costs $ 36,921,139 $ 33,096,000 $ 3,825,139 11.6 % Compensation 12,463,095 11,381,279 1,081,816 9.5 % General and administrative 8,624,998 7,198,213 1,426,785 19.8 % Operating expenses $ 58,009,232 $ 51,675,492 $ 6,333,740 12.3 % Marketing costs consist mostly of traffic acquisition costs and include those expenses required to attract an audience to owned and operated web properties. Marketing costs year ended December 31, 2022 compared to the same period in 2021 increased as the result of higher revenue. In June 2022, we identified some of the advertising we purchased from a prominent advertising network during the quarter ended June 30, 2022 appeared, according to our technology and assessment, to be comprised of invalid advertising clicks. As a result, we refunded $1.5 million to our clients that were impacted by the invalid clicks and reversed any revenue that would have been recognized during the quarter ended June 30, 2022 related to this invalid traffic. In addition, we provided evidence to the network from which we bought the media and demanded a refund of the spend. The network in question immediately launched an internal investigation. We have held back approximately $1.4 million in net payments due until such time as a satisfactory resolution is determined and have not reflected any offsetting adjustment to the related marketing expense and payables. As a result, we have entered into a mediation process with the advertising network. For the time being, the amount held back is recorded as a marketing expense and an accounts payable. The fraud that was discovered was atypical, sophisticated and not common within the network in question. As of December 31, 2022, no invalid traffic associated from the fraud was detected and the recompense from the advertising network is still pending. 16 Compensation expense was higher for the year ended December 31, 2022 compared to the same time period in 2021 due primarily to higher salaries and benefits. Our total employment, both full and part-time, was 86 at December 31, 2022 compared to 75 at December 31, 2021. General and administrative costs were higher for the year ended December 31, 2022 compared to the same time period in 2021 primarily due to higher reserve for doubtful accounts, professional fees, travel and entertainment expense, IT costs and insurance expense. Financing expense, net Finance expense, net, for the year ended December 31, 2022 was approximately $21 thousand and was primarily due to financing expenses of approximately $59 thousand offset by interest income, net of fees, on marketable securities of approximately $38 thousand. Finance expense, net, was approximately $87 thousand for the year ended December 31, 2021 and was primarily composed of financing expense on finance lease obligations, the Hitachi Loan and Security Agreement and our marketable securities. Other (expense) income, net Other income (expense), net, for the year ended December 31, 2022 was an expense of approximately $436 thousand from net realized and unrealized gains and losses discussed in Note 3 to our Consolidated Financial Statements. Other income, net, was approximately $257 thousand for the year ended December 31, 2021 and included the reversal of deferred revenue from the contract cancellation of approximately $415 thousand and reversal of an accrued sales reserve of $50 thousand, partially offset by the unrealized losses on trading securities discussed in Note 3 to our Consolidated Financial Statements. Liquidity and Capital Resources Our principal sources of liquidity are the sale of our common stock and our credit facility with Hitachi described in Note 7 to our Consolidated Financial Statements. On January 19, 2021, we raised $8 million in gross proceeds, before expenses, through the sale of our common stock, and on January 22, 2021, we raised an additional $6.25 million in gross proceeds, before expenses, through sales of our common stock. In March 2021, we contracted with an investment management company to manage our cash in excess of current operating needs. We placed $2 million in cash equivalent accounts and $10 million in an interest-bearing account. At December 31, 2022, our funds with the investment management company were approximately $2 million and were invested in cash equivalent accounts and marketable debt and equity securities. A detail of the activity is described in Note 3 to our Consolidated Financial Statements. On May 28, 2021, we entered into a Sales Agreement (the "Sales Agreement") with A.G.P./Alliance Global Partners, as sales agent (the "Sales Agent"), pursuant to which we may offer and sell through or to the Sales Agent shares of our common stock (the "ATM Program") up to an aggregate amount of gross proceeds of $35,000,000. During the year ended December 31, 2022, we did not issue any shares of common stock or receive any aggregate proceeds from the ATM Program, and we did not pay any commissions to the Sales Agent. Any shares of common stock offered and sold in the ATM Program will be issued pursuant to our universal shelf registration statement on Form S-3 (the “Shelf Registration Statement”). The ATM Program will terminate upon (a) the election of the Sales Agent upon the occurrence of certain adverse events, (b) 10 days’ advance notice from one party to the other, or (c) the sale of the balance available under our Shelf Registration Statement. Under the terms of the Sales Agreement, the Sales Agent is entitled to a commission at a fixed rate of 3.0% of the gross proceeds from each sale of shares under the Sales Agreement. We have focused our resources behind a plan to grow our AI technology, the IntentKey, where we have a technological advantage and higher margins. If we are successful in implementing our plan, we expect to return to a positive cash flow from operations. However, there is no assurance that we will be able to achieve this objective. As of December 31, 2022, we have approximately $4.5 million in cash, cash equivalents and short-term marketable securities. Our net working capital was $2.8 million. We have encountered recurring losses and cash outflows from operations, which historically we have funded through equity offerings and debt facilities. For the year ended December 31, 2022 we had a net loss of $13.1 million and net cash outflows from operations of $5.6 million. In addition, our investment in internally developed 17 software consists primarily of labor costs which are of a fixed nature and amounted to approximately $1.7 million for the year ended December 31, 2022. Through December 31, 2022, our accumulated deficit was $157.1 million. Management plans to support the Company’s future operations and capital expenditures primarily through borrowings from the Hitachi credit facility, until reaching profitability. The