KVH INDUSTRIES INC \DE\ 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction The statements included in this quarterly report on Form 10-Q, other than statements of historical fact, are forward-looking statements. Examples of forward-looking statements include statements regarding our future financial results, operating results, business strategies, projected costs, products and services, competitive positions and plans, customer preferences, consumer trends, anticipated product development, and objectives of management for future operations. In some cases, forward-looking statements can be identified by terminology such as “may,” “will,” “should,” “would,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue,” or the negative of these terms or other comparable terminology. Any expectations based on these forward-looking statements are subject to risks and uncertainties and other important factors, including those discussed in the section entitled “Risk Factors” in Item 1A of Part I of our annual report on Form 10-K for the year ended December 31, 2022. These and many other factors could affect our future financial and operating results and could cause actual results to differ materially from expectations based on forward-looking statements made in this document or elsewhere by us or on our behalf. For example, our expectations regarding certain items as a percentage of sales assume that we will achieve our anticipated sales goals. The following discussion and analysis should be read in conjunction with our consolidated interim financial statements and related notes appearing elsewhere in this report. Overview We design, develop, manufacture and market mobile connectivity products and services for the marine and land mobile markets. We manufacture and sell our solutions in a number of major geographic areas, including internationally. We generate a majority of our revenues from various international locations, primarily consisting of Singapore, Canada, European Union countries and other European countries, countries in Africa, Asia/Pacific and the Middle East, and India. We offer satellite communications products and services. Our satellite-only and hybrid products enable marine customers to receive data, Voice over Internet Protocol (VoIP), and value-added services via satellite, cellular, and shore-based Wi-Fi networks onboard commercial, leisure, and military/government vessels. In addition, the Company’s in-motion television terminals permit customers to receive live digital television via regional satellite services in marine vessels, recreational vehicles, buses and automobiles. We sell our products through an extensive international network of dealers and distributors. We also sell and lease products to service providers and end users. Our service sales primarily represent revenue earned from satellite Internet airtime services. We provide, for monthly fixed fees and per-usage fees, satellite connectivity encompassing broadband Internet, data and VoIP services, to our TracNet H-series and TracPhone V-series customers via our global HTS network. Revenue from our cellular airtime service has increasingly supplemented, and we expect will continue to supplement, our satellite-only airtime revenue following the mid-2022 launch of the KVH ONE hybrid network and TracNet H-series terminals. This product and service combination integrates global satellite service with KVH-provided cellular service in more than 150 countries, along with shore-based Wi-Fi access. These sales also include the distribution of entertainment, including news, sports, music, and movies, to commercial customers in the maritime, hotel, and retail markets through KVH Media Group, along with supplemental value-added services. In addition, we earn monthly usage fees for third-party satellite connectivity for VoIP, data and Internet services to our Inmarsat and Iridium customers who choose to activate their subscriptions with us. Service sales also include sales from product repairs and extended warranty sales. Our marine leisure business is highly seasonal, and seasonality can also impact our commercial marine business. Historically, we have generated the majority of our marine leisure product revenues during the first and second quarters of each year, and these revenues typically decline in the third and fourth quarters of each year, compared to the first two quarters. Temporary suspensions of our airtime services typically increase in the third and fourth quarters of each year as boats are placed out of service during the winter months. Management Transition and Restructuring On March 7, 2022, we announced that our President and Chief Executive Officer, Martin Kits van Heyningen, was retiring from his executive and Board roles after more than 40 years of service and assuming a consulting position with us. We incurred approximately $0.5 million of costs associated with the management transition through March 31, 2022, including a separation payment, consulting fees and health insurance coverage for Mr. Kits van Heyningen, as well as professional and advisory fees. As of March 31, 2023 all payments related to the additional fees had been completed. 