TELOS CORP 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believes," "anticipates," "plans," "expects," and similar expressions are intended to identify forward-looking statements. Several important factors could cause the Company's actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth in the risk factors section included in the Company's Form 10-K for the year ended December 31, 2022, as filed with the Securities and Exchange Commission ("SEC") on March 16, 2023. General and Business Overview We offer technologically advanced, software-based security solutions that empower and protect the world's most security-conscious organizations against rapidly evolving, sophisticated and pervasive threats. Our portfolio of security products, services and expertise empowers our customers with capabilities to reach new markets, serve their stakeholders more effectively, and successfully defend the nation or their enterprise. We protect our customers' people, information, and digital assets so they can pursue their corporate goals and conduct their global missions with confidence in their security and privacy. Our primary customers include the U.S. federal government, large commercial businesses, state and local governments, and international customers. Our consolidated revenue is largely attributable to prime contracts or to subcontracts with our contractors engaged in work for the U.S. government, with the remaining attributable to state, local and commercial markets. Information regarding our two reportable segments – Security Solutions and Secure Networks – is presented in Note 17 – Segment Information to the unaudited consolidated financial statements at Item 1 of this Form 10-Q. Fiscal year 2023 continues to be a transition year for Telos, focusing on streamlining our operations and rebuilding and growing the revenue base by generating new business wins. Our 2023 business development priorities are to: • Reorganize internally to consolidate and centralize business development resources; • Add new talent to drive execution of solution development and new business generation; • Maximize existing strategic partnerships for market expansion; and • Increase our opportunity portfolio and quality of contract vehicles. Business Environment U.S. Budget The President’s proposed FY2024 budget released in March called for a $26 billion increase for the Department of Defense ("DoD") next year, a little more than 3% above the FY2023 enacted level. The debt ceiling legislation (the "Fiscal Responsibility Act") subsequently enacted into law in early June contains spending caps which reflected that level of defense spending, as have the House and Senate versions of the defense authorization and appropriations bills. While there are many in Congress who want to boost this increase further to offset current and expected inflation and the continued threats posed by foreign adversaries, final decisions on FY 2024 defense spending are now not likely to be made until December at the very earliest. The President's FY2024 budget also proposed increased investments for cybersecurity within numerous federal civilian departments and agencies. In general, the President's budget reflects the prioritization of accelerated cloud adoption, IT modernization, further private sector collaboration for sector risk management responsibilities, ensuring adequate cyber threat information sharing, and supply chain risk management. These priorities align with the solutions Telos has been developing and bringing to market for the past several years. However, such increased spending by civilian agencies on cybersecurity could be difficult to achieve, given the caps on non-defense discretionary spending included in the Fiscal Responsibility Act and subsequent efforts by the House majority to seek further reductions in all non-defense discretionary spending. This could impact future cybersecurity investments by current and potential civilian federal customers. 21 Table of Contents Congress was unable to enact any of its annual appropriation bills before the start of FY2024 on October 1, 2023 and instead approved a Continuing Resolution (“CR”), which funded the government at FY2023 levels until November 17, 2023 and restricted new contracts and acceleration of current programs. It is unlikely Congress will enact any individual appropriation bills before the current CR expires, and prospects for approving another CR by then are uncertain. Failure to enact a new CR by November 17, 2023 would result in a federal government shutdown after that date. Finally, under the terms of the Fiscal Responsibility Act, if all appropriations legislation is not enacted by January 1, 2024, and the government remains under another CR, appropriations government-wide will revert to the FY2023 level minus an additional one percent. This uncertainty could impact federal customers' ability to move forward on their planned expenditures in FY2024. Cybersecurity Landscape In recent