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, 2023, as filed with the Securities and Exchange Commission on March 15, 2024. 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 16 - Segment Information to the unaudited consolidated financial statements at Item 1 of this Form 10-Q. The restructuring initiatives carried out by the Company in fiscal year 2023 are exhibiting promising outcomes in fiscal year 2024 in the form of new business wins. The Company continues to optimize its solution portfolio, expand its business pipeline, strengthen new business proposals and build a healthy culture by engaging employees through improved synergy, performance management, and benefits. With this foundation established, the Company's current year priorities remain focused on strategically increasing its business development pipeline, effective execution of significant new business wins with our prime partners, and further expansion of TSA PreCheck ® enrollment sites. Business Environment U.S. Budget The fiscal year ("FY") 2024 budget appropriation was approved in March 2024 and has allowed federal departments and agencies to proceed with new program starts and acceleration for the final six months of the fiscal year. With the enactment of the Fiscal Responsibility Act ("FRA"), appropriations bills were marked up in the House and Senate in June and July. The FRA caps total base discretionary spending at $1.6 trillion for FY2024, with base defense spending capped at $886 billion (a three percent increase from FY2023) and base non-defense spending capped at $704 billion (up to a nine percent decrease from FY2023). In March 2024, the U.S. President proposed the annual appropriations for FY2025 to fit within the tight caps set as part of last year's debt ceiling agreements. The Defense Department budget includes $850 billion in discretionary budget authority for 2025, a $34 billion or 4.1% increase from the 2023 enacted level. This growth is in alignment with levels agreed to in the FRA of 2023 and enables the DoD to make the investments necessary to execute the Administration's 2022 National Security Strategy and 2022 National Defense Strategy. The President's FY2025 budget also proposed several increases for key cyber programs and initiatives. For FY2025, the White House had directed agencies to prioritize cyber investments in "secure by design" technologies and the modernization of legacy technology. The budget provides $13 billion in cybersecurity funding across civilian departments and agencies to advance the Administration's commitment to making cyberspace more resilient and defensible. The proposed FY2025 budget includes $3 billion for the Cybersecurity and Infrastructure Security Agency ("CISA"), a $103 million increase over the agency's current budget. CISA's 2025 cyber budget proposal also includes $469.8 million for the Continuous Diagnostics and Mitigation ("CDM") program, wherein the agency would use the CDM funding to complete mobile asset deployments, continued asset deployments, initiate Internet of Things ("IoT") activities in asset management, continue to fill gaps in identity and access management capabilities, and align the agency to Zero Trust use cases. In the wake of the President's executive order on artificial intelligence last fall, the 2025 budget proposal includes plenty of AI-related spending, much of which intersects with cybersecurity and AI safety. This includes $470 million to deploy Federal network tools, including endpoint detection and response capabilities; $394 million for CISA's internal cybersecurity and analytical capabilities; $41 million for critical infrastructure security coordination; and $116 million for critical infrastructure cyber event reporting. 21 Table of Contents Congress was unable to enact any of its annual appropriation bills before the start of FY2025 on October 1, 2024. Instead, Congress passed and the President has signed into law a Continuing Resolution ("CR") that will extend funding for the federal government until December 20, 2024. The CR provides minimal needed spending adjustments for certain programs to ensure that the federal government can receive adequate funding to operate for the duration of the CR. However, in the current political environment in Congress and with the presidential election in November 2024, it is highly questionable whether Congress and the President will reach an agreement on FY2025 appropriations bills within the duration of the CR. This means the Defense Department and the rest of the federal government will likely be restricted from beginning their planned expenditures in FY2025. Cybersecurity Landscape The scope of cybersecurity