credit facility is due upon demand and therefore there can be no assurances that sufficient borrowings will be available to support future operations until profitability is reached.We believe our current cash position and credit facility will be sufficient to sustain operations for at least the next twelve months from the date of this filing. If our plan to grow the IntentKey product is unsuccessful, we may need to fund operations through private or public sales of securities, debt financings or partnering/licensing transactions over the long term. Cash Flows The table below sets forth a summary of our cash flows for the years ended 2022 and 2021: 2022 2021 Net cash used in operating activities $(5,573,991) $(5,276,257) Net cash used in investing activities $(1,666,125) $(4,597,885) Net cash (used in)/provided by financing activities $(304,433) $12,459,441 Cash Flows - Operating Net cash used in operating activities was $5,573,991 during 2022. We reported a net loss of $13,106,539, which included non-cash expenses; depreciation and amortization of $2,598,957, amortization of right of use assets $103,926 and stock-based compensation of $2,350,314; change in operating assets and liabilities was a net use of cash of $753,111 primarily due to an increase in the accounts receivable balance by $3,119,222, partially offset by an increase in the accounts payable balance of $3,200,086. Our terms are such that we generally collect receivables prior to paying trade payables. However, our Media sales arrangements typically have slower payment terms than the terms of related payables. In recent quarters, we expanded our Direct customer business in part by acquiring new customers (see Note 2). These customers typically require longer credit terms than traditional cents per click ("CPC") based customer, in some cases to 120 days and beyond. During 2021, cash used in operating activities was $5,276,257. We reported a net loss of $7,600,649 which included the non-cash expenses of depreciation and amortization of $3,143,168, amortization of right of use assets $322,746 and stock-based compensation expenses of $2,179,254. The change in operating assets and liabilities was a net use of cash of $3,077,525. Cash Flows - Investing Net cash used in investing activities was $1,666,125 and $4,597,885 for 2022 and 2021, respectively. Cash used in investing activities in 2022 and 2021 consisted of capitalized internal development costs and purchase of marketable securities. Cash Flows - Financing Net cash used in financing was $304,433 during 2022. Net cash provided by financing activities was $12,459,441 in 2021, primarily from proceeds from the sale of common stock. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses during the reported periods. The following disclosure supplements the descriptions of our accounting policies, which are described in Note 2 to our Consolidated Financial Statements regarding significant areas of judgement. The estimates and assumptions that management makes affect the reported amounts of assets, liabilities, net revenues and expenses and disclosure of contingent assets and liabilities. The estimates and assumptions used are based upon management’s regular evaluation of the relevant facts and circumstances as of the date of the consolidated financial statements. Actual results may differ from the estimates and assumptions used in preparing the accompanying consolidated financial 18 statements, and such differences could be material. A discussion of some of our more significant accounting policies and estimates follows. Revenue recognition - Both of our platforms generate revenue from ad placements and clicks on advertisements on websites, some of which we own. We recognize revenue from ad placements and clicks in the period in which they occur. We also recognize revenue from serving impressions when we complete all or a part of an order from an advertiser. The revenue is recognized in the period that the impression is served. Revenues are recognized net of adjustments based on the traffic generated and is billed monthly. We subsequently settle these transactions with our business partners at which time adjustments for invalid traffic may impact the amount collected. Payments to publishers who display advertisements on our behalf and payments to ad exchanges are recognized as cost of revenue. There have been no material changes to our estimates of revenue for the periods presented within this Annual Report on Form 10-K. Accounts receivable - Accounts receivable consists of trade receivables from customers. We record accounts receivable at its net realizable value, recognizing an allowance for doubtful accounts based on our best estimate of probable credit losses on our existing accounts receivable. Balances are written off against the allowance after all means of collection have been exhausted and the possibility of recovery is considered remote. Goodwill - Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. We perform an impairment test annually as of December 31, 2022. As a result, we perform our annual goodwill impairment test by comparing the fair value of our reporting unit with its carrying amount. We generally determine the fair value of our reporting unit using the income approach methodology of valuation that includes the undiscounted cash flow method as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the amount it exceeds fair value is equivalent to the amount of impairment loss. Intangible Assets - We allocate a portion of the purchase price of acquisitions to identifiable intangible assets and we amortize definite-lived assets over their estimated useful lives. We consider our indefinite-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Trade names are not amortized as they are believed to have an indefinite life. Trade names are reviewed annually for impairment under ASC 350. We also acquire intangible assets outside of acquisitions and record them at their fair value and amortize them over their estimated useful lives. We recorded no impairment of intangible assets during 2022 or 2021. Capitalized Software Costs - We capitalize certain costs related to internally developed software and amortize these costs using the straight-line method over the estimated useful life of the software, generally two years. We do not sell internally developed software. Certain development costs not meeting the criteria for capitalization, in accordance with ASC 350-40 Internal-Use Software, are expensed as incurred. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not applicable to a smaller reporting company. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Our Consolidated Financial Statements begin on page F-1 at the end of this annual report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None.