TSS, Inc. (TSSI) FY 2022 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains statements that are forward-looking. These statements are based on expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of, among other reasons, factors discussed in Item 1A – Risk Factors and elsewhere in this Annual Report. The commentary should be read in conjunction with the consolidated financial statements and related notes and other statistical information included in this Annual Report.

Overview

TSS, Inc. (“TSS”, the “Company”, “we”, “us” or “our”) provides a range of comprehensive services to enable the planning, design, deployment, maintenance, and refurbishment of end-user and enterprise systems, including the mission-critical facilities they are housed in. We provide a single source solution for enabling technologies in data centers, operation centers, network facilities, server rooms, security operations centers, communications facilities and the infrastructure systems that are critical to their function. Our services include technology consulting, design and engineering, project management, systems integration, system installations, facilities management, and IT procurement services. Our headquarters and our integration facility are located in Round Rock, Texas

Our business is concentrated on the U.S. data center infrastructure and services market. This market continues to be highly competitive as commerce moves to cloud-based solutions and as data storage requirements continue to escalate for many industries. These underlying macroeconomic trends are driving demand for more information technology equipment and more efficient data center design and operation, resulting in continued overall growth in this market. We compete against many larger competitors who have greater resources than we do, which may affect our competitiveness in the market. We rely on several large customers to win contracts and to provide business to us under “Master Service Agreements”, and the loss of such customers would have a material negative effect on our results.

Almost all of the components used in our systems integration business are consigned to us by our original equipment manufacturer (OEM) or their end-user customers, thus our revenues reflect only the services we perform, and the consigned components are not reflected in our balance sheet. We also offer our customers the ability to procure third-party hardware, software and services on their behalf that are then used in our integration services as we integrate these components to deliver a completed system to our customer. In some cases, we also act as an agent and arrange for the purchase of third-party hardware, software or services that are to be provided to our customers by another party and we have no control of the goods or services before they are transferred to the customer. In these instances, we are acting as an agent in the transaction. These procurement and reseller activities allow us to develop relationships with new hardware, software and professional service providers and allow us to generate higher margins on integration projects by broadening our revenue and customer base.

In March 2020, the coronavirus disease 2019 (“COVID-19”) was declared a pandemic by the World Health Organization and a national emergency by the U.S. Government. The pandemic has negatively affected the U.S. and global economy, disrupted global supply chains and financial markets, and resulted in governments around the world implementing increasingly stringent measures to help control the spread of the virus, including quarantines, “shelter in place” and “stay at home” orders, travel restrictions, business curtailments, school closures and other measures. In addition, governments and central banks in several parts of the world have subsequently enacted fiscal and monetary stimulus measures to counteract the impacts of COVID-19.

The COVID-19 pandemic had an immediate and ongoing impact on our operations in both our facilities segment and our systems integration segment since it began. Travel restrictions and other customer actions that restricted physical access to customer sites negatively impacted our facilities segment because we were unable to access customer locations to provide our services. We also experienced supply-chain disruptions beginning in the second half of 2021 until early 2022 that delayed the delivery of equipment needed for both integration and for deployments, further delaying customer projects. Overall, these travel restrictions and supply chain challenges directly impacted our operating results through the first quarter of 2022 for our facilities segment and up to the third quarter of 2022 for our systems integration business. Additionally, as our customers deferred or cancelled the deployment of new modular data centers (MDCs) in 2021, they instead maintained and updated their existing MDCs. As supply chain issues continued to improve during 2022, we were able to source the needed equipment and complete MDC deployments, including for those projects deferred from 2021. Revenue from MDC deployments have increased during 2022 by $3.9 million or 262% compared to 2021, driving the overall increase in our facilities revenues in 2022.

Our systems integration business has also been negatively impacted due to logistical and supply-chain issues that have continued to affect component supply to us and negatively impact our revenue through the pandemic. Safety and other measures that we had to implement in our systems integration facility so that we could continue to operate safely despite the pandemic materially increased the cost of operating and providing our integration services, particularly at the onset of the pandemic. As time has passed and with knowledge gained, we have been able to significantly reduce those incremental operating costs. The supply-chain disruptions have prevented our customers from providing product to us for use in our integration business, preventing us from providing our services, and negatively impacting our revenue. The disruptions began to dissipate in the second half of 2022 but still persist. The improvement in supply chain has helped our integration revenues grow by 27% in 2022 compared to 2021.

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At this point we do not know how long this pandemic and its associated impact on our business will continue, or if it will worsen or improve. To the extent these customer delays continue, the pandemic worsens, or we have continued supply chain challenges, our business will continue to be negatively impacted.

