Forward-Looking Statements
The discussion below contains certain forward-looking statements including, but not limited to, among others, statements concerning future revenues and future business plans. Forward-looking statements include statements in which we use words such as "expect", "believe", "anticipate", "intend", "project", "estimate", "should", "could", "may", "plan", "potential", "predict", "project", "will", "would" and similar expressions. Although we believe the expectations reflected in such forward-looking statements are based on reasonable assumptions, the forward-looking statements are subject to significant risks and uncertainties, and thus we cannot assure you that these expectations will prove to have been correct, and actual results may vary from those contained in such forward-looking statements. We discuss many of these risks and uncertainties in Item 1A under the heading "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended September 30, 2022. Factors that may cause such variances include, but are not limited to, our dependence on a small number of customers for a significant portion of our revenue, our high dependence on contracts with the U.S. federal government, our reliance in certain circumstances on single sources for supply of key product components, intense competition in the market segments in which we operate, changes in the U.S. Tax laws, continued disruptions in the supply chain and inflationary pressures, the impact of the Ukraine-Russian military conflict on global trade and financial markets, and the impact of the novel coronavirus (COVID-19) on our business, results of operations and financial condition. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our estimates and assumptions only as of the date of this document. Except as required by law, we do not undertake any obligation to publicly update or revise any forward-looking statements contained in this report, whether as a result of new information, future events or otherwise. This management's discussion and analysis of financial condition and results of operations should be read in conjunction with our financial statements and the related notes included elsewhere in this filing and in our Annual Report on Form 10-K for the fiscal year ended September 30, 2022.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations
are based upon our condensed consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses. On an on-going basis, we evaluate our estimates,
including those related to uncollectible receivables, inventory valuation,
impairment assessment of intangibles, income taxes, deferred compensation and
retirement plans, as well as estimated selling prices used for revenue
recognition and contingencies. We base our estimates on historical performance
and on various other assumptions that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions. A description of our critical accounting policies is
contained in our Annual Report on Form 10-K for the fiscal year ended September
30, 2022 in the "Critical Accounting Policies" section contained in Item 7,
Management's Discussion and Analysis of Financial Condition and Results of
Operations. Management believes there have been no significant changes for the
three months ended December 31, 2022 to the items that we disclosed as our
critical accounting estimates in the Management's Discussion and Analysis of
Financial Condition and Results of Operations section of our Annual Report on
Form 10-K for the fiscal year ended September 30, 2022.
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Observations on effects of novel coronavirus and Russia/Ukraine Conflict
On March 11, 2020, the World Health Organization characterized the novel coronavirus outbreak as a pandemic. The outbreak has and continues to adversely affect the economies of the U.S., U.K., and other international markets and economies in which we operate. As a result of the World Health Organization characterizing the COVID-19 outbreak as a pandemic, national, state, and local governments have and continue to take actions such as declaring a state of emergency, implementing social distancing and other guidelines, and shutting down and/or limiting the opening or operation of certain businesses which are not considered essential. In these times of pandemic, our top priorities are to protect the health, well-being, and safety of our employees and partners, while still focusing on the key drivers of our business. To that end, and to insure we continue to operate safely and cautiously while also meeting our public health responsibilities, the Company has adopted flexible business practices including allowing most employees to work remotely in all locations. COVID-19 has adversely affected the distribution channel leading to significantly longer lead times when ordering product. Manufacturers are not producing as much product as prior to the pandemic due to disruptions, resulting in supply shortages. Additionally, recent global shipping