is on the edge of transformative changes. Cyber threats are not just escalating in frequency but are also becoming more sophisticated, thus challenging traditional security standards. In this rapidly evolving cybersecurity landscape, the need for vigilant defense is vital, and cybersecurity is a priority for organizations to mitigate their risk and keep safe from threats and exploitation. Understanding the threat environment and the impending trends (both current and future) is a matter of foresight and is crucial in designing effective security strategies. The Defense Department's budget continues to invest in cybersecurity programs to protect the nation from malicious cyber actors and cyber campaigns. These investments strengthen cyber protection standards for the defense industrial base ("DIB") and cybersecurity of DoD networks. With this growing threat, below are some trends to consider when looking at the cybersecurity landscape: Addresses Emerging Cyber and Counterintelligence Threats: The FY2025 budget expands the Department of Justice’s ("DOJ") ability to pursue threats through investments in the FBI’s cyber and counterintelligence investigative capabilities. These investments sustain the FBI’s cyber intelligence, counterintelligence, and analysis capabilities and include funding to enhance those cyber response and counterintelligence capabilities. The budget also includes funding to expand a new section within the DOJ’s National Security Division to focus on cyber threats. These investments align with the National Cybersecurity Strategy that emphasizes a whole-of-nation approach to addressing ongoing cyber threats. Finally, the budget also provides for the DOJ to support the implementation of Executive Order 14110, “Safe, Secure, and Trustworthy Development and Use of Artificial Intelligence.” Rising Threats, Rising Liability: Ransomware remains arguably the most severe cyber threat to enterprises in the commercial, state, and local government and education sectors. Phishing is one of the top distribution channels for ransomware. Modern phishing attacks have become adept at bypassing traditional security measures, using more personalized and technically advanced tactics to deceive users. 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 IoT are among the categories at greatest risk of cyberattacks. The IoT continues its rapid growth, interconnecting an increasing number of devices. However, this expansion brings with it a host of security challenges. The widespread range of IoT devices make them attractive targets for cyberattacks, and their interrelated nature can lead to pervasive susceptibilities. Navigating a Changing Regulatory Landscape and Compliance: The regulatory landscape governing cybersecurity is developing swiftly. Over time, the government mandates stronger security in highly regulated industries. These government initiatives and audit fatigue continue to burden highly regulated organizations, with automation solutions recognized as the most effective remedy for the many repetitive and redundant tasks that security compliance requires. Additionally, the SEC adopted new rules on cybersecurity risk management, strategy, governance and incident disclosure by public companies. The required reporting of this information leads 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 continue 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. The shift to a Zero Trust framework represents a fundamental change in approach in cybersecurity, focusing on identity and access management, continuous monitoring and robust authentication mechanisms to establish a secure digital environment. 22 Table of Contents Enhancing Identity Security: The shift towards biometric authentication methods is redesigning identity verification in the digital domain. Integrating biometrics with multi-factor authentication can provide a robust defense against unauthorized access. Machine Learning : Artificial Intelligence ("AI") and Machine Learning are set to play a critical role in cybersecurity. Cybercriminals are using AI to launch more sophisticated attacks that can quickly adapt to changing environments, making detection harder. AI's advanced data analysis capabilities are increasingly used for defensive measures over time. 