Our total revenue in 2022 was $30.6 million, a $3.2 million or 12% increase from our 2021 revenues of $27.4 million. Our facilities revenues increased by $3.1 million or 44% to $10.2 million, driven by an increase in deployments of MDCs as customer projects delayed by the COVID-19 pandemic during 2021 were now able to be completed. Our systems integration revenues grew by $1.5 million or 27% compared to 2021 as supply-chain issues attributable to the COVID-19 pandemic dissipated, and because of stronger demand from our OEM partner. Our procurement and reseller revenues decreased by $1.3 million or 11% compared to 2021 because we completed more agent-type transactions in 2022 than we did in 2021, resulting in lower recorded revenue but higher profits from this line of business.

Our gross profits increased by $2.6 million or 41% compared to 2021, mainly due to the higher volumes of activity across all our business units, and our gross profit margin as a percentage of sales increased to 29% in 2022 from 23% in 2021. The primary cause of the increase in gross profit margin percentage was the decrease in volume of our procurement and reseller business as a proportion of our total revenue where we generally earn much lower margins on product purchase/resell services than we do with our traditional maintenance and integration services. Absent this business, the margins on our core integration and maintenance operations decreased to 37% in 2022 from 44% in 2021 as we experienced higher operating costs in our integration business attributable to the deployment of new lines of services and increased wage costs and from inefficiencies in running this business because of fluctuating monthly production volumes and higher turnover of employees during 2022.

Our selling, general and administrative expenses of $7.7 million were 15% higher than the $6.7 million we recorded in selling, general and administrative expenses in 2021. The increase was primarily due to higher labor costs, including approximately $0.6 million attributable to a change in our chief executive officer in the fourth quarter of 2022, and the impact of wage inflation which was more pronounced during 2022 than the previous year.

Because of the higher overall gross profits, even with higher selling, general and administrative expenses, we were able to improve our operating profit by $1.7 million or 210% from 2021, recording operating income of $914,000 in 2022 compared to an operating loss of $831,000 that we recorded in 2021.

Our interest expense increased substantially compared to 2021. This was due to higher activity in our procurement and reseller business. During 2022 we transacted approximately $73 million of transactions in this business activity, although $60 million of this was for agent-type transactions. With our receivable-financing program that we have with a third-party banking partner, all of these procurement and reseller transactions are financed via this program, and we incur interest cost on the gross value of these transactions. As volume increases in these procurement and reselling activities, our interest cost will increase. This was exacerbated by the increase in interest rates during the second half of 2022. By way of comparison, we transacted approximately $28.3 million of such transactions in 2021.

We ended 2022 with $20.4 million of cash on hand, an increase of $12.4 million from the balance at the end of 2021. This increase was primarily due to the timing of cash flows connected with our procurement and reseller activities. These activities also resulted in a large increase in our accounts payable at the end of 2022 and drive large quarterly fluctuations in our accounts receivables, inventory and deferred revenues, depending on the timing of particular transactions. We were able to generate $14.7 million of cash flows from operations during 2022, and we were able to repay all the Company’s long-term notes payable during 2022 from our operating cash flows. We have been able to structure our procurement and reseller activities in such a way as to minimize their overall impact on our liquidity by using trade creditors as the primary way to finance these activities.

Critical Accounting Policies and Estimates

We consider an accounting policy to be critical if:

Management has reviewed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors, and the Audit Committee has reviewed these disclosures. In addition, there are other items within our financial statements that require estimation but are not deemed critical as defined above. Changes in these and other items could still have a material impact upon our financial statements.

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Revenue Recognition

We recognize revenues when control of the promised goods or services is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services.

Some of our contracts with customers contain multiple performance obligations. For these contracts, we account for individual performance obligations separately if they are distinct. The transaction price is allocated to the separate performance obligations based on relative standalone selling prices.

Maintenance services

We generate maintenance services revenues from fees that provide our customers with as-needed maintenance and repair services on modular data centers during the contract term. Our contracts are typically one year in duration, are billed annually in advance, and are non-cancellable. As a result, we record deferred revenue (a contract liability) and recognize revenue from these services on a ratable basis over the contract term. We can mitigate our exposure to credit losses by discontinuing services in the event of non-payment, however our history of non-payments and bad debt expense has been insignificant.

Integration services

We generate integration services revenues from fees that provide our customers with customized system and rack-level integration services. We typically recognize revenue upon shipment to the customer of the completed systems as this is when we have completed our services and when the customer obtains control of the promised goods. We typically extend credit terms to our integration customers based on their creditworthiness and generally do not receive advance payments. As such, we record accounts receivable at the time of shipment, when our right to the consideration becomes unconditional. Accounts receivable from our integration customers are typically due within 30-105 days of invoicing. An allowance for doubtful accounts is provided based on a periodic analysis of individual account balances, including an evaluation of days outstanding, payment history, recent payment trends, and our assessment of our customers’ creditworthiness. As of December 31, 2022 and 2021, our allowance for doubtful accounts was $7,000.