years, we have seen cybersecurity threats become more complex, with threat actors leveraging a wide variety of tactics to exploit their victims. With this growing threat, below are some trends to consider when looking at the cybersecurity landscape: Rising Threats, Rising Liability : Ransomware remains arguably the most severe cyber threat to enterprises in the commercial, state, and local government and education sectors. One reason for the rise of ransomware attacks is that it is exceedingly profitable for cybercriminals, and ransomware victims generally settle the ransom rather than restoring the system from backups or dealing with the fallout from a data breach. Aside from the financial costs of paying the ransom and restoring the system, the consequences of a successful ransomware attack can include damage to the organization's reputation, stolen sensitive data being used for malicious purposes, and loss of business. The Nation's Critical Systems Are Still at Risk : Critical infrastructure and industrial Internet of Things ("IoT") are among the categories at greatest risk of cyberattacks. The Challenging Complexity of Regulatory Compliance : Government mandates stronger security in highly regulated industries. These government initiatives and audit fatigue continue to burden highly regulated organizations, with automation solutions being recognized as the most effective remedy for the many repetitive and redundant tasks that security compliance requires. Additionally, the SEC has finalized and adopted new cybersecurity rules for publicly traded companies, which will require registrants to disclose additional cyber-related information in their regulatory filings. Specifically, they will have to: (1) regularly disclose their governance methods, risk analysis and management processes; (2) meet specific disclosure requirements and deadlines for reporting and describing material cyber incidents; and (3) describe the board's oversight of risks from cybersecurity threats, and management's expertise and role in assessing and managing material risks from cybersecurity threats. The required reporting of this information will lead many companies to proactively establish policies that will improve their cyber risk management posture and enable them to better withstand heightened public and regulatory scrutiny. Identity Assurance and Privacy Protection are Essential for Today's Enterprises : Identity and access management continues to be a major cybersecurity concern for organizations and individuals that need to ensure their security and protect their privacy. Trusted identities are essential to confidence in IT and physical security strategies and to the success of Zero Trust security models and architectures. Artificial Intelligence : Cybercriminals are using Artificial Intelligence ("AI") to launch more sophisticated attacks that can quickly adapt to changing environments, making detection harder. To protect against AI-powered cyberattacks, organizations must stay vigilant and adopt advanced cybersecurity tools and techniques that can detect and respond to these threats timely before they can cause damage. Backlog Backlog is a useful measure in developing our annual budgeted revenue by estimating for the upcoming year our continuing business from existing customers and active contracts. We consider backlog, both funded and unfunded (as explained below), other expected annual renewals, and expansion planned by our current customers. Total backlog consists of the aggregate contract revenues remaining to be earned by us at a given time over the life of our contracts, whether funded or unfunded. Funded backlog consists of the aggregate contract revenues remaining to be earned at a given time, which, in the case of U.S. government contracts, means that they have been funded by the procuring agency. Unfunded backlog is the difference between total backlog and funded backlog and includes potential revenues that may be earned if customers exercise delivery orders and/or renewal options to continue these contracts. Based on historical experience, we generally assume option year renewals to be exercised. Most of our customers fund contracts on the basis of one year or less, and, as a result, funded backlog is generally expected to be earned within one year from any point in time, whereas unfunded backlog is expected to be earned over a longer period. 