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 in a timely manner before they cause damage. The DoD budget provides $455 million to extend the frontiers of AI for science and technology and to increase AI’s safety, security, and resilience. These investments enhance the DoD’s computing capabilities and support the development of AI testbeds to build foundation models for energy security, national security, and climate resilience as well as tools to evaluate AI capabilities to generate outputs that may represent nuclear, nonproliferation, biological, chemical, critical-infrastructure, and energy security threats or hazards. Financial Overview A number of factors have contributed to our third quarter ended September 30, 2024, results of operations, the most significant of which are described below. More details on these changes are presented below within our "Results of Operations" section. • The decline in our year-over-year revenue was primarily driven by the successful completion and ramp down of programs in Secure Networks without corresponding new business wins to backfill completed programs. • The growth in TSA PreCheck revenue was driven by the increase in our enrollment locations. • The reduction in our gross margins was driven by the impact of an impairment loss on intangible assets of $5.3 million and an increase in restructuring expenses of $0.4 million. • Higher operating expenses were due to an impairment loss on intangible assets of $6.4 million and higher stock-based compensation expense. Results of Operations Table MD&A 1: Consolidated Results of Operations For the Three Months Ended For the Nine Months Ended September 30, 2024 September 30, 2023 Dollar Change September 30, 2024 September 30, 2023 Dollar Change (dollars in thousands) Revenue $ 23,783 $ 36,186 $ (12,403) $ 81,900 $ 104,319 $ (22,419) Cost of sales 20,640 23,173 (2,533) 58,089 65,465 (7,376) Gross profit 3,143 13,013 (9,870) 23,811 38,854 (15,043) Gross margin 13.2 % 36.0 % 29.1 % 37.2 % Operating expenses 32,007 22,706 9,301 69,757 70,984 (1,227) Operating expenses as percentage of revenue 134.6 % 62.7 % 85.2 % 68.0 % Operating loss (28,864) (9,693) (19,171) (45,946) (32,130) (13,816) Other income 983 1,222 (239) 3,299 5,367 (2,068) Interest expense (157) (178) 21 (492) (611) 119 Loss before income taxes (28,038) (8,649) (19,389) (43,139) (27,374) (15,765) Provision for income taxes (17) (23) 6 (51) (68) 17 Net loss $ (28,055) $ (8,672) $ (19,383) $ (43,190) $ (27,442) $ (15,748) Consolidated Results Our business segments have different factors driving revenue fluctuations and profitability. The discussion of the changes in our revenue and gross margin are covered in greater detail in the following section, "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. 23 Table of Contents Operating expenses In the third quarter of 2024, operating expenses increased by 41.0%, compared to the same quarter in 2023, primarily due to increases in impairment loss on intangible assets of $6.0 million, restructuring expenses of $1.1 million, and stock-based compensation expenses of $3.6 million. For the nine months ended September 30, 2024, operating expenses decreased by 1.7%, compared to the same period in 2023, primarily due to a decrease in stock-based compensation expenses of $8.4 million, partially offset by an increase in impairment loss on intangible assets of $6.0 million. Other income The decrease in other income for the three months ended September 30, 2024, compared to the same quarter in 2023, was primarily due to the change in dividend income from money market placements. Other income decreased for the nine months ended September 30, 2024, compared to the same period in 2023, primarily due to the gain on early extinguishment of other financing obligations of $1.4 million in fiscal year 2023, without a similar gain in fiscal year 2024. The remaining variance is attributable to the change in dividend income from money market placements. 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, 2024 September 30, 2023 Dollar Change September 30, 2024 September 30, 2023 Dollar Change (dollars in thousands) Revenue $ 18,332 $ 19,795 $ (1,463) $ 54,839 $ 56,764 $ (1,925) Cost of sales (excluding impairment loss, depreciation and amortization) 9,201 8,498 703 26,505 25,304 1,201 Impairment loss on intangible assets 5,333 — 5,333 5,333 — 5,333 Depreciation and amortization 1,488 1,943 (455) 4,800 2,281 2,519 Total cost of sales 16,022 10,441 5,581 36,638 27,585 9,053 Gross profit $ 2,310 $ 9,354 $ (7,044) $ 18,201 $ 29,179 $ (10,978) Gross margin 12.6 % 47.3 % 33.2 % 51.4 % For the quarter ended September 30, 2024, Security Solutions segment revenue decreased by 7.4%, compared to the same quarter in 2023. This was due to the reduction in revenue from a long-term program and the completion of a short-term program in the prior year, partially offset by the growth in TSA PreCheck. Further, Security Solutions segment gross profit for the third quarter of 2024 declined by 75.3%, compared to the same quarter in 2023, and segment gross margin