Equipment sales

We generate revenues under fixed price contracts from the sale of data center and related ancillary equipment to customers in the United States. We typically recognize revenue when the product is shipped to the customer as that is when the customer obtains control of the promised goods. Typically, we do not receive advance payments for equipment sales, however if we do, we record the advance payment as deferred revenue. Normally we record accounts receivable at the time of shipment when our right to the consideration has become unconditional. Accounts receivable from our equipment sales are typically due within 30-45 days of invoicing.

Deployment and Other services

We generate revenues from fees we charge our customers for other services, including repairs or other services not covered under maintenance contracts, installation and servicing of equipment including modular data centers that we sold, and other fixed-price services including repair, design and project management services. In some cases, we arrange for a third party to perform warranty and servicing of equipment, and in these instances, we recognize revenue as the amount of any fees or commissions that we expect to be entitled to. Other services are typically invoiced upon completion of services or completion of milestones. We record accounts receivable at the time of completion when our right to consideration becomes unconditional.

Procurement and Reseller services

We generate revenues from fees we charge our customers to procure third-party hardware, software and professional services on their behalf that are then used in our integration services as we integrate these components to deliver a completed system to our customer. We recognize our procurement and reseller services revenue upon completion of the procurement activity. In some cases, we arrange for the purchase of third-party hardware, software or professional services that are to be provided to our customers by another party and we have no control of the goods before they are transferred to the customer. In these instances, we are acting as an agent in the transaction and recognize revenue as the amount of any fee or commissions that we expect to be entitled to after paying the other party for the goods or services provided to the customer. Accounts receivable from our reseller activities are typically due within 30-60 days of invoicing.

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Judgments

We consider several factors in determining that control transfers to the customer upon shipment of equipment or upon completion of our services. These factors include that legal title transfers to the customer, we have a present right to payment, and the customer has assumed the risks and rewards of ownership at the time of shipment or completion of the services.

Sales taxes

Sales (and similar) taxes that are imposed on our sales and collected from customers are excluded from revenues.

Shipping and handling costs

Costs for shipping and handling activities, including those activities that occur subsequent to transfer of control to the customer, are recorded as cost of sales and are expensed as incurred. We accrue costs for shipping and handling activities that occur after control of the promised good or service has transferred to the customer.

The following table shows our revenues disaggregated by reportable segment and by product or service type (in $’000):

Remaining Performance Obligations

Remaining performance obligations include deferred revenues and amounts we expect to receive for goods and services that have not yet been delivered or provided under existing, non-cancellable contracts. For contracts that have an original duration of one year or less, we have elected the practical expedient applicable to such contracts and we do not disclose the transaction price for remaining performance obligations at the end of each reporting period and when we expect to recognize this revenue. As of December 31, 2022, current deferred revenue of $2,080,000 consists of $1,787,000 representing our remaining performance obligations for our maintenance contracts, all of which are expected to be recognized within one year, and $293,000 relating to procurement and integration services where we have yet to complete our services for our customers, all of which are expected to be recognized within one year.

Intangible Assets

We recorded goodwill and intangibles with definite lives, including customer relationships and acquired software, in conjunction with the acquisition of various businesses. Intangible assets with finite lives are amortized based on their estimated economic lives. Goodwill represents the excess of the purchase price over the fair value of net identified tangible and intangible assets acquired and liabilities assumed, and it is not amortized.

We perform an impairment test of goodwill on an annual basis with a measurement date of December 31, or whenever events or circumstances make it more likely than not that impairment of goodwill may have occurred. Our goodwill impairment test involves comparing the fair value of a reporting unit with its carrying amount. If that fair value exceeds the carrying amount, no impairment charge is required to be recorded. If the carrying value exceeds the reporting unit’s fair value, an entity should recognize a goodwill impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. However, the impairment losses recognized cannot exceed the total amount of goodwill allocated to that reporting unit. If necessary, the fair value of a reporting unit will be determined using a discounted cash flow, which requires the use of estimates and assumptions. Significant assumptions that may be required include forecasted operating results, and the determination of an appropriate discount rate. Actual results may differ from forecasted results, which may have a material impact on the conclusions reached.

We also review intangible assets with definite lives for impairment whenever events or circumstances indicate that the carrying amount may not be recoverable.  If the sum of the expected undiscounted cash flows is less than the carrying value of the related asset, a loss is recognized for the difference between the fair value and carrying value of the intangible asset.