22 Table of Contents Business Highlights Although a number of factors have contributed to the results of our third quarter of fiscal year 2023, the notable events and significant factors are described below. More details on these changes are presented below within our "Results of Operations" section. • The completion of certain programs and lower revenue on ongoing major programs resulted in a decline in the current quarter's revenue compared with 2022 results. • Gross margin increased significantly primarily due to revenue mix and improved margins due to strong program management within Secure Networks programs. • Operating costs are lower through a combination of lower stock-based compensation and the results of the restructuring plan announced in the first quarter of 2023. Results of Operations Table MD&A 1: Consolidated Results of Operations For the Three Months Ended For the Nine Months Ended September 30, 2023 September 30, 2022 September 30, 2023 September 30, 2022 (dollars in thousands) Total revenue $ 36,186 $ 63,593 $ 104,319 $ 169,544 Cost of sales (exclusive of depreciation and amortization shown separately below) 21,228 42,457 63,174 108,197 Depreciation and amortization 1,945 191 2,291 602 Total cost of sales 23,173 42,648 65,465 108,799 Gross profit 13,013 20,945 38,854 60,745 Gross margin 36.0 % 32.9 % 37.2 % 35.8 % Selling, general and administrative expenses 22,706 29,729 70,984 99,932 Selling, general and administrative expenses as percentage of revenue 62.7 % 46.7 % 68.0 % 58.9 % Operating loss (9,693) (8,784) (32,130) (39,187) Other income 1,222 518 5,367 648 Interest expense (178) (181) (611) (558) Loss before income taxes (8,649) (8,447) (27,374) (39,097) Provision for income taxes (23) (8) (68) (133) Net loss $ (8,672) $ (8,455) $ (27,442) $ (39,230) Consolidated Results Our business segments have different factors driving revenue fluctuations and profitability. The discussion of the changes in our revenue and profitability is set forth in greater detail under the section that follows "Segment Results." We generate revenue from the delivery of products and services to our customers. Cost of sales, for both products and services, consists of labor, materials, subcontracting costs and an allocation of indirect costs. Selling, general, and administrative expenses (SG&A). SG&A decreased by $7.0 million, or 23.6%, for the three months ended September 30, 2023, compared to the same period in 2022. Sales and marketing expenses decreased by $1.3 million, research and development expenses decreased by $0.8 million, and general and administrative expenses decreased by $4.9 million. Lower compensation costs are the primary driver for reductions across all of these areas. SG&A decreased by $28.9 million, or 29.0%, for the nine months ended September 30, 2023, as compared to the same period in the prior year. Sales and marketing expenses decreased by $7.9 million primarily due to lower compensation costs. Research and development expenses decreased by $5.3 million due to lower compensation costs and increased capitalization of software development. General and administrative expenses also decreased by $15.8 million due to lower compensation costs, partially offset by restructuring expenses. Other income. Other income increased by $0.7 million for the three months ended September 30, 2023, due to increases in dividend income from money market placements as a result of increasing interest rates, compared to the same period in 2022. Other income increased by $4.7 million for the nine months ended September 30, 2023, as compared to the same period in the prior year, primarily due to an increase in dividend income from money market placement of $3.3 million, and a gain on early extinguishment of other financing obligations of $1.4 million in 2023 without a similar gain in the same period in 2022. 23 Table of Contents Interest expense . There was no significant change in interest expense between comparable periods. Provision for income taxes . The change in the income tax provision for the three and nine months ended September 30, 2023, compared to the same period in 2022, is based on the estimated annual effective tax rate applied to the pretax loss incurred for the quarter plus discrete tax items, based on our expectation of pretax loss for the fiscal year. Segment Results The accounting policies of each business segment are the same as those followed by the Company as a whole. Management evaluates business segment performance based on gross profit. Table MD&A 2: Security Solutions Segment - Financial Results For the Three Months Ended For the Nine Months Ended September 30, 2023 September 30, 2022 September 30, 2023 September 30, 2022 (dollars in thousands) Revenue $ 19,795 $ 32,440 $ 56,764 $ 90,178 Cost of sales (exclusive of depreciation and amortization shown separately below) 8,498 16,680 25,304 42,536 Depreciation and amortization 1,943 183 2,281 580 Total cost of sales 10,441 16,863 27,585 43,116 Gross profit $ 9,354 $ 15,577 $ 29,179 $ 47,062 Gross margin 47.3 % 48.0 % 51.4 % 52.2 % For the three months ended September 30, 2023, Security Solutions segment revenue decreased by $12.6 million, or 39.0%, compared to the same period in 2022, primarily due to lower revenues on ongoing programs. Security Solutions segment revenue for the nine months ended September 30, 2023, decreased by $33.4 million, or 37.1%, compared to the same period in 2022, primarily due to lower revenues on ongoing programs. Gross profit for Security Solutions decreased by $6.2 million, or 39.9%, for the third quarter