25 In March 2022, we also restructured our operations to reduce costs and better pursue a more focused strategy. We reduced our workforce by approximately 10% and began incurring reduced expenses from these actions beginning in the second quarter of 2022. Approximately $1.7 million of severance payments, other employee benefits, and legal and advisory fees were incurred for the three months ended March 31, 2022. For the three months ended March 31, 2023, we did not incur any additional expenses associated with this restructuring. We also modified impacted employee's stock option and restricted stock awards. Please see Note 5 to our consolidated interim financial statements for further discussion. During the third quarter of 2022, we restructured our foreign operations by closing our India and Cyprus offices and our Denmark warehouse to reduce costs. All costs associated with the severance payments, other employee benefits, and legal and advisory fees were incurred in the 2022. Executive Employment Agreements In May 2022, we entered into executive employment agreements with each of Brent C. Bruun, Roger A. Kuebel, Felise Feingold and Robert Balog in order to retain their services and provide them with certain benefits in the event that we terminate the executive’s employment without cause (as defined in the agreement) or the executive terminates his or her employment for good reason (as defined in the agreement) (either such termination, a “Qualifying Termination”), including following a change of control. The terms of the agreements are substantially identical except as to title, salary, target bonus and reporting responsibilities. The agreements provided that, if the executive continued to serve as an employee through December 31, 2022 (the “Retention Date”), we would pay the executive a retention bonus equal to 75% of the executive’s base salary at the agreement date, and we would accelerate the vesting of the executive’s equity awards that would otherwise have vested in the twelve months after the Retention Date. On October 11, 2022, we entered into an amendment to the employment agreement with Mr. Bruun that, among other things, increased his annual base salary to $448,360 per year, retroactive to July 1, 2022, increased his target annual incentive compensation for the second half of 2022 to 80% of his base salary (without changing his target annual incentive compensation for the first half of 2022), extended his Retention Date from December 31, 2022 to December 31, 2023, which effectively extended the period during which Mr. Bruun must remain employed by us in order to earn his retention bonus, and modified the amount of the retention bonus from 75% of his base salary in effect on May 2, 2022 to 75% of the highest base salary in effect for Mr. Bruun on or before the date he becomes entitled to receive the retention bonus or the “Partial Retention Bonus” (as defined in the employment agreement). If a Qualifying Termination occurs before December 31, 2023, Mr. Bruun will receive a pro rata portion of the retention bonus. If in connection with such a termination he becomes entitled to receive the change in control severance payments and benefits, he will also become entitled to receive the full retention bonus, and the Retention Date will be the later of the date of such change in control or such termination of employment. The amendment did not modify the terms of the employment agreement relating to acceleration of vesting of certain equity awards if Mr. Bruun remains employed by us through December 31, 2022. In January 2023, we paid out all contracted benefits to Roger A. Kuebel, Felise Feingold and Robert Balog as the conditions of their agreements were satisfied on December 31, 2022. As of March 31, 2023, we have accrued approximately $0.2 million for the retention bonus payable to Brent Bruun. In addition to the amendment to Mr. Bruun’s employment agreement, the Compensation Committee also granted Mr. Bruun a restricted stock award and a non-statutory stock option, which together had an aggregate grant date fair value of approximately $100,000. The restricted stock award and the non-statutory stock option have terms that are materially consistent with the previously disclosed terms of similar grants to our executive officers. Supply Chain During the three months ended March 31, 2023, we continued to experience delays in the availability and delivery of certain raw material components, which has impacted our manufacturing as well as resulted in shipping delays in getting products out to our customers. We also experienced increased raw material costs, which we expect to continue throughout 2023. We are continuing to monitor global developments and are prepared to implement any actions that we determine to be necessary to sustain our business. 