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Allowance for Doubtful Accounts

We estimate an allowance for doubtful accounts based on factors related to the specific credit risk of each customer. Historically our credit losses have been minimal. We perform credit evaluations of new customers and may require prepayments or use of bank instruments such as trade letters of credit to mitigate credit risk. We monitor outstanding amounts to limit our credit exposure to individual accounts. We continue to pursue collection even if we have fully provided for an account balance.

Stock Based Compensation

We account for stock-based compensation using a fair-value based recognition method. Stock-based compensation cost is estimated at the grant date based on the fair value of the award and is recognized ratably over the requisite service period of the award. Determining the appropriate fair-value model and calculating the fair value of stock-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life and forfeiture rates. We develop our estimates based on historical data and market information that can change significantly over time. A small change in estimates used can have a relatively large change in the estimated valuation.

We use the Black-Scholes option valuation model to value employee stock option awards that are not performance- based awards. We estimate stock price volatility based upon our historical volatility. Estimated option life and forfeiture rate assumptions are derived from historical data. For restricted stock awards, we use the quoted price of our common stock on the grant date as the fair value of the award. For stock-based compensation awards with graded vesting, we recognize compensation expense using the straight-line amortization method. For performance-based stock awards, if applicable, we may use third-party valuation specialists and a Monte-Carlo simulation model to ascertain the fair value of the award at grant date.

Results of Operations

Comparison of 2022 to 2021

Revenue

Revenue consists of fees earned from the planning, design and project-management of mission-critical facilities and information infrastructures, as well as fees earned from providing maintenance services on these facilities. We also earn revenue from providing system configuration and integration services, including reseller services, to IT equipment vendors. Currently we derive all our revenue from the U.S. market.

We contract with our customers under five primary contract types: fixed-price service and maintenance contracts, time and material contracts, cost-plus-fee, guaranteed maximum price and fixed-price contracts. Cost-plus-fee and guaranteed maximum price contracts are typically lower risk arrangements and thus yield lower profit margins than time-and-materials and fixed-price arrangements which generate higher profit margins generally, relative to their higher risk. Certain of our service and maintenance contracts provide comprehensive coverage of all of the customer’s equipment (generally excluding IT equipment) at a facility during the contract period. Where customer requirements are clear, we prefer to enter comprehensive fixed-price arrangements or time-and-materials arrangements rather than cost-plus-fee and guaranteed maximum price contracts.

Most of our revenue is generated based on services provided either by our employees or subcontractors. To a lesser degree, the revenue we earn includes reimbursable travel and other costs to support the project. Since we earn higher profits from the labor services that our employees provide compared with use of subcontracted labor and other reimbursable costs, we seek to optimize our labor content on the contracts we are awarded to maximize our profitability.

We have been concentrating our sales efforts towards maintenance and integration services where we have traditionally earned higher margins. Historically we performed design, construction and project-management services in a concentrated number of high-value contracts for the construction of new data centers, but we have transitioned our business away from this market. We have also focused on providing maintenance services for modular data center applications as this market matures. We continue to focus on increasing our systems integration revenues through more consistent revenue streams that will better utilize the assets in that business, and through adding additional services such as procurement and reseller services, to help drive volume through the facility. This includes adapting our integration services to stay abreast of emerging technologies such as immersion computing, liquid-cooled computing, and edge-based technology, so that we can help our customers succeed in these new markets.

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Our total revenue in 2022 was $30.6 million, a $3.2 million or 12% increase from our 2021 revenues of $27.4 million. Our facilities revenues increased by $3.1 million or 44% to $10.2 million, driven by an increase in deployments of MDCs as customer projects delayed by the COVID-19 pandemic during 2021 were now able to be completed. Our systems integration revenues grew by $1.5 million or 27% compared to 2021 as supply-chain issues attributable to the COVID-19 pandemic dissipated, and because of stronger demand from our OEM partner. Our procurement and reseller revenues decreased by $1.3 million or 11% compared to 2021 because we completed more agent-type transactions in 2022 than we did in 2021, resulting in lower recorded revenue but higher profits from this line of business.

The volume and timing of revenues from our procurement and reseller services is unpredictable and dependent on customer requirements. Our experience to date with this business is that we have seen material fluctuations in our quarterly and annual level of revenue and profits from these activities and we have not yet established a consistent flow of transactions. We anticipate that this business will continue to fluctuate quarterly, and that as we reduce our customer concentration and increase revenues from our core integration and maintenance businesses, we will have more opportunities to grow and predict our procurement and reseller business.

