TSS, Inc. (TSSI) FY 2023 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 integration and technology services that enable enterprises and users to successfully implement, operate and maintain their Information Technology systems. As a provider of technology services businesses built on a platform of experienced program management, we have expertise in delivering complex, end-to-end IT technology solutions cost-effectively. These IT solutions can be deployed in a variety of physical settings such as data centers, co-location facilities, server rooms, modular or edge-based solutions, security operations, and communications facilities. Our services include rack and systems integration, configuration services, data center and modular data center facility management integrations, deployment and maintenance services, strategic procurement services, project management and technology consulting, design and engineering services. Our headquarters and our systems integration and configuration services facility are located in Round Rock, Texas

We support a broad range of enterprise customers who utilize our services to deploy solutions in their own data centers, in modular data centers (MDC), in colocation facilities or at the edge of the network. This market remains highly competitive and is subject to constant evolution as new computing technologies or applications drive continued demand for more computing and storage capacity. In 2023 these enterprises shifted their investment priorities towards artificial intelligence (AI) and accelerated computing infrastructure initiatives. Enterprises and data center operators are facing immense pressure to rapidly integrate and deploy the latest AI equipment and GPUs and will need to adopt these next-generation servers and custom rack-scale architectures to compete in the market successfully and quickly. Ensuring adequate power and thermal management systems are implemented to support these new technologies while meeting increasingly stringent sustainability requirements is critical to a successful deployment. TSS exists to assist these operators in achieving these benefits over the life cycle of their IT investments.

Over the last ten years, we have focused our business on providing world-class integration services to our customer base. As computing technologies evolve, and as we currently see new power and cooling technologies emerge, including direct liquid-cooled IT solutions and the rapid adoption of AI computing solutions, we will continue to adapt our rack and systems integration businesses to support these new products. We will also continue to offer expanded services to enable the integration, deployment, support, and maintenance of these new IT solutions. We compete in expanding market segments, often against larger competitors who have extensive resources. We rely on several large relationships and one US-based OEM customer to win contracts and to provide business to us under “Master Service Agreements”. The loss of this customer could have a material negative effect on our results. Our operational focus is to ensure this doesn’t happen.

Most 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 income statement or on our balance sheet. We also offer our customers strategic procurement services whereby we procure third-party hardware, software, and services on their behalf. Our configuration and integration service businesses integrate these components to deliver a complete system to our customers.

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. However, we have no control over 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 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.

Our facilities business rebounded in the second half of 2022 as COVID-related supply chain conditions improved and the number of Modular Data Center (MDC) deployments that we performed increased as we satisfied the backlog that had accumulated during the COVID pandemic. This led to a $3.9 million increase in revenues from MDC deployments in our fiscal year 2022. We have since seen a $3.7 million decrease in revenue from MDC deployments in 2023 compared to 2022. This whiplash impact has altered the underlying demand and delivery of MDC deployments, and we expect the number of MDC deployments that we complete to fluctuate on a quarterly basis for the foreseeable future, causing our quarterly revenues and profits to fluctuate. To offset this, we are selectively investing in direct sales capabilities to work alongside our OEM partners to re-create demand lost during and post the pandemic period.

Our systems integration business was negatively impacted during the COVID pandemic due to logistical and supply-chain issues. Supply constraints that initially were due to disruptions caused by the pandemic have continued to occur and create obstacles that still affect component supply to us and negatively impact our integration revenues. The latter half of 2023 was characterized by supply shortages of AI chips and servers, and challenges procuring fiber-optic and high-speed cables for example. We believe that these ongoing constraints will dissipate as additional production capacity comes online, and we are optimistic that increases in demand for AI solutions will create new opportunities to grow our integration business in 2024 and beyond. As this AI technology and other computing technology evolves, including liquid-cooled solutions, we believe this will drive growth in the data center market and provide new revenue opportunities for us. Despite these ongoing challenges, there has been an improvement in supply-chain issues since the second half of 2022, which, along with pricing adjustments, has helped us grow our integration revenues by 23% in 2023 compared to 2022.