26 International Sales We operate in a number of major geographic areas across the globe. We generate our international net sales, based upon customer location, primarily from customers located in Singapore, Canada, European Union countries and other European countries, as well as countries in Africa, Asia/Pacific and the Middle East, and India. International revenues represented 64% and 61% of our consolidated net sales for the three months ended March 31, 2023 and 2022, respectively. Sales to Singapore customers represented 18% and 16% of our consolidated net sales for the three months ended March 31, 2023 and 2022, respectively. No other individual foreign country represented 10% or more of our consolidated net sales for the three months ended March 31, 2023 and 2022. Critical Accounting Estimates The discussion and analysis of our financial condition and results of operations are based upon our consolidated interim financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these interim financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure at the date of our interim financial statements. Our significant accounting policies are summarized in Note 1 to the consolidated financial statements in our annual report on Form 10-K for the year ended December 31, 2022. C ritical accounting estimates are those estimates made that involve a significant level of estimation uncertainty and have had or are reasonably likely to have an impact on our statement of operations. As described in our annual report on Form 10-K for the year ended December 31, 2022, our accounting policies for goodwill, intangible assets, and other long-lived assets are the estimates most critical to an understanding and evaluation of our consolidated financial statements. We have reviewed our accounting policies and critical accounting estimates and determined that these remain our most critical accounting policies and estimates for the three months ended March 31, 2023. Readers should refer to our annual report on Form 10-K for the year ended December 31, 2022 under “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Critical Accounting Estimates” for descriptions of these policies and estimates, as well as the notes to the consolidated interim financial statements included elsewhere within this report. 27 Results of Operations The following table provides, for the periods indicated, certain financial data relating to our continuing operations expressed as a percentage of net sales: Three Months Ended March 31, 2023 2022 Sales: Product 14.7 % 19.8 % Service 85.3 80.2 Net sales 100.0 100.0 Cost and expenses: Costs of product sales 15.5 16.3 Costs of service sales 47.7 45.0 Research and development 7.6 9.1 Sales, marketing and support 17.0 21.0 General and administrative 13.8 21.3 Total costs and expenses 101.6 112.7 Loss from operations (1.6) (12.7) Interest income 2.3 0.6 Interest expense — — Other (expense) income, net (0.7) 0.3 Income (loss) from continuing operations before income tax expense — (11.8) Income tax expense from continuing operations 0.1 1.0 Net loss from continuing operations (0.1) % (12.8) % Three months ended March 31, 2023 and 2022 Net Sales Our net sales for the three months ended March 31, 2023 and 2022 were as follows: Change For the three months ended March 31, 2023 vs. 2022 2023 2022 $ % (dollars in thousands) Product $ 4,949 $ 6,563 $ (1,614) (25) % Service 28,740 26,588 2,152 8 % Net sales $ 33,689 $ 33,151 $ 538 2 % Net sales increased by $0.5 million, or 2%, for the three months ended March 31, 2023 as compared to the three months ended March 31, 2022. Product sales decreased by $1.6 million, or 25%, to $4.9 million for the three months ended March 31, 2023 from $6.6 million for the three months ended March 31, 2022. The decrease in product sales was primarily due to a $1.5 million decrease in VSAT Broadband product sales. The decrease in VSAT product sales was primarily due to a decrease in unit sales volume, particularly with 37cm units in our global leisure segment. Alternative solutions offered by recent LEO entrants have heightened competition in this segment of the market. Service sales increased by $2.2 million, or 8%, to $28.7 million for the three months ended March 31, 2023 from $26.6 million for the three months ended March 31, 2022. The increase was primarily due to a $3.0 million increase in our VSAT 28 airtime sales, partially offset by a $0.8 million decrease in our content service sales, primarily driven by the sale of a subsidiary in April 2022. Costs of Sales Costs of sales consists of costs of product sales and costs of service sales. Costs of sales increased by $1.0 million, or 5%, in the three months ended March 31, 2023 to $21.3 million from $20.3 million in the three months ended March 31, 2022. The increase in costs of sales was driven by a $1.2 million increase in costs of service sales, partially offset by a $0.2 million decrease in costs of product sales. As a percentage of net sales, costs of sales were 63% and 61% for the three months ended March 31, 2023 and 2022, respectively. Our costs of product sales consist primarily of materials, manufacturing overhead, and direct labor used to produce our products. For the three months ended March 31, 2023, costs of product sales decreased by $0.2 million, or 3%, to $5.2 million from $5.4 million in the three months ended March 31, 2022, primarily due to a $0.3 million decrease in our marine cost of product sales. As a percentage of product sales, costs of product sales were 106% and 83% for the three months ended March 31, 2023 and 2022, respectively. Cost of product sales increased as a percentage of product sales primarily due to two factors; the first being a write-down of inventory by $0.6 million and the second being purchase price variance of $0.3 