Cost of Revenue

Cost of revenue includes the cost of component parts for our products, labor costs expended in the production and delivery of our services, subcontractor and third-party expense, equipment and other costs associated with our test and integration facilities, excluding depreciation of our manufacturing property and equipment, shipping costs, and the costs of support functions such as purchasing, logistics and quality assurance. The cost of revenue as a percentage of revenue was 71% for the year ended December 31, 2022, compared to 77% for 2021. This decrease in margin percentage from 2021 reflects the lower proportion of our total revenues that come from our procurement and reseller activities. Our reseller and procurement revenues were 43% of total revenue in 2022 compared to 54% of total revenues in 2021. We earn much lower margins on product purchase/resell services, unless we are acting as an agent in the transaction, than we do with our traditional maintenance and integration services. As the percentage of revenues derived from procurement and reseller services decreases, we would anticipate that cost of revenue as a percentage of sale will decrease.

As our procurement and reseller service business is relatively new, the level of expected revenues from this business has and will continue to fluctuate significantly on a quarterly basis. As a result, our cost of revenue as a percentage of total revenue will also fluctuate significantly. Cost of revenue for procurement and reseller services is higher than cost of revenue for our integration and maintenance services. Thus, as procurement and reseller revenues as a percentage of total revenue increases, our cost of sales will increase and our gross profit margin will decrease.

Since we earn higher profits when using our own labor services, we expect gross margins to improve when our labor service mix increases relative to the use of subcontracted or third-party labor. Our direct labor costs are relatively fixed in the short-term, and the utilization of direct labor is critical to maximizing our profitability. As we continue to bid and win contracts that require specialized skills that we do not possess, we would expect to have more third-party subcontracted labor to help us fulfill those contracts. In addition, we can face hiring challenges in internally staffing larger contracts. While these factors could lead to a higher ratio of cost of services to revenue, the ability to outsource these activities without carrying a higher level of fixed overhead allows us to increase income, broaden our revenue base and have a favorable return on invested capital. As we increase the level of procurement and reseller services in the future, we anticipate that our overall gross margin will decrease as the normal margins on reseller activities are lower than the margins from our traditional facilities and systems integration services.

A large portion of our revenue is derived from fixed price contracts. Under these contracts, we set the price of our services and assume the risk that the costs associated with our performance may be greater than we anticipated. Our profitability is therefore dependent upon our ability to estimate accurately the costs associated with our services. These costs may be affected by a variety of factors, such as lower than anticipated productivity, conditions at the work sites differing materially from what was anticipated at the time we bid on the contract, and higher than expected costs of materials and labor. Certain agreements or projects could have lower margins than anticipated or losses if actual costs for contracts exceed our estimates, which could reduce our profitability and liquidity.

Gross Profit

Our gross profits increased by $2.6 million or 41% compared to 2021, mainly due to the higher volume of activity across all our business units, and our gross profit margin as a percentage of sales increased to 29% in 2022 from 23% in 2021. The increase in gross profit was greater than the increase in total revenues due in part to the impact of growth in the number of agent-type transactions in our procurement and reseller business in 2022. Under these transactions we recognize as revenue the net margin we receive after paying the other party for goods or services that they deliver to the customer. Profits from our procurement and reseller services increased by $1.7 million in 2022 compared to 2021. Absent this business, the margins on our core integration and maintenance operations decreased from 44% in 2021 to 37% in 2022 despite higher revenues. This was primarily due to an increase in costs, particularly labor costs, in our integration business that reflected higher wage inflation, higher levels of employee turnover that impacted efficiency, and development and other costs incurred in developing and introducing new types of integration service during 2022.

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Our ability to maintain and to further improve gross profits will depend, in part, upon our ability to continue increasing sales of our higher-margin services including maintenance and integration services, improve our service margins by passing our higher operating costs on to our customers through increasing pricing, improving the operating efficiency of the integration business including utilization of our direct labor, and increasing the total revenues to a level that will allow us to increase the utilization of our integration and service operations. Our gross profit margin is likely to fluctuate based on the proportion of our total revenues that comes from our reseller activities.

Selling, General and Administrative Expenses

Selling, general and administrative expenses primarily consist of compensation and related expenses, including variable sales compensation, for our executive, administrative and sales and marketing personnel, as well as related travel, selling and marketing expenses, professional fees, facility costs, insurances and other corporate costs. For the year ended December 31, 2022, our selling, general and administrative expenses of $7.7 million increased by $1 million, or 15% compared to 2021. The increase was primarily due to higher labor costs, including approximately $0.6 million attributable to a change in our chief executive officer in the fourth quarter of 2022, and the impact of wage inflation on our workforce which was more pronounced during 2022 than in previous years.