delays have exacerbated this problem. The TS segment has many vendors it transacts with and supply shortages are pervasive with many of them. The HPP segment has and continues to experience shortages with their vendors as well. If we are unable to successfully resolve these disruptions and shortages, the timing and amount of our future results may be materially impacted. The HPP segment secured a $1.8 million contract for real-time networking monitoring for cyber attack detection in the first quarter of fiscal year 2022, but due to the delays by manufacturers the sale was recognized fully in revenue in the first quarter of fiscal year 2023 when we obtained the product from the manufacturers. Related to the supply shortage and potentially inflation, we have experienced price increases for our products, which we try to pass on to the customer. We recognize the pandemic has created a dynamic and uncertain situation in the national economy, and we continue to closely monitor the latest information to make timely, informed business decisions and public disclosures regarding the potential impact of the pandemic on our operations. Despite reduced infection rates and ever-increasing vaccination rates in the United States, many nations and certain pockets within the United States are still battling various strains/variants of the novel coronavirus, creating ongoing uncertainties as to when economies will return to business as usual and what that will look like, what regulatory measures or voluntary actions will be further implemented to limit the spread of COVID-19 and its variants and the duration of any such measures. The extent, severity and impact of any further spread of COVID-19 variants or resurgence of COVID-19 in a given geographic region after it has hit its "peak," and the extent to which herd immunity will be achieved through the vaccination process is still uncertain. In summary, the scope of this pandemic and its effects are unprecedented, and we cannot at this time make a reasonable estimate on the extent or duration of the impacts on our business. As of December 31, 2022, the Russian/Ukrainian military conflict has not had a direct significant impact on revenue as we do not have any recurring customers in either country. However, we do have customers and suppliers in surrounding regions which may be affected and further escalation of the Russian-Ukraine military conflict and geopolitical tensions related to such military conflict could adversely affect our business, financial condition and results of operations, by among other things, cyber attacks, supply disruptions, lower consumer demand, and changes to foreign exchange rates and financial markets. It is not possible at this time to predict the size of the impact or consequences of the conflict to the Company and our customers and suppliers.
Results of Operations.
Overview of the three months ended December 31, 2022
Our sales increased by approximately $5.9 million, or 48%, to $18.3 million for the three months ended December 31, 2022 as compared to $12.4 million for the three months ended December 31, 2021. The increase in sales is the result of an increase of $4.5 million in our TS segment combined with a $1.4 million increase in our HPP segment. Our gross margin percentage increased to 32% of sales for the three months ended December 31, 2022 as compared to 29% for the three months ended December 31, 2021. For the three months ended December 31, 2022 there
was
an operating income
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of $1.4 million compared to an operating loss of $0.4 million for the three
months ended December 31, 2021. Other income, (expense) net decreased $0.3
million for the three months ended to December 31, 2022 as compared to the three
months ended December 31, 2021. An income tax expense of $133 thousand was
recorded for the three months ended December 31, 2022 compared to an income tax
expense of $12 thousand in the same period of fiscal year 2022.
The following table details our results of operations in dollars and as
a percentage of sales for the three months ended December 31, 2022 and 2021:
% %
December 31, 2022 of sales December 31, 2021 of sales
(Dollar amounts in thousands)
Sales $ 18,344 100 % $ 12,369 100 %
Costs and expenses:
Cost of sales 12,527 68 % 8,755 71 %
Engineering and development 836 5 % 627 5 %Selling, general and administrative 3,617
20 % 3,383 27 % Total costs and expenses 16,980 93 % 12,765 103 % Operating income (loss) 1,364 7 % (396) (3) % Other income (expense), net (270) (1) % 42 - %
Income (loss) before income taxes 1,094
6 % (354) (3) % Income tax expense 133 1 % 12 - % Net income (loss) $ 961 5 % $ (366) (3) % Sales
Our sales increased by approximately $5.9 million to $18.3 million for the three months ended December 31, 2022 as compared to $12.4 million for the prior year period. The increase in sales is the result of an increase of $4.5 million in our TS segment combined with a $1.4 million increase in our HPP segment.