for the three months ended September 30, 2024, decreased from 47.3% in 2023 to 12.6% in 2024. The gross margin decline was primarily due to an increase in costs related to the impairment loss on intangible assets and program mix within the portfolio. For the nine months ended September 30, 2024, Security Solutions segment revenue decreased by 3.4%, compared to the same period in 2023. This was due to the reductions in revenue of two long-term programs and completion of a short-term program in the prior year, partially offset by the growth in TSA PreCheck. In addition, segment gross profit for the nine months ended September 30, 2024 decreased by 37.6%, compared to the same period in 2023, and segment gross margin declined from 51.4% in 2023 to 33.2% in 2024. The gross margin decline was due to increases in costs related to the impairment loss on intangible assets, higher amortization of software development costs, and program mix within the portfolio. 24 Table of Contents Table MD&A 3: Secure Networks Segment - Financial Results For the Three Months Ended For the Nine Months Ended September 30, 2024 September 30, 2023 Dollar Change September 30, 2024 September 30, 2023 Dollar Change (dollars in thousands) Revenue $ 5,451 $ 16,391 $ (10,940) $ 27,061 $ 47,555 $ (20,494) Cost of sales (excluding impairment loss, depreciation and amortization) 4,616 12,730 (8,114) 21,444 37,870 (16,426) Depreciation and amortization 2 2 — 7 10 (3) Cost of sales 4,618 12,732 (8,114) 21,451 37,880 (16,429) Gross profit $ 833 $ 3,659 (2,826) $ 5,610 $ 9,675 (4,065) Gross margin 15.3 % 22.3 % 20.7 % 20.3 % For the quarter ended September 30, 2024, Secure Networks segment revenue decreased by 66.7%, compared to the same period in 2023, primarily due to the successful completion and ramp down of programs, without corresponding new business wins to backfill completed programs. Further, segment gross profit decreased by 77.2% in the third quarter of 2024, compared to the same quarter in 2023, primarily due to lower revenue. Gross margin declined from 22.3% in 2023 to 15.3% in 2024, primarily due to restructuring costs and revenue mix within the portfolio. For the nine months ended September 30, 2024, Secure Networks segment revenue decreased by 43.1%, compared to the same period in 2023, primarily due to the successful completion and ramp down of programs without corresponding new business wins to backfill completed programs. Segment gross profit for the nine months ended September 30, 2024, decreased by 42.0%, compared to the same period in 2023, primarily due to lower revenue. By contrast, segment gross margin in the nine months ended September 30, 2024, slightly increased from 20.3% in 2023 to 20.7% in 2024, due to program mix and strong program management. 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, Adjusted Earnings Per Share ("EPS"), Adjusted Gross Profit, Adjusted Gross Margin, Cash Gross Profit, Cash Gross Margin and Free Cash Flow are useful in evaluating our operating and cash flow 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 and cash 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 and cash flow performance that are not made under GAAP and do not represent, and should not be considered as an alternative to net (loss) income 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, impairment loss on intangible assets, and restructuring expenses (adjustments). 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 of Directors, 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 is used by the Board of Directors and management to prepare and approve our annual budget, and to evaluate the performance of certain management personnel when determining incentive compensation. 25 Table of Contents Table MD&A 4: Reconciliation of Net Loss to EBITDA, Adjusted EBITDA and Adjusted EBITDA Margin For the Three Months Ended For the Nine Months Ended September 30, 2024 September 30, 2023 September 30, 2024 September 30, 2023 Amount Margin Amount Margin Amount Margin Amount Margin (dollars in thousands) Net loss $ (28,055) (118.0 %) $ (8,672) (24.0 %) $ (43,190) (52.8) % $ (27,442) (26.3) % Other income (983) (4.1 %) (1,222) (3.4 %) (3,299) (4.0) % (5,367) (5.1) % Interest expense 157 0.6 % 178 0.5 % 492 0.6 % 611 0.6 % Provision for income taxes 17 0.1 % 23 0.1 % 51 0.1 % 68 0.1 % Depreciation and amortization (3) 2,748 11.6 % 3,215 8.9 % 9,368 11.4 % 6,336 6.0 % EBITDA (Non-GAAP) (26,116) (109.8 %) (6,478) (17.9 %) (36,578) (44.7) % (25,794) (24.7) % Stock-based compensation expense (1) 8,814 37.1 % 5,218 14.4 % 14,017 17.1 % 22,462 21.5 % Impairment loss on intangible assets (3) 11,706 49.2 % — — % 11,706 14.3 % — — % Restructuring expenses (2) 1,447 6.1 % — — % 1,437 1.8 % 1,197 1.2 % Adjusted EBITDA (Non-GAAP) $ (4,149) (17.4) % $ (1,260) (3.5) % $ (9,418) (11.5) % $ (2,135) (2.0) % (1) The stock-based compensation expense 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 $8.4 million and $12.4 million for the three and nine months ended September 30, 2024, respectively, and $5.2 million and $18.6 million, for the three and nine months ended September 30, 2023, respectively. Stock-based compensation expense from other sources was $0.5 million and $1.6 million for the three and nine months ended September 30, 2024, 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. 