Operating income (loss)

Because of the higher absolute gross profits, even with the higher level of selling, general and administrative expenses, we were able to improve our operating profit by $1.7 million or 210% from 2021, and recorded operating income of $914,000 in 2022 compared to an operating loss of $831,000 that we recorded in 2021.

Interest expense

For the year ended December 31, 2022 we recorded interest expense, net of interest income, of $931,000. This compares to interest expense, net of interest income, of $401,000 for the year ended December 31, 2021. The increase in interest expense was due to the higher number of agent-type transactions that were factored in our procurement and reseller business compared to 2021. Interest expense in our procurement and reseller activities increased by $480,000 in 2022 due to the higher number of transactions and the impact of higher interest rates during 2022.

Income tax expense

Due to a history of consolidated net operating losses, we have not recorded any income tax expenses, other than minimum or statutory costs. As of December 31, 2022, our accumulated net operating loss carry forward was $41 million. We anticipate that these loss carry-forwards may offset future taxable income that we may achieve and future tax liabilities. However, because of uncertainty regarding our ability to use these carry forwards and the potential limitations due to ownership changes, we have established a valuation allowance for the full amount of our net deferred tax assets.

Net income (loss)

After interest, other income and income taxes, we recorded a net loss of $73,000, or $(0.00) per share for the year ended December 31, 2022. This compares to a net loss of $1.3 million, or $(0.07) per share we recorded for the year ended December 31, 2021.

Comparison of 2021 to 2020

Revenue

Our total revenue in 2021 was $27.4 million, a $17.7 million or 39% decrease from our 2020 revenues of $45.1 million. This decrease was driven by a $14.1 million decrease in revenues from our procurement and reseller services that decreased by 49% from 2020 levels. Our remaining core businesses were both impacted by the COVID-19 pandemic that resulted in customer delays and cancellations of modular data center deployments which caused our facilities revenues to decrease by 21% to $7.1 million. Our integration services decreased 22% or $1.6 million compared to 2020 on lower volumes from our OEM partner primarily attributable to the impact of supply-chain interruptions and other factors related to the COVID-19 pandemic.

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Cost of revenue

Cost of revenue includes the cost of component parts for our products, labor costs expended in the production and delivery of our services, subcontractor and third-party expense, equipment and other costs associated with our test and integration facilities, excluding depreciation of our manufacturing property and equipment, shipping costs, and the costs of support functions such as purchasing, logistics and quality assurance. The cost of revenue as a percentage of revenue was 77% for the year ended December 31, 2021 compared to 85% for 2020. This decrease in costs from 2020 reflects the lower proportion of our total revenues that come from our procurement and reseller business where we earn much lower margins on product purchase/resell services than we do with our traditional maintenance and integration services. As the percentage of revenues derived from procurement and reseller services decreases, we would anticipate that cost of revenue as a percentage of sale will decrease. The profit margin from our maintenance and integration services increased by 14% from 2020 despite lower revenue levels, primarily due to lower operating costs on our integration facility in 2021 as we adjusted to operating our business in a pandemic environment.

Gross Profit

Our gross profits decreased by $0.4 million or 6% compared to 2020, mainly due to the lower volume of procurement service, while our gross profit margin as a percentage of sales increased to 23% in 2021 from 15% in 2020. The primary cause of the increase in gross profit margin was the change in volume of our procurement and reseller business where we earn much lower margins on product purchase/resell services than we do with our traditional maintenance and integration services. Absent this business, the margins on our core integration and maintenance operations increased from 30% in 2020 to 44% in 2021 as we eliminated costs from operating our integration facility that had increased in 2020 as we adapted to operating in a pandemic and had to introduce safety and other measures to keep the facility operating. With experience we have been able to lower our labor requirements and reduce many of these costs during 2021, helping to increase the gross margins in our integration services by 23% compared to 2020. We continued to experience fluctuating volumes in our systems integration facility throughout the year that prevented us from optimizing the utilization of this facility on a consistent basis, further dampening the overall profitability of this operation.

Selling, General and Administrative Expenses

Selling, general and administrative expenses primarily consist of compensation and related expenses, including variable sales compensation, for our executive, administrative and sales and marketing personnel, as well as related travel, selling and marketing expenses, professional fees, facility costs, insurances and other corporate costs. For the year ended December 31, 2021, our selling, general and administrative expenses of $6.7 million decreased by $18,000, compared to 2020.

Operating Income

Because of the lower overall gross profits, with consistent selling, general and administrative expenses, we incurred a higher operating loss of $831,000 in 2021. This was $431,000 higher than the operating loss of $400,000 that we recorded in 2020.