TS segment sales change was as follows for the three months ended December 31, 2022 and 2021:
December 31, Increase
2022 2021 $ %
(Dollar amounts in thousands)
Products $ 12,059 $ 8,000 $ 4,059 51 %
Services 3,796 3,305 491 15 %
Total $ 15,855 $ 11,305 $ 4,550 40 %
The increase in TS segment product sales of $4.1 million during the period is
primarily attributable to an increase in the U.S. division due to increased
sales to several major customers. Service sales for the three months ended
December 31, 2022 increased $0.5 million from the prior year period, which is
attributable to the U.S. division. The increase in service sales included
increased third party maintenance sales of $0.4 million, increased managed
services sales of $0.3 million, partially offset with decreased internal and
third party service sales of $0.2 million.
HPP segment sales change was as follows for the three months ended December 31,
2022 and 2021:
December 31, Increase (decrease)
2022 2021 $ %
(Dollar amounts in thousands)
Products $ 2,162 $ 720 $ 1,442 200 %
Services 327 344 (17) (5) %
Total $ 2,489 $ 1,064 $ 1,425 134 %
The HPP product sales increased by $1.4 million for the three months ended December 31, 2022 as compared to the prior year period primarily as a result of one large Myricom product order placed in the first quarter of fiscal year 2022,
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but due to supply chain delays was not fully fulfilled until the first quarter
of fiscal year 2023. The HPP services sales remained relatively flat for the
three months ended December 31, 2022 compared to the prior year period as a
result of ARIA revenue increasing $0.1 million, which was offset with a decrease
of $0.1 million in royalties on high-speed processing boards related to the E2D
program.
Our sales by geographic area, which is based on the customer location to which the products were shipped or services rendered, were as follows for the three months ended December 31, 2022 and 2021:
December 31, Increase (decrease)
2022 % 2021 % $ %
(Dollar amounts in thousands)
Americas $ 17,940 97 % $ 11,625 94 % $ 6,315 54 %
Europe 288 2 % 635 5 % (347) (55) %
Asia 116 1 % 109 1 % 7 6 %
Totals $ 18,344 100 % $ 12,369 100 % $ 5,975 48 %
The $6.3 million increase in sales to the Americas was primarily the result of an increase in the TS segment's U.S. division of $4.8 million combined with sales by our HPP segment of $1.5 million. The $0.3 million decrease in sales to Europe was primarily the result of decreased sales by our TS segment's U.S. division of $0.2 million combined with a decrease in the HPP division of $0.1 million. The sales to Asia remained relatively flat compared to prior year without any significant changes in any divisions.
Gross Margins
Our gross margin ("GM") increased $2.2 million for the three months ended December 31, 2022 as compared to the prior year period. The GM as a percentage of sales increased to 32% for the three months ended December 31, 2022 as compared to the prior year period of 29%.
December 31,
2022 2021 Increase
GM$ GM% GM$ GM% GM$ GM%
(Dollar amounts in thousands)
TS $ 4,164 26 % $ 2,992 26 % $ 1,172 - %
HPP 1,653 66 % 622 58 % 1,031 8 %
Total $ 5,817 32 % $ 3,614 29 % $ 2,203 3 %
The impact of product mix within our TS segment on gross margin for the three months ended December 31, 2022 and 2021 was as follows:
December 31,
2022 2021 Increase
GM$ GM% GM$ GM% GM$ GM%
(Dollar amounts in thousands)
Products $ 2,029 17 % $ 1,144 14 % $ 885 3 %
Services 2,135 56 % 1,848 56 % 287 - %
Total $ 4,164 26 % $ 2,992 26 % $ 1,172 - %
The overall TS segment GM as a percentage of sales remained flat at 26% for the
three month period ended December 31, 2022 compared to the prior year period.
This was primarily due to prior year's services GM being a larger percentage of
total GM relative to product GM, which was offset in the current year by
improved product GM as a percentage of product sales. Product GM as a percentage
of product sales increased to 17% for the three months ended December 31, 2022
from 14% for the prior year period. This was primarily due to higher margin
products being sold to several major customers. Service GM as a percentage of
service sales remained flat at 56% for the three months ended December 31, 2022
compared to the prior year period due to no significant changes in any types of
service revenue margin as a percentage of its respective revenue.