million. Our costs of service sales consist primarily of satellite service capacity, depreciation, service network overhead expense associated with our VSAT Broadband network infrastructure, direct network service labor, Inmarsat service costs, product installation costs, media materials and distribution costs, and service repair materials. For the three months ended March 31, 2023, costs of service sales increased by $1.2 million, or 8%, to $16.1 million from $14.9 million for the three months ended March 31, 2022, primarily due to a $1.5 million increase in VSAT airtime costs of service sales. The increase in airtime cost of sales is primarily related to capacity increases necessary to support growth in our airtime subscriber base. This was partially offset by a $0.3 million decrease in content services cost of service sales, primarily driven by the sale of a subsidiary in April 2022. As a percentage of service sales, costs of service sales were 56% for each of the three months ended March 31, 2023 and 2022. Operating Expenses Research and development expense consists of direct labor, materials, external consultants, and related overhead costs that support our internally funded product development and product sustaining engineering activities. Research and development expense for the three months ended March 31, 2023 decreased by $0.4 million, or 15%, to $2.6 million from $3.0 million for the three months ended March 31, 2022. The decrease primarily resulted from a $0.3 million decrease in salaries, benefits and taxes, which was driven by costs related to the reduction in our workforce in March 2022. As a percentage of net sales, research and development expense was 8% and 9% for the three months ended March 31, 2023 and 2022, respectively. Sales, marketing, and support expense consists primarily of salaries and related expenses for sales and marketing personnel, commissions for both in-house and third-party representatives, costs related to the co-development of certain content, other sales and marketing support costs such as advertising, literature and promotional materials, product service personnel and support costs, warranty-related costs and bad debt expense. Sales, marketing and support expense also includes the operating expenses of our sales office subsidiaries in Denmark, Singapore, Brazil, and Japan. Sales, marketing and support expense for the three months ended March 31, 2023 decreased by $1.3 million, or 18%, to $5.7 million from $7.0 million for the three months ended March 31, 2022. The decrease primarily resulted from a $1.5 million decrease in salaries, benefits and taxes, which was driven by the reduction in our workforce in March 2022. As a percentage of net sales, sales, marketing and support expense was 17% and 21% for the three months ended March 31, 2023 and 2022, respectively. 29 General and administrative expense consists of costs attributable to management, finance and accounting, information technology, human resources, certain outside professional services, and other administrative costs. General and administrative expense for the three months ended March 31, 2023 decreased by $2.4 million, or 34%, to $4.7 million from $7.1 million, for the three months ended March 31, 2022. The decrease primarily resulted from a $2.0 million decrease in salaries, benefits, and taxes, which was driven by the reduction in our workforce in March 2022, and the incurrence in the three months ended March 31, 2022 of $0.5 million of expenses related to the separation and retirement of Mr. Kits van Heyningen. In addition, during the three months ended March 31, 2023 we were reimbursed by EMCORE for $0.5 million of expenses incurred under the Transition Service Agreement relating to the sale of the inertial navigation business in 2022. Partially offsetting these items was a $0.5 million increase in professional fees primarily related to additional accounting and consulting costs incurred to prepare our annual filings. As a percentage of net sales, general and administrative expense was 14% and 21% for the three months ended March 31, 2023 and 2022, respectively. Interest and Other Income, Net Interest income represents interest earned on our cash and cash equivalents, as well as from investments and our sale-type lease receivables. Interest income increased $0.6 million for the three months ended March 31, 2023 to $0.8 million from $0.2 million for the three months ended March 31, 2022. Of the current period interest income of $0.8 million, $0.6 million is attributable to interest gained from cash and cash equivalents, while the remaining $0.2 million was due to interest from lease receivables. Interest expense remained flat period-over-period at less than $0.1 million for both of the three months ended March 31, 2023 and 2022. Other (expense) income, net decreased to other expense, net of $0.2 million for the three months ended March 31, 2023 from other income, net of $0.1 million for the three months ended March 31, 2022. Other expense, net of $0.2 million for the three months ended March 31, 2023 primarily relates to foreign exchange losses from our UK operations. Income Tax Expense Income tax expense for the three months ended March 31, 2023 was less than $0.1 million and related to taxes on