of 2023 compared with the same period in 2022, primarily due to the decrease in revenue and a slight decrease in gross margin. Segment gross margin decreased to 47.3% for the third quarter of 2023 from 48.0% for the same period in 2022, primarily due to amortization of software development costs partially offset by favorable revenue mix. For the nine months ended September 30, 2023, Security Solutions segment gross profit decreased by $17.9 million, or 38.0%, compared to the same period in 2022, primarily due to the decrease in revenue and a small decrease in gross margin. Segment gross margin decreased from 52.2% to 51.4%, primarily due to amortization of software development costs partially offset by favorable revenue mix within the portfolio. Table MD&A 3: Secure Networks Segment - Financial Results For the Three Months Ended For the Nine Months Ended September 30, 2023 September 30, 2022 September 30, 2023 September 30, 2022 (dollars in thousands) Revenue $ 16,391 $ 31,153 $ 47,555 $ 79,366 Cost of sales (exclusive of depreciation and amortization shown separately below) 12,730 25,777 37,870 65,661 Depreciation and amortization 2 8 10 22 Total cost of sales 12,732 25,785 37,880 65,683 Gross profit $ 3,659 $ 5,368 $ 9,675 $ 13,683 Gross margin 22.3 % 17.2 % 20.3 % 17.2 % Secure Networks segment revenue for the three months ended September 30, 2023, decreased by $14.8 million, or 47.4%, compared to the same period in 2022, primarily due to the successful completion of certain programs and lower revenue on ongoing major programs as expected. For the nine months ended September 30, 2023, Secure Networks segment revenue decreased by $31.8 million, or 40.1%, compared to the same period in 2022, primarily due to the successful completion of certain programs and lower revenue on ongoing major programs as expected. 24 Table of Contents Gross profit for Secure Networks decreased by $1.7 million, or 31.8%, for the third quarter of 2023, compared with the same period in 2022, primarily due to lower revenue but partially offset by higher gross margins. Segment gross margin increased to 22.3% for the third quarter of 2023 from 17.2% for the same period in 2022, primarily due to strong program management and the successful wind-down of certain lower-margin programs. For the nine months ended September 30, 2023, Secure Networks segment gross profit decreased by $4.0 million, or 29.3%, compared to the same period in 2022, primarily due to lower revenue, partially offset by higher gross margins. Segment gross margin increased from 17.2% in 2022 to 20.3% in 2023 due to strong program management and a shift in the mix across the portfolio driven by the successful wind-down of lower-margin programs. Non-GAAP Financial Measures In addition to our results determined in accordance with U.S. GAAP, we believe the non-GAAP financial measures of EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net (Loss)/Income, Adjusted Earnings Per Share ("EPS"), Non-GAAP Gross Profit, Non-GAAP Gross Margin and Free Cash Flow are useful in evaluating our operating performance. We believe that this non-GAAP financial information, when taken collectively with our GAAP results, may be helpful to readers of our financial statements because it provides consistency and comparability with past financial performance and assists in comparisons with other companies, some of which use similar non-GAAP financial information to supplement their GAAP results. The non-GAAP financial information is presented for supplemental informational purposes only, should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly-titled non-GAAP measures used by other companies. A reconciliation is provided below for each of these non-GAAP financial measures to the most directly comparable financial measure stated in accordance with GAAP. We believe these non-GAAP financial measures facilitate comparison of our operating performance on a consistent basis between periods by excluding certain items that may, or could, have a disproportionately positive or negative impact on our results of operations in any particular period. When viewed in combination with our results prepared in accordance with GAAP, these non-GAAP financial measures help provide a broader picture of factors and trends affecting our results of operations. EBITDA, Adjusted EBITDA, EBITDA Margin and Adjusted EBITDA Margin EBITDA, Adjusted EBITDA, EBITDA Margin and Adjusted EBITDA Margin are supplemental measures of operating performance that are not made under GAAP and do not represent, and should not be considered as, an alternative to net loss as determined by GAAP. We define EBITDA as net (loss)/income, adjusted for non-operating (income)/expense, interest expense, provision for/(benefit from) income taxes, and depreciation and amortization. We define Adjusted EBITDA as EBITDA, adjusted for stock-based compensation expense and restructuring expenses. We define EBITDA Margin as EBITDA as a percentage of total