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The impact of product mix within our HPP segment on gross margin for the three months ended December 31, 2022 and 2021 was as follows:
December 31,
2022 2021 Increase (decrease)
GM$ GM% GM$ GM% GM$ GM%
(Dollar amounts in thousands)
Products $ 1,421 66 % $ 299 42 % $ 1,122 24 %
Services 232 71 % 323 94 % (91) (23) %
Total $ 1,653 66 % $ 622 58 % $ 1,031 8 %
The overall HPP segment GM as a percentage of sales increased to 66% for the
three months ended December 31, 2022 from 58% for the three months ended
December 31, 2021. The 24% increase in product GM as a percentage of product
revenue for the three months ended December 31, 2022 compared to the same prior
year period is primarily due to one major order that did not occur in the prior
year period. The 23% decrease in service GM as a percentage of services revenue
from prior year was due to decreased royalty sales, which are nearly all margin.
Engineering and Development Expenses
The engineering and development expenses incurred by our HPP segment increased $0.2 million for the three months ended December 31, 2022 to $0.8 million when compared to the prior year period due to increased consulting expenses. The current period expenses were primarily for product engineering expenses incurred in connection with the continued development of the ARIA Zero Trust Gateway cyber security products.
Selling, General and Administrative Expenses
The following table details our selling, general and administrative ("SG&A")
expense by operating segment for the three months ended December 31, 2022 and
2021:
Three months ended December 31, $ %
% of % of Increase Increase
2022 Total 2021 Total (Decrease) (Decrease)
(Dollar amounts in thousands)
By Operating Segment:
TS segment $ 2,703 75 % $ 2,383 70 % $ 320 13 %
HPP segment 914 25 % 1,000 30 % (86) (9) %
Total $ 3,617 100 % $ 3,383 100 % $ 234 7 %
SG&A expenses of $3.6 million for the three months ended December 31, 2022
increased $0.2 million as compared to the prior year period. The TS segment G&A
expenses increased by approximately $0.3 million due to increased variable
compensation as there were higher sales in the first quarter of fiscal year 2023
when compared to the prior year period. The HPP segment SG&A expenses decreased
approximately $0.1 million for the three months ended December 31, 2022 as
compared to the prior year period due to decreased labor expenses and
consulting.
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Other Income/Expenses
The following table details other income (expense) for the three months ended
December 31, 2022 and 2021:
Three months ended
Increase
December 31, 2022 December 31, 2021 (Decrease)
(Amounts in thousands)
Foreign exchange loss $ (501) $ (17) $ (484)
Interest expense (64) (105) 41
Interest income 261 145 116
Other income (expense), net 34 19 15Total other income (expense), net $ (270) $ 42 $ (312)
The $0.3 million decrease in total other income (expense), net for the three months ended December 31, 2022 as compared to the prior year period is primarily due to a net increase in foreign exchange loss of $0.5 million, partially offset by an increase in interest income of $0.1 million.
In consolidation, U.S. dollars and Euros are remeasured into the functional currency, British Pounds, of our U.K. subsidiary. This non-cash remeasurement is included in foreign exchange gain or loss on the income statement and the foreign exchange gain is primarily from a Euro and U.S. Dollar bank account. The US dollar weakened relative to the British Pound for the three months ended December 31, 2022 causing a foreign exchange loss, partially offset with the Euro strengthening relative to the British Pound for the same period. The interest income increase of $116 thousand for the three months ended December 31, 2022 as compared to the prior year period is primarily due to new agreements that have payment terms in excess of one year (see Note 6 in Item 1 to this Quarterly Report on Form 10-Q for details) entered into subsequent to the first quarter of fiscal year 2022 in the TS-US division combined with higher interest income from our cash and cash equivalents due to increased interest rates in the first quarter of fiscal year 2023. This was partially offset by less interest income from agreements that have payments in excess of one year that were entered into in the first quarter of fiscal year 2022 or prior due to more principal payments resulting in the receivables accruing less interest income. The interest expense decrease of $41 thousand for the three months ended December 31, 2022 as compared to the prior year period is related to the TS U.S. division entering into multi-year contracts in prior years, which incur less interest expense as time elapses due to principal payments being made. Payments on these agreements contain both principal and interest expense. See Note 10 in Item 1 to this Quarterly Report on Form 10-Q for details.