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 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. (3) Due to its immaterial amount, the impairment loss on intangible assets of $0.3 million for the three and nine months ended September 30, 2023 was reported as part of depreciation and amortization expenses in 2023. Adjusted Net Loss and Adjusted EPS Adjusted Net Loss and Adjusted EPS are supplemental measures of operating and cash flow performance that are not made under GAAP and do not represent, and should not be considered as an alternatives to net (loss) income and earnings per share as determined by GAAP. We define Adjusted Net Loss as net (loss) income, adjusted for non-operating (income) expense, stock-based compensation expense, impairment loss on intangible assets, and restructuring expenses (adjustments). We define Adjusted EPS as Adjusted Net Loss divided by the weighted-average number of common shares outstanding for the period. Adjusted Net Loss and Adjusted EPS provide the Board of Directors, 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. 26 Table of Contents Table MD&A 5: Reconciliation of Net Loss and GAAP EPS to Non-GAAP Adjusted Net Loss and Adjusted EPS For the Three Months Ended For the Nine Months Ended September 30, 2024 September 30, 2023 September 30, 2024 September 30, 2023 Adjusted Net Loss Adjusted Earnings Per Share Adjusted Net Loss Adjusted Earnings Per Share Adjusted Net Loss Adjusted Earnings Per Share Adjusted Net Loss Adjusted Earnings Per Share (in thousands, except per share data) Net loss $ (28,055) $ (0.39) $ (8,672) $ (0.12) $ (43,190) $ (0.60) $ (27,442) $ (0.40) Adjustments: Other income (983) (0.01) (1,222) (0.02) (3,299) (0.05) (5,367) (0.08) Stock-based compensation expense (1) 8,814 0.12 5,218 0.07 14,017 0.20 22,462 0.33 Impairment loss on intangible assets (3) 11,706 0.16 — — 11,706 0.16 — — Restructuring expenses (2) 1,447 0.02 — — 1,437 0.02 1,197 0.02 Adjusted net loss (Non-GAAP) $ (7,071) $ (0.10) $ (4,676) $ (0.07) $ (19,329) $ (0.27) $ (9,150) $ (0.13) Weighted-average shares of common stock outstanding, basic 72,309 69,571 71,654 69,062 (1) The stock-based compensation expense to net loss 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 $8.4 million and $12.4 million for the three and nine months ended September 30, 2024, respectively, and $5.2 million and $18.6 million, for the three and nine months ended September 30, 2023, respectively. Stock-based compensation expense from other sources was $0.5 million and $1.6 million for the three and nine months ended September 30, 2024, 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. 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. (2) The restructuring expenses 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. (3) Due to its immaterial amount, the impairment loss on intangible assets of $0.3 million for the three and nine months ended September 30, 2023 was reported as part of depreciation and amortization expenses in 2023. Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin and Cash Gross Margin Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin and Cash Gross Margin are supplemental measures of operating and cash flow performance that are not made under GAAP and do not represent, and should not be considered as an alternatives to gross profit and gross margin as determined by GAAP. We define Adjusted Gross Profit as gross profit, plus stock-based compensation expense, impairment loss on intangible assets, restructuring expenses, as well as non-recurring items charged under cost of sales. We define Adjusted Gross Margin as Adjusted Gross Profit as a percentage of total revenue. We define Cash Gross Profit as Adjusted Gross Profit, plus depreciation and amortization. We define Cash Gross Margin as Cash Gross Profit as a percentage of total revenue. Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin and Cash 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. 