revenue. We define Adjusted EBITDA Margin as Adjusted EBITDA as a percentage of total revenue. We believe that EBITDA, EBITDA Margin, Adjusted EBITDA and Adjusted EBITDA Margin provide the Board, management and investors with clear representation of our core operating performance and trends, provide greater visibility into the long-term financial performance of the Company, and eliminate the impact of items that do not relate to the ongoing operating performance of the business. Further, Adjusted EBITDA and Adjusted EBITDA Margin are used by the Board and management to prepare and approve our annual budget, and to evaluate the performance of certain management personnel when determining incentive compensation. Table MD&A 4: Reconciliation of Net Loss to EBITDA, Adjusted EBITDA, EBITDA Margin and Adjusted EBITDA Margin For the Three Months Ended For the Nine Months Ended September 30, 2023 September 30, 2022 September 30, 2023 September 30, 2022 Amount Margin Amount Margin Amount Margin Amount Margin (dollars in thousands) Net loss $ (8,672) (24.0 %) $ (8,455) (13.3 %) $ (27,442) (26.3) % $ (39,230) (23.1) % Other income (1,222) (3.4 %) (518) (0.8 %) (5,367) (5.1) % (648) (0.4) % Interest expense 178 0.5 % 181 0.3 % 611 0.6 % 558 0.3 % Provision for income taxes 23 0.1 % 8 — % 68 0.1 % 133 0.1 % Depreciation and amortization 3,215 8.9 % 1,517 2.4 % 6,336 6.0 % 4,427 2.6 % EBITDA (Non-GAAP) (6,478) (17.9 %) (7,267) (11.4 %) (25,794) (24.7) % (34,760) (20.5) % Stock-based compensation expense (1) 5,218 14.4 % 15,836 24.9 % 22,462 21.5 % 48,843 28.8 % Restructuring expenses (2) — — % — — % 1,197 1.2 % — — % Adjusted EBITDA (Non-GAAP) $ (1,260) (3.5 %) $ 8,569 13.5 % $ (2,135) (2.0 %) $ 14,083 8.3 % 25 Table of Contents (1) The stock-based compensation adjustment to EBITDA is made up of stock-based compensation expense for the awarded RSUs, PSUs and stock options, and other sources. Stock-based compensation expense for the awarded RSUs, PSUs and stock options was $5.2 million and $18.6 million for the three and nine months ended September 30, 2023, respectively, and $16.1 million and $46.8 million for the three and nine months ended September 30, 2022, respectively. No stock-based compensation from other sources was recorded for the three months ended September 30, 2023, while $3.8 million was recorded for the nine months ended September 30, 2023. Stock-based compensation (adjustment)/expense from other sources was $(0.3) million and $2.0 million for the three and nine months ended September 30, 2022, respectively. The other sources of stock-based compensation consist of accrued compensation, which the Company intends to settle in shares of the Company's common stock. However, it is the Company’s discretion whether this compensation will ultimately be paid in stock or cash. The Company has the right to dictate the form of these payments up until the date at which they are paid. Any change to the expected payment form would result in out-of-quarter adjustments to this add back to Adjusted EBITDA. (2) The restructuring expenses to EBITDA include severance and other related benefit costs (including outplacement services and continuing health insurance coverage), external consulting and advisory fees related to implementing the restructuring plan. Adjusted Net (Loss)/Income and Adjusted EPS Adjusted Net (Loss)/Income and Adjusted EPS are supplemental measures of operating performance that are not made under GAAP and do not represent, and should not be considered as, alternatives to net (loss)/income as determined by GAAP. We define Adjusted Net (Loss)/Income as net loss, adjusted for non-operating (income)/expense, stock-based compensation expense and restructuring expense. We define Adjusted EPS as Adjusted Net (Loss)/Income divided by the weighted-average number of common shares outstanding for the period. Adjusted Net (Loss)/Income and Adjusted EPS provide the Board, management and investors with clear representation of our core operating performance and trends, provide greater visibility into the long-term financial performance of the Company, and eliminate the impact of items that do not relate to the ongoing operating performance of the business. Table MD&A 5: Reconciliation of Net Loss to Non-GAAP Adjusted Net (Loss)/Income and Adjusted EPS For the Three Months Ended For the Nine Months Ended September 30, 2023 September 30, 2022 September 30, 2023 September 30, 2022 Amount Earnings Per Share Amount Earnings Per Share Amount Earnings Per Share Amount Earnings Per Share (in thousands, except per share data) Net loss $ (8,672) $ (0.12) $ (8,455) $ (0.13) $ (27,442) $ (0.40) $ (39,230) $ (0.58) Adjustments: Other income (1,222) (0.02) (518) (0.01) (5,367) (0.08) (648) (0.01) Stock-based compensation expense (1) 5,218 0.07 15,836 0.24 22,462 0.33 48,843 0.72 Restructuring expenses (2) — — — — 1,197 0.02 — — Adjusted net (loss)/income, Adjusted EPS (Non-GAAP) $ (4,676) $ (0.07) $ 6,863 $ 0.10 $ (9,150) $ (0.13) $ 8,965 $ 0.13 