14

The volume of transactions we engaged in with our strategic procurement services grew substantially in 2023. Customers value our ability to source disparate hardware, software and services and provide a single-source solution for their IT needs. In some cases, we merely act as agents in these transactions, and so the reported revenues will be different and only reflect our fees earned in the transaction. Overall, we were able to increase our revenues from procurement transactions by $25.3 million or 191%, compared to 2022. The aggregate gross value of all procurement transactions increased from $73 million in 2022 to $123.1 million in 2023.

Our total revenue in 2023 was $54.4 million, a $23.8 million or 78% increase from our 2022 revenues of $30.6 million. The majority of this increase came from growth in our procurement and systems integration businesses, offset by a $3M decrease in our facilities revenues as the number of MDC deployments decreased compared to 2022.

Our gross profits increased by $2 million or 23% compared to 2022, mainly due to the higher volumes of activity in our procurement and integration businesses. Our gross profit margin as a percentage of sales decreased to 20% in 2023 from 29% in 2022. The primary cause of the decrease in gross profit margin percentage was the increase in volume of our procurement 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 36% in 2023 from 37% in 2022 due to the lower volume of maintenance business during 2023.

Our selling, general and administrative expenses of $8.9 million were 16% higher than the $7.7 million we recorded in selling, general and administrative expenses in 2022. The increase was primarily due to higher labor costs as we made a number of strategic investments during 2023 in our sales, marketing, production and support organizations, to enable us to expand our capabilities and to position us to capitalize on future growth opportunities.

Because of the higher overall gross profits, even with higher selling, general and administrative expenses, we were able to improve our operating profit by $0.8 million or 91% from 2022, recording operating income of $1,750,000 in 2023 compared to an operating profit of $914,000 that we recorded in 2022.

Our interest expense increased by $0.7 million compared to 2022. This was due to a combination of higher interest rates during 2023 and higher levels of activity in our procurement business compared to the prior year. During 2023 we transacted approximately $123.1 million in transactions in this business activity, although $84.5 million of this was for agent-type transactions. With the receivable-financing program that we have with a third-party banking partner, all of these procurement transactions are financed via this program, and we incur interest costs on the gross value of these transactions. As the gross volume increases in these procurement activities, our interest cost will increase. This increase in volume was exacerbated by the increase in interest rates during 2023. By comparison, we transacted approximately $72.8 million in such transactions in 2022.

We ended 2023 with $11.8 million of cash on hand, a decrease of $8.6 million from the balance at the end of 2022. This decrease was primarily due to the timing of cash flows connected with our procurement activities. The volume of procurement activities in progress was lower at the end of 2023 compared to the end of 2022. These activities resulted in a large increase in our accounts payable at the end of 2022 which were paid in the first quarter of 2023. The procurement activities 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 but as the transactions completed, we used $8.3 million in operating activities during 2023. We have been able to structure our procurement 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 on our financial statements.

15

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 expected credit losses based on current estimates, which also includes a review of individual account balances, including an evaluation of days outstanding, payment history, recent payment trends, and our assessment of our customer’s creditworthiness. As of December 31, 2023 and 2022, 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 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 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 procurement activities are typically due within 30-60 days of invoicing.

16

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, 2023, current deferred revenue of $3,370,000 consists of $2,404,000 representing our remaining performance obligations for our maintenance contracts, all of which are expected to be recognized within one year, and $966,000 relating to procurement and integration services where we have yet to complete our services for our customers as of December 31, 2023, 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.

17

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.

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 2023 to 2022

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 procurement 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 services and data center moves, 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.

Our total revenue in 2023 was $54.4 million, a $23.8 million or 78% increase from our 2022 revenues of $30.6 million. The majority of this increase came from growth of $25.3 million in our procurement business and from growth of $1.6 million in our systems integration business, offset by a $3.1 million decrease in our facilities revenues as the number of MDC deployments decreased compared to 2022.