27 Table of Contents Table MD&A 6: Reconciliation of Gross Profit to Adjusted Gross Profit and Cash Gross Profit; Gross Margin to Adjusted Gross Margin and Cash Gross Margin For the Three Months Ended For the Nine Months Ended September 30, 2024 September 30, 2023 September 30, 2024 September 30, 2023 Amount Margin Amount Margin Amount Margin Amount Margin (dollars in thousands) Gross profit $ 3,143 13.2% $ 13,013 36.0% $ 23,811 29.1% $ 38,854 37.2% Adjustments: Stock-based compensation expense – cost of sales 115 0.5% 73 0.2% 600 0.7% 624 0.6% Impairment loss on intangible assets – cost of sales 5,333 22.4% — —% 5,333 6.5% — —% Restructuring expenses – cost of sales 393 1.7% — —% 393 0.5% — —% Adjusted gross profit (Non-GAAP) 8,984 37.8% 13,086 36.2% 30,137 36.8% 39,478 37.8% Depreciation and amortization – cost of sales 1,490 6.2% 1,945 5.3% 4,807 5.9% 2,291 2.2% Cash gross profit (Non-GAAP) $ 10,474 44.0% $ 15,031 41.5% $ 34,944 42.7% $ 41,769 40.0% Free Cash Flow Free Cash Flow is a supplemental measure of operating and cash flow performance that are not made under GAAP and do not represent, and should not be considered as an alternative to net cash flow (used in) provided by operating activities, as determined by GAAP. We define Free Cash Flow as net cash (used in) provided by operating activities, less net purchases of property and equipment, and capitalized software development costs. 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 and cash flow performance and liquidity, and to evaluate the performance of certain management personnel when determining incentive compensation. Table MD&A 7: Reconciliation of Net Cash (Used in) Provided by Operating Activities to Free Cash Flow For the Three Months Ended For the Nine Months Ended September 30, 2024 September 30, 2023 September 30, 2024 September 30, 2023 (in thousands) Net cash (used in) provided by operating activities $ (7,080) $ 846 $ (15,420) $ (3,367) Adjustments: Purchases of property and equipment, net (49) (80) (381) (350) Capitalized software development costs (2,789) (3,762) (9,104) (11,960) Free cash flow (Non-GAAP) $ (9,918) $ (2,996) $ (24,905) $ (15,677) EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net Loss, Adjusted EPS, Adjusted Gross Profit, Adjusted Gross Margin, Cash Gross Profit, Cash Gross Margin and Free Cash Flow each 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, Adjusted EPS, Adjusted Gross Profit, Adjusted Gross Margin, Cash Gross Profit, Cash 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, Adjusted EPS, Adjusted Gross Profit, Adjusted Gross Margin, Cash Gross Profit, Cash 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, Adjusted EPS, Adjusted Gross Profit, Adjusted Gross Margin, Cash Gross Profit, Cash 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. 28 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, 2024, we had cash and cash equivalents of $69.8 million and our working capital was $72.0 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, 2024 September 30, 2023 (in thousands) Net cash used in operating activities $ (15,420) $ (3,367) Net cash used in investing activities (12,485) (12,310) Net cash used in financing activities (1,591) (3,673) Net change in cash, cash equivalents, and restricted cash $ (29,496) $ (19,350) Net cash used in operating activities for the nine months ended September 30, 2024, was $15.4 million, an increase of $12.1 million compared to the same period in 2023. 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 that do not impact cash flows from operating activities. Net cash used in investing activities for the nine months ended September 30, 2024, slightly increased by $0.2 million, compared to the same period of the prior year, primarily due to the cash outflow from the purchase of an investment of $3.0 million in 2024, with no similar transaction in 2023. This is partially offset by a decrease of $2.8 million in capital expenditures in 2024. Net cash used in financing activities for the nine months ended September 30, 2024, decreased by $2.1 million, compared to the same period in 2023. This is primarily attributable to the decreases in payment of tax withholding related to net share settlement of equity awards of $0.5 million in the first half of 2024, compared with $1.7 million in the same period of 2023, and a $0.6 million payment for the Diamond Fortress Technologies ("DFT") holdback in February 2023, with no similar payment in 2024. 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 2023 Form 10-K, as filed with the SEC on March 15, 2024, 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, 2024. Item 3. Quantitative and Qualitative Disclosures about Market Risk Not applicable. 29 Table of Contents