Weighted-average shares of common stock outstanding, basic 69,571 67,493 69,062 67,641 (1) The stock-based compensation adjustment to net (loss)/income is made up of stock-based compensation expense for the awarded RSUs, PSUs and stock options, and other sources. Stock-based compensation expense for the awarded RSUs, PSUs and stock options was $5.2 million and $18.6 million for the three and nine months ended September 30, 2023, respectively, and $16.1 million and $46.8 million for the three and nine months ended September 30, 2022, respectively. No stock-based compensation from other sources was recorded for the three months ended September 30, 2023, while $3.8 million was recorded for the nine months ended September 30, 2023. Stock-based compensation (adjustment)/expense from other sources was $(0.3) million and $2.0 million for the three and nine months ended September 30, 2022, respectively. The other sources of stock-based compensation consist of accrued compensation, which the Company intends to settle in shares of the Company's common stock. However, it is the Company’s discretion whether this compensation will ultimately be paid in stock or cash. The Company has the right to dictate the form of these payments up until the date at which they are paid. Any change to the expected payment form would result in out-of-quarter adjustments to this add back to Adjusted Net (Loss)/Income. (2) The restructuring expenses to net loss include severance and other related benefit costs (including outplacement services and continuing health insurance coverage), external consulting and advisory fees related to implementing the restructuring plan. 26 Table of Contents Non-GAAP Gross Profit and Non-GAAP Gross Margin Non-GAAP Gross Profit and Non-GAAP Gross Margin are supplemental measures of operating performance that are not made under GAAP and do not represent, and should not be considered as, alternatives to gross profit and gross margin as determined by GAAP. We define Non-GAAP Gross Profit as gross profit, adjusted for stock-based compensation expense, and depreciation and amortization charged under cost of sales. We define Non-GAAP Gross Margin as Non-GAAP Gross Profit as a percentage of total revenue. Non-GAAP Gross Profit and Non-GAAP Gross Margin provide management and investors a clear representation of the core economics of gross profit and gross margin without the impact of non-cash expenses and sunk costs expended. Table MD&A 6: Reconciliation of Gross Profit to Non-GAAP Gross Profit; Gross Margin to Non-GAAP Gross Margin For the Three Months Ended For the Nine Months Ended September 30, 2023 September 30, 2022 September 30, 2023 September 30, 2022 Amount Margin Amount Margin Amount Margin Amount Margin (dollars in thousands) Gross profit $ 13,013 36.0 % $ 20,945 32.9 % $ 38,854 37.2 % $ 60,745 35.8 % Adjustments: Stock-based compensation expense — cost of sales 73 0.2 % 929 1.5 % 624 0.6 % 2,798 1.6 % Depreciation and amortization — cost of sales 1,945 5.3 % 191 0.3 % 2,291 2.2 % 602 0.4 % Non-GAAP gross profit $ 15,031 41.5 % $ 22,065 34.7 % $ 41,769 40.0 % $ 64,145 37.8 % Free Cash Flow Free cash flow, as reconciled in the table below, is a non-GAAP financial measure defined as net cash provided by/(used in) operating activities, less purchases of property and equipment, and capitalized software development costs. This non-GAAP financial measure may be a useful measure for investors and other users of our financial statements as a supplemental measure of our cash performance and to assess the quality of our earnings as a key performance measure in evaluating management. We use Free Cash Flow to understand the cash flows that directly correspond with our operations and the investments we must make in those operations, using a methodology that combines operating cash flows and capital expenditures. Further, Free Cash Flow may be useful to management and investors in evaluating the Company's operating performance and liquidity. Table MD&A 7: Free Cash Flow For the Three Months Ended For the Nine Months Ended September 30, 2023 September 30, 2022 September 30, 2023 September 30, 2022 (in thousands) Net cash provided by/(used in) operating activities $ 846 $ 11,986 $ (3,367) $ 20,118 Adjustments: Purchases of property and equipment (80) (174) (350) (815) Capitalized software development costs (3,762) (3,446) (11,960) (8,580) Free cash flow (Non-GAAP) $ (2,996) $ 8,366 $ (15,677) $ 10,723 Each of EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net (Loss)/Income, Adjusted EPS, Non-GAAP Gross Profit, Non-GAAP Gross Margin and Free Cash Flow has limitations as an analytical tool, and you should not consider any of them in isolation, or as a substitute for analysis of our results as reported under GAAP. Among other limitations, each of EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net (Loss)/Income, Adjusted EPS, Non-GAAP Gross Profit, Non-GAAP Gross Margin and Free Cash Flow does not reflect our cash