18

Our procurement business involves us procuring third-party hardware, software and services on our customers’ behalf that are then typically used in our integration services as we integrate those components to deliver a completed system to our customer. The volume and timing of revenues from our procurement business has been unpredictable and subject to large fluctuations, especially on a quarterly basis. Most transactions are for discrete projects that do not recur, and the time to complete most projects is usually less than six months. 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 customer by another party, and we have no control over the goods or services 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 commission that we expect to be entitled to after paying the other party for the goods or services provided to the customer. We had a substantial increase in the number of procurement transactions we completed in 2023 compared to 2022, including a large increase in agent-type transactions, that allowed us to increase revenues from procurement activities from $13.2 million in 2022 to $38.5 million in 2023.

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 80% for the year ended December 31, 2023, compared to 71% for 2022. This increase is primarily due to the higher proportion of our total revenue that is from procurement services in 2023. Absent the procurement business, the cost of revenue as a percentage of revenue on our traditional integration and maintenance businesses was 64% in 2023 compared to 63% in 2022.

Our procurement revenues were 71% of total revenue in 2023 compared to 43% of total revenues in 2022. We earn much lower margins from our procurement 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 services increases, we would anticipate that cost of revenue as a percentage of sales will also increase, and result in lower gross profit margins.

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 profit margin for the year ended December 31, 2023 was 20% compared to a gross profit margin of 29% for the year ended December 31, 2022. This decrease in gross profit margin as a percentage of revenue compared to 2022 was primarily from the higher percentage of our total revenue in 2023 that came from procurement services. As the percentage of total revenue from procurement services increases, our gross profit margin will decrease as the cost of sales is higher for this revenue than our traditional integration and facilities revenues. Absent the impact from our procurement services, the gross profit margin on our traditional integration and facilities revenues was 36% in 2023 compared to 37% in 2022.

The growth in our total revenues in 2023 compared to 2022 allowed us to increase our overall gross profit by 23% or $2 million to $11 million in 2023 compared to gross profit of $9 million in 2022.

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 and improve the utilization of our integration and service operations. Our gross profit margin is also likely to fluctuate based on the proportion of our total revenues that comes from our procurement activities.

19

Selling, General and Administrative Expenses

Selling, general and administrative expenses primarily consist of compensation and related expenses, including variable sales and incentive compensation, for our executive, administrative, 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, 2023, our selling, general and administrative expenses of $8.9 million increased by $1.2 million, or 16%, compared to 2022. The increase was primarily due to higher labor costs as we made a number of strategic investments during 2023 in our sales, marketing, production and support organizations, to enable us to expand our capabilities and to position us to capitalize on future growth opportunities.

Operating income

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 $0.8 million or 91% from 2022 and record an operating income of $1,750,000 in 2023 compared to operating income of $914,000 that we recorded in 2022.

Interest expense, net

For the year ended December 31, 2023 we recorded interest expense, net of interest income, of $1,616,000. This compares to interest expense, net of interest income, of $931,000 for the year ended December 31, 2022. The increase in interest expense was due to both higher interest rates in 2023 compared to 2022 and to an increase in the value of transactions that were factored, which was approximately $137 million in 2023 compared to approximately $87.8 million in 2022. The increase in amounts factored was because of the higher number of procurement projects, including agent-type transactions, that we processed in 2023. This increase in interest expense attributable to factoring was partially offset in 2023 when there was no interest expense for related party debt which was extinguished in July 2022. We were also able to offset this increase with an additional $322,000 of interest income during 2023 as we managed cash flows from our procurement transactions and were able to invest surplus funds until required.

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, 2023, our accumulated net operating loss carry-forward was $40 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 net interest and income taxes, we recorded net income of $74,000, or $0.00 per share for the year ended December 31, 2023. This compares to a net loss of $73,000, or $(0.00) per share we recorded for the year ended December 31, 2022.