Other Income

During the second quarter of 2020 we were able to participate in the Payroll Protection Program of the Coronavirus Aid, Relief and Economic Security Act of 2020 (the “CARES Act”) and qualified for a loan of approximately $890,000. The proceeds were received in April 2020 and were used for covered payroll costs, rent and utilities in accordance with the relevant terms and conditions of the CARES Act. We applied for forgiveness of this loan amount during the third quarter of 2020 and in November 2020 were notified by the Small Business Administration that this loan had been forgiven in full. The gain on forgiveness of debt is shown as other income in our 2020 financial statements.

Income tax expense

Due to a history of consolidated net operating losses, we have not recorded any income tax expenses, other than minimum or statutory costs. As of December 31, 2021, our accumulated net operating loss carry forward was $42.1 million. We anticipate that these loss carry-forwards may offset future taxable income that we may achieve and future tax liabilities. However, because of uncertainty regarding our ability to use these carry forwards and the potential limitations due to ownership changes, we have established a valuation allowance for the full amount of our net deferred tax assets.

Net income (loss)

After interest, other income and income taxes, we recorded a net loss of $(1.3 million), or $(0.07) per share for the year ended December 31, 2021. This compares to net income of $0.1 million, or $0.001 per share we recorded for the year ended December 31, 2020.

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LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity at December 31, 2022 are our cash and cash equivalents on hand, funds available under our bank credit facility and projected cash flows from operating activities.

As of December 31, 2022, the Company had an accumulated deficit of $66,385,000. In addition, the Company has a history of annual operating and net losses which have been due, in part, to the effects of COVID-19 and related supply chain constraints. These factors may be indicative of doubt about the Company’s ability to continue as a going concern.  Management has evaluated the significance of these conditions in relation to its ability to meet its obligations. Our primary sources of funds to meet our liquidity and capital requirements include cash on hand, funds generated from operations including the funds from our customer financing programs, trade credit extended to us by our vendors, and borrowings under our bank credit facility. If our future results do not meet expectations, management believes that we can implement reductions in selling, general and administrative expenses to better achieve profitability and therefore improve cash flows, or that we could take further steps such as the issuance of new equity or debt. We may also require additional capital if we seek to acquire additional businesses as a way to increase the scale of our operations, or if there is a sudden increase in the level of reseller services. There can be no assurance as to the Company’s ability to scale its business operations on terms upon which additional financing might be available.

Management believes that we will be able to generate sufficient cash flows and liquidity as described above, as we still have a significant backlog of projects which have been impacted due to COVID-19 and the related supply chain constraints. We have invested in supporting new IT technologies and received new orders that should drive an increase in our integration business going forward and have also seen new MDC customers emerge during 2022 These factors among others allow us to believe that we will be profitable in 2023. We anticipate generating further cash flows from operations and, having repaid all of the Company’s long-term debt during 2022 from existing sources, we now have no long-term debt outstanding apart from lease obligations.  As a result, management has concluded that there is not substantial doubt about the Company’s ability to continue as a going concern

If we continue to meet the cash flow projections in our current business plan, we expect that we will have adequate capital resources necessary to continue operating our business for at least the next twelve months. Our business plan and our assumptions around the adequacy of our liquidity are based on estimates regarding expected revenues and future costs. However, there are potential risks, including that our revenues may not meet our projections, our costs may exceed our estimates, or our working capital needs may be greater than anticipated. Further, our estimates may change, and future events or developments may also affect our estimates. Any of these factors may change our expectation of cash usage in 2023 and beyond or significantly affect our level of liquidity, which may limit our opportunities to grow our business.

As of December 31, 2022 and 2021, we had cash and cash equivalents of $20.4 million and $8.0 million, respectively.

Significant uses of cash

Operating activities:

Cash provided by operating activities was $14.7 million for the year ended December 31, 2022, compared to cash used in operating activities of $10.5 million for the year ended December 31, 2021. The primary reason for the increase in cash is due to the timing and financial impact of our procurement and reseller services on our financial statements. At the end of 2022 we were able to be paid for multiple large procurement projects but had yet to pay vendors for these same projects. This resulted in an increase of approximately $14 million in our outstanding accounts payable at the end of 2022. During the first quarter of 2023 we paid those vendors and both our cash and accounts payable decreased by over $12 million. We had a similar situation at the end of 2020 and during the first quarter of 2021, where we paid over $10 million to vendors from transactions that we had collected funds from during 2020 causing us to use cash in operations during 2021. We have been able to structure our procurement and reseller activities in such a way as to minimize their overall impact on our liquidity by using trade creditors as the primary way to finance these activities. We have been able to leverage the increase in trade payables tied to procurement and reseller services to finance the growth in inventory and receivables and believe that we will have adequate trade credit to continue to grow this service line in 2023.