expenditures, or future requirements, for capital expenditures or contractual commitments, does not reflect the impact of certain cash and non-cash charges resulting from matters we consider not to be indicative of our ongoing operations, and does not reflect income tax expense or benefit. Other companies in our industry may calculate Adjusted EBITDA, Adjusted EBITDA Margin, Adjusted Net (Loss)/Income, Adjusted EPS, Non-GAAP Gross Profit, Non-GAAP Gross Margin and Free Cash Flow differently than we do, which limits their usefulness as comparative measures. Because of these limitations, neither EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net (Loss)/Income, Adjusted EPS, Non-GAAP Gross Profit, Non-GAAP Gross Margin nor Free Cash Flow should be considered as a replacement for gross profit, gross margin, net (loss)/income, earnings per share or net cash flows (used in)/provided by operating activities, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. 27 Table of Contents Liquidity and Capital Resources Our primary sources of liquidity are cash on hand, future operating cash flows, and, if needed, borrowings under our $30.0 million revolving credit facility, with an available expansion feature of up to $30.0 million of additional revolver facility. While a variety of factors related to sources and uses of cash, such as timeliness of accounts receivable collections, vendor credit terms, or significant collateral requirements, ultimately impact our liquidity, such factors may or may not have a direct impact on our liquidity. As of September 30, 2023, we had cash and cash equivalents of $100.0 million and our working capital was $106.6 million. We place a strong emphasis on liquidity management. This focus gives us the flexibility for capital deployment while preserving a strong balance sheet to position us for future opportunities. We believe we have adequate funds on hand to execute our financial and operating strategy. Our overall financial position and liquidity are strong. Although no assurances can be given, we believe the available cash balances and access to our revolving credit facility are sufficient to maintain the liquidity we require to meet our operating, investing and financing needs for the next 12 months. Cash Flow Table MD&A 8: Net Change in Cash, Cash Equivalents, and Restricted Cash For the Nine Months Ended September 30, 2023 September 30, 2022 (in thousands) Net cash (used in)/provided by operating activities $ (3,367) $ 20,118 Net cash used in investing activities (12,310) (9,395) Net cash used in financing activities (3,673) (11,821) Net change in cash, cash equivalents, and restricted cash $ (19,350) $ (1,098) Net cash used in operating activities for the nine months ended September 30, 2023, was $3.4 million, a decrease in cash inflow of $23.5 million in cash outflow, compared to the same period in 2022. The change is primarily driven by the Company's operating losses, the timing of receipts of customer payments, the timing of payments to vendors and employees, and the timing of inventory turnover, adjusted for certain non-cash items (i.e. stock-based compensation costs lower by $26.4 million) that do not impact cash flows from operating activities. Net cash used in investing activities for the nine months ended September 30, 2023, increased by $2.9 million compared to the same period of the prior year, primarily due to the higher investment in software development costs of $12.0 million and $8.6 million for the nine months ended September 30, 2023 and 2022, respectively, partially offset by the slight decrease in purchases of property and equipment. Net cash used in financing activities for the nine months ended September 30, 2023, decreased by $8.1 million compared to the same period in 2022. This is primarily attributable to the decrease in payment of tax withholding related to net share settlement of equity awards of $1.7 million for the nine months ended September 30, 2023, compared with $3.1 million in the same period of 2022, and the cash outflow on repurchases of common stock of $7.6 million in 2022 compared with $0.1 million in 2023 under the share repurchase program (see Note 13 – Share Repurchases ). This is partially offset by the payment of the DFT holdback amount of $0.6 million in February 2023. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires us to make estimates, judgments, and assumptions that affect the amounts reported. Actual results could differ from those estimates. The 2022 Form 10-K, as filed with the SEC on March 16, 2023, includes a summary of critical accounting policies we believe are the most important to aid in understanding our financial results. There have been no changes to those critical accounting policies that have had a material impact on our reported amounts of assets, liabilities, revenues, or expenses during the nine months ended September 30, 2023. Item 3. Quantitative and Qualitative Disclosures about Market Risk None. 28 Table of Contents