Comparison of 2022 to 2021

Revenue

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 revenues decreased by $1.4 million or 10% 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.

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.

20

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 activities. Our 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 services decreases, we would anticipate that cost of revenue as a percentage of sale will decrease.

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 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 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.

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

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 compared 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 business compared to 2021. Interest expense in our procurement 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.

21

LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity at December 31, 2023 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, 2023, the Company had an accumulated deficit of $66,311,000. Although we reported operating income in 2023 and 2022 and net income in 2023, we do have a history of annual operating and net losses which have been due, in part, to the effects of COVID-19 and subsequent supply chain constraints. These factors may be indicative of doubt regarding 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 program, and trade credit extended to us by our vendors, or under our revolving credit facilities with our bank. 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 to increase the scale of our operations, or if there is a sudden increase in the level of procurement 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 have been able to grow our revenues and order backlog and seen an improvement in supply chain constraints. We believe that we will continue to be profitable on a quarterly and annual basis in 2024 and beyond. As a result, management has concluded that there is not substantial doubt about the Company’s ability to continue as a going concern. These financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern for a reasonable period of time.

As of December 31, 2023 and 2022, we had cash and cash equivalents of $11.8 million and $20.4 million, respectively.

Significant uses of cash

Operating activities:

Cash used in operating activities was $8.3 million for the year ended December 31, 2023, compared to cash provided by operating activities of $14.7 million for the year ended December 31, 2022. This change in cash from operating activities was primarily attributable to the timing and financial impacts of our procurement services. The volume of procurement activities was higher at the end of 2023 compared to the end of 2022, however, 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 $14 million. The increases in our inventory and receivables in 2023 compared to 2022 are also attributable to the timing of in-progress procurement projects. We have been able to structure our procurement 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. However, due to timing, it is possible to see fluctuations on a quarterly and annual basis for procurement projects that are in progress at the end of a reporting period. We believe that we will have adequate trade credit available to use to continue financing our procurement activities as we grow this business during 2024 and beyond.

Investing activities:

Cash used in investing activities was $0.3 million in 2023, primarily for the upgrading of our integration business and improvements to our facility. This compares to cash used in investing activities of $0.5 million in 2022 for the expansion and upgrading of our integration facility to support our business.

Finance activities:

Cash used in financing activities was $40,000 in 2023 compared to cash used in financing activities of $1.8 million during 2022. The cash used in financing activities during 2023 was for the purchase of stock related to tax obligations around vesting of restricted stock by our employees. In 2022 we used $134,000 for tax obligations around restricted stock vesting, and we received $41,000 in proceeds from the exercise of stock options by employees. We also received $367,000 in proceeds from the exercise of warrants by our former note holders, and we used $2.045 million to repay all of the company’s outstanding long-term debt upon its maturity in July 2022.

22

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 2024 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 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.

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. This guidance was adopted by us in the fourth quarter of 2023 and did not have a material impact on our consolidated results of operation, cash flows, financial position or disclosure.

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 the same as in ASU 2016-13.

Recently Issued Accounting Pronouncements

In November 2023, FASB issued Accounting Standards Update ASU No. 2023-07, Segment Reporting (Topic 280): Improvements to Reportable Segment Disclosures. (“ASU 2023-07”). ASU 20203-07 improves reportable segment disclosure requirements for public business entities primarily through enhanced disclosures about significant segment expenses that are regularly provided to the chief operating decision-maker, and included within each reported measure of segment profit (referred to as the “significant expense principle”). ASU 2023-07 will become effective for the fiscal year 2024 annual financial statements and interim financial statements thereafter, and will be applied retrospectively for all prior periods presented in the financial statements, with early adoption permitted. We intend to adopt the standard when it becomes effective in the fiscal year 2024 annual financial statements and we are currently evaluating the impact this guidance will have on the disclosures included in the Notes to the Consolidated Financial Statements.