We expect that our balance sheet will continue to be materially impacted by the timing of cash flows tied to particular reseller and procurement projects. This will cause cash, receivables, inventory, payables and deferred revenue balances to fluctuate, sometimes materially, on a quarterly basis.

Investing activities:

Cash used in investing activities was $0.5 million in 2022, primarily for the expansion and upgrading of our integration business and improvements to our facility. This compares to cash used in investing activities was $0.1 million in 2021 for the purchases of computer equipment as we added new infrastructure and equipment to support our business.

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Finance activities:

Cash used in financing activities was $1.8 million in 2022 compared to cash used in financing activities of $0.5 million during 2021. During the third quarter of 2022 we repaid outstanding interest and principal on our notes payable of $2,045,000, and we received $367,000 in proceeds from the exercise of warrants that had been issued in connection with our notes payable. We also received $41,000 in proceeds during 2022 from the exercise of employee stock options and used $134,000 during 2022 for the purchase of stock related to tax obligations around option exercises and the vesting of restricted shares. In 2021 we used $352,000 to retire a portion of our long-term notes payable after the lenders offered us an incentive to repay this debt prior to maturity. We also received $45,000 in proceeds in 2021 from the exercise of employee stock options, and we used $197,000 in 2021 for the purchase of stock related to tax obligations from option exercises and the vesting of restricted shares by our employees.

Future uses of cash

Our business plans and our assumptions around the adequacy of our liquidity are based on estimates regarding estimated revenues and future costs and our ability to secure sources of funding when needed. Further, our estimates may change, and future events or developments may also affect our estimates. Any of these factors may change our expectation of cash usage during 2023 and beyond or significantly affect our level of liquidity, which may require us to take other measures to reduce our operating costs in order to continue operating. Any action to reduce operating costs may negatively affect our range of products and services that we offer or our ability to deliver such products and services, which could materially impact our financial results depending on the level of cost reductions taken.

Our primary liquidity and capital requirements are to fund working capital from current operations. Our primary sources of funds to meet our liquidity and capital requirements include cash on hand, funds generated from operations including the funds from our customer financing programs, and, if needed, borrowings under our bank credit facility. We believe that if future results do not meet expectations, we can implement reductions in selling, general and administrative expenses to better achieve profitability and therefore improve cash flows, or that we could take further steps such as the issuance of new equity or debt. However, the timing and effect of these steps may not completely alleviate a material effect on liquidity. We may also require additional capital if we seek to introduce new lines of business or if we seek to acquire additional businesses as a way to increase the scale of our operations.

New Accounting Pronouncements

Recently Adopted Accounting Guidance

In December 2019, FASB issued Accounting Standards Update 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (“ASU 2019-12). ASU 2019-12 simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740. The guidance also clarifies and amends existing guidance to improve consistent application. The standard was adopted by us in our first quarter of fiscal 2021 and did not have any material impact on our consolidated results of operations, cash flows, financial position or disclosure.

In March 2020, FASB issued Accounting Standards Update ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, (“ASU 2020-04”). ASU 2020-04 provides optional expedients and exceptions for applying GAAP principles to contracts, hedging relationships, and other transactions that reference London Interbank Offered Rate (LIBOR) or another reference rate expected to be discontinued due to reference rate reform. This guidance was effective beginning on March 12, 2020 and was adopted by us in the fourth quarter of 2022 and did not have any material impact on our consolidated results of operations, cash flows, financial position or disclosure.

Recently Issued Accounting Pronouncements

In June 2016, FASB issued Accounting Standards Update ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). The standard’s main goal is to improve financial reporting by requiring earlier recognition of credit losses on financing receivables and other financial assets. Among the provisions of ASU 2016-13 is a requirement that assets measured at amortized cost, which includes trade accounts receivable, be presented at the net amount expected to be collected. This pronouncement requires that an entity reflect all of its expected credit losses based on current estimates which will replace the current standard requiring that an entity need only consider past events and current conditions in measuring an incurred loss. We are subject to this guidance effective with the consolidated financial statements we issue for the annual and interim periods during the year ending December 31, 2023. We are currently evaluating the adoption date and the impact of the adoption of this guidance on our consolidated financial statements and disclosures and do not expect it to have a material impact on our consolidated results of operation, cash flows, financial position or disclosure.

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In May 2019, FASB issued Accounting Standards Update ASU No. 2019-15, Financial Instruments – Credit Losses (Topic 326), (“ASU 2019-15”). ASU 2019-15 provides final guidance that allows entities to make an irrevocable one-time election upon adoption of the new credit losses standard to measure financial assets at amortized cost (except held-to-maturity securities) using the fair value option. The effective date and transition methodology are same as in ASU 2016-13.