Income Taxes
An income tax expense of $133 thousand was recorded for the three months ended
December 31, 2022 compared to an income tax expense of $12 thousand in the same
period of fiscal year 2022. The income tax expense for three months ended
December 31, 2022 is primarily driven by minimum state tax expenses and the
required capitalization of R&D expenses under IRC Section 174, offset by the use
of federal NOL and R&D credits. The Company continues to maintain a full
valuation allowance on its operations but will continue to evaluate this need
going forward. The income tax expense for the three months ended December 31,
2021 was driven by an increase in the valuation allowance against deferred tax
assets in the period, offset by a benefit recorded for a change in tax law,
allowing for the immediate deduction of covered expenses incurred through the
Paycheck Protection Program (PPP).
We have in general historically calculated the provision for income taxes during
interim reporting periods by applying an estimate of the annual effective tax
rate for the full calendar year to ordinary income or loss for the reporting
period. However, we used a discrete effective tax rate method to calculate
income taxes for the three months ended December 31, 2022 because we determined
that our ordinary income or loss cannot be reliably estimated and small changes
in estimated ordinary income would result in significant changes in the
estimated annual effective tax rates.
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Liquidity and Capital Resources
Our primary source of liquidity is our cash and cash equivalents, which decreased by $4.4 million to $19.6 million as of December 31, 2022 from $24.0 million as of September 30, 2022.
Our significant sources of cash for the three months ended December 31, 2022 included a decrease in accounts receivable and long-term receivable of $1.2 million, an increase of $0.3 million in net amount received under the line-of-credit agreement, a decrease in other assets of $0.3 million, and a decrease in inventories of $0.2 million.
Our significant uses of cash for the three months ended December 31, 2022 were primarily related to a decrease in accounts payable and accrued expenses and other long-term liabilities of $7.4 million and repayments on notes payable of $0.4 million. Our cash held by our foreign subsidiary in the United Kingdom totaled approximately $5.0 million as of December 31, 2022 and consisted of 0.4 million Euros, 0.2 million British Pounds, and 4.4 million U.S. Dollars. This cash is included in our total cash and cash equivalents reported within our financial statements. Approximately 3.5 million U.S. Dollars was transferred from the foreign subsidiary in the U.K. to Modcomp, Inc. (TS-US) to use in operations during the first quarter of fiscal year 2023. As of December 31, 2022 and September 30, 2022, the Company maintained a line of credit with a capacity of up to $15.0 million for inventory accessible to both the HPP and TS segments. This line of credit also includes availability of a limited cash withdrawal of up to $1.0 million. An amount of $11.5 million and $11.9 million were available as of December 31, 2022 and September 30, 2022, respectively. As of December 31, 2022 and September 30, 2022 there were no cash withdrawals outstanding. For a further discussion of the Company's line of credit, including its financial covenants, see Item 1, Note 10 "Notes Payable and Line of Credit." If cash generated from operations is insufficient to satisfy working capital requirements, we may need to access funds through bank loans or other means. If we are unable to secure additional financing, we may not be able to complete development or enhancement of products, take advantage of future opportunities, respond to competition, retain key employees, or continue to effectively operate our business. Based on our current plans and business conditions, management believes that the Company's available cash and cash equivalents, the cash generated from operations, and availability on our line of credit will be sufficient to provide for the Company's working capital and capital expenditure requirements for at least 12 months from the date of this filing.
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