income earned in foreign jurisdictions. Income tax expense for the three months ended March 31, 2022 was $0.3 million and related to taxes on income earned in foreign jurisdictions. Discontinued Operations On August 9, 2022, we sold our inertial navigation business for net proceeds $54.9 million, less specified deductions. We determined that the sale met the requirements for reporting as discontinued operations in accordance with ASC 205-20. Accordingly, we have classified the results of the inertial navigation business as discontinued operations for all prior periods presented. Please see Notes 1 and 18 for further discussion. Results for discontinued operations are as follows: Three months ended March 31, 2022 (dollars in thousands) Sales from discontinued operations $ 7,943 Net loss from discontinued operations, net of tax $ (425) Liquidity and Capital Resources Our primary liquidity needs have been to fund general business requirements, including working capital requirements and capital expenditures. In recent years, we have funded our operations primarily from the sale of two businesses in 2022, the sale of a business in 2019, a PPP loan, cash flows from operations, bank financings and proceeds received from exercises of stock options and the issuance of stock. On August 9, 2022, we sold our inertial navigation business to EMCORE Corporation for net proceeds of $54.9 million, less specified deductions. 30 As of March 31, 2023, we had $68.7 million in cash, cash equivalents, and marketable securities, of which $2.5 million in cash and cash equivalents was held in local currencies by our foreign subsidiaries. Our foreign subsidiaries held no marketable securities as of March 31, 2023. As of March 31, 2023, we had $95.6 million in working capital. Based upon our current working capital position, current operating plans and expected business conditions, we expect to have sufficient funds, through at least twelve months from the date that this report is filed with the SEC, to fund our short-term and long-term working capital requirements, including capital expenditures and contractual obligations. Our funding plans for our working capital needs and other commitments may be adversely impacted if our underlying assumptions regarding our anticipated revenues and expenses are not realized. If our operating results fail to meet our expectations, we could be required to seek additional funding through public or private financings or other arrangements. In that event, adequate funds may not be available when needed or may be available only on terms which could have a negative impact on our business and results of operations. In addition, if we raise funds by issuing equity securities, our stockholders may experience dilution. Net cash used in operations was $6.8 million for the three months ended March 31, 2023 compared to net cash used in operations of $3.5 million for the three months ended March 31, 2022. The $3.3 million increase in cash used in operations is primarily driven by a net increase in cash outflows of $15.1 million related to accounts payable, an increase of $0.5 million related to non-cash items, and a $0.4 million increase in non-current assets. Partially offsetting these items was a $5.8 million increase in accrued compensation, product warranty and other expenses, a $4.7 million decrease in net loss, a $1.6 million increase in cash inflows relating to accounts receivable, a $0.4 million decrease in cash outflows related to prepaid expenses and current assets, and a $0.3 million increase in cash inflows related to contract liabilities. Net cash used in investing activities was $2.7 million for the three months ended March 31, 2023 compared to net cash provided by investing activities of $0.1 million for the three months ended March 31, 2022. The $2.8 million change in net cash used in investing activities was primarily the result of a $5.1 million increase in net investment in marketable securities, partially offset by a $2.3 million decrease in capital expenditures. Net cash provided by financing activities was $0.8 million for the three months ended March 31, 2023 compared to net cash provided by financing activities of $0.1 million for the three months ended March 31, 2022. The $0.6 million increase in net cash provided by financing activities is primarily attributable to the $0.8 million increase in cash inflows relating to proceeds from stock options exercised and the employee stock purchase plan, partially offset by a $0.2 million increase in cash outflows related to the repurchase of common stock to satisfy specific tax withholding obligations arising from accelerated vesting of executive stock grants. Other Matters We intend to continue to invest in our global HTS network on a worldwide basis. As part of the future potential capacity expansion, we plan to acquire additional satellite capacity from satellite operators, expend funds to seek regulatory approvals and permits, develop product enhancements in anticipation of the expansion, and hire additional personnel. From time to time we have entered into multi-year agreements to lease satellite capacity, and we have also purchased numerous satellite hubs to support the added capacity. These transactions can involve millions of dollars.