Firefly Neuroscience, Inc.: Form 10-Q for the period ended Sep 30, 2022

Cautionary Statement Regarding Forward-Looking Statements

This Form 10-Q contains forward-looking statements regarding our business, customer prospects, or other factors that may affect future earnings or financial results that are subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. Such statements involve risks and uncertainties which could cause actual results to vary materially from those expressed in the forward-looking statements. Investors should read and understand the risk factors detailed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2021 (“Annual Report”) and in other filings with the Securities and Exchange Commission.

We operate in a rapidly changing environment that involves a number of risks, some of which are beyond our control. This list highlights some of the risks which may affect future operating results. These are the risks and uncertainties we believe are most important for you to consider. Additional risks and uncertainties, not presently known to us, which we currently deem immaterial, or which are similar to those faced by other companies in our industry or business in general, may also impair our business operations. If any of the following risks or uncertainties actually occur, our business, financial condition and operating results would likely suffer. These risks include, among others, the following:

• Our ability to successfully execute our business plan and necessary transition activities following the acquisition of Gray Matters, Inc.
• Recent, past and future acquisitions and investments could disrupt our business and harm our financial condition and operating results.
• Our business is subject to risks related to the COVID-19 pandemic and the conflict in Ukraine.
• Our operating history and recent and proposed changes to our business model make it difficult to evaluate our current business and prospects and may increase the risk that we will not be successful.
• We have had operating losses in three of each of the last four years and may not achieve or maintain profitability in the future.
• If the cybersecurity, Internet of Things (“IoT”), enterprise resource planning (“ERP”), command and control (“C2”), or supply chain management (“SCM”) markets are not receptive to our solutions, our sales will not grow as quickly as anticipated, or at all, and our business, results of operations and financial condition would be harmed.
• A portion of our revenue is expected to be generated by sales to government entities, which are subject to a number of challenges and risks.
• We face intense competition and could lose market share to our competitors, which could adversely affect our business, financial condition, and results of operations.
• We rely on our management team and other key employees and will need additional personnel to grow our business, and the loss of one or more key employees or our inability to hire, integrate, train and retain qualified personnel, including members for our board of directors, could harm our business.
• Our business is subject to risks related to the use of blockchain and distributed ledger technology.
• We are dependent on a few key customer contracts for a significant portion of our future revenue, and a significant reduction in services to one or more of these contracts would reduce our future revenue and harm our anticipated operating results.
• Our Gray Matters business currently has one key customer and since our acquisition of GMI in December 2022, there have been delays in the timing of revenue recognition vs our initial expectations. Continued delays in recognizing revenue for GMI could have an adverse impact on the carrying value of the intangible assets and goodwill that was recorded in connection with the acquisition of GMI.
• Our proprietary rights may be difficult to enforce or protect, which could enable others to copy or use aspects of our products or subscriptions without compensating us.
• Our use of open-source software in our products and subscriptions could negatively affect our ability to sell our products and subscriptions and subject us to possible litigation.
• We are dependent on information technology, and disruptions, failures or security breaches of our information technology infrastructure could have a material adverse effect on our operations.
• We depend on computing infrastructure operated by Amazon Web Services (“AWS”), Microsoft, and other third parties to support some of our solutions and customers, and any errors, disruption, performance problems, or failure in their or our operational infrastructure could adversely affect our business, financial condition, and results of operations.
• Failure to comply with governmental laws and regulations could harm our business.
• We are subject to risks associated with our strategic investments, and impairments in the value of our investments could negatively impact our financial results.
• Our failure to raise additional capital or generate the significant capital necessary to expand our operations and invest in new products and subscriptions could reduce our ability to compete and could harm our business.
• The requirements of being a public company may strain our resources, divert management’s attention, and affect our ability to attract and retain qualified board members.
• If we are not able to maintain and enhance our brand and our reputation as a provider of high-quality security solutions and services, our business and results of operations may be adversely affected.

In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “intends,” “potential” and similar expressions intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We discuss many of these risks in greater detail under the heading “Risk Factors” in Item 1A of our 2021 10-K. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this report. Except as required by law, we assume no obligation to update any forward-looking statements after the date of this report.

Our Business

Founded in 1979 as Information Analysis Incorporated, the Company changed its name to WaveDancer, Inc. and converted from a Virginia corporation to a Delaware corporation in December 2021. The Company is in the business of developing and maintaining information technology (“IT”) systems, modernizing client information systems, and performing other IT-related professional services to government and commercial organizations.

The Company is an IT provider primarily for the benefit of federal government agencies. At present, we primarily apply our technology, services and experience to legacy software migration and modernization, developing web-based and mobile device solutions, including dynamic electronic forms development and conversion, data analytics, and we are in the process of acquiring talent and expertise in developing cybersecurity and cloud services practices. Our focus is on enterprise IT solutions primarily relating to system modernization, cloud-based solutions and cybersecurity protection.

Since the Company’s inception, we have performed software development and conversion projects for over 100 commercial and government customers including, but not limited to, the Department of Agriculture, Department of Defense, Department of Education, Department of Homeland Security, Department of the Treasury, U.S. Small Business Administration, U.S. Army, U.S. Air Force, Department of Veterans Affairs, and General Dynamics Information Technology (formerly Computer Sciences Corporation, CSRA).

Modernization has been a core competency of the Company for over 20 years. We have modernized over 100 million lines of COBOL code for over 35 governmental and commercial customers. We maintain a pool of skilled COBOL programmers. This provides us with a competitive advantage as the labor pool of such programmers is shrinking as aging software professionals retire. Our business has also historically relied upon the reselling of applications, primarily for forms development.

Through our acquisition in April 2021 of Tellenger, Inc. (“Tellenger”), which is now a wholly-owned subsidiary of the Company, we acquired competencies in web-based solutions and cybersecurity. Tellenger is a boutique IT consulting and software development firm specializing in modernization, software development, cybersecurity, cloud solutions, and data analytics. We believe combining web-based solutions with system modernization will provide us with the skill sets that are needed to migrate legacy systems to the cloud. We foresee this as a key component of our modernization growth since there are billions of lines of code, in both the governmental and commercial sectors, that eventually must be modernized. It is also our intention to better leverage our resources, largely gained through the acquisition of Tellenger, to take advantage of the growth in the cybersecurity market.

In December 2021, we announced the reorganization of our entire professional services practice into Tellenger, and as a result, our professional services are contained in a single entity. Through Tellenger, we perform services such as business process re-engineering, cloud migrations, and Software-as-a-Service (“SaaS”) implementations on behalf of clients in the private and public sector with an aim to increase productivity, gain efficiencies, and achieve key performance indicators. Tellenger is appraised at Capability Maturity Model Integration (CMMI) Level 3.

Through our acquisition of Gray Matters, Inc. and in connection with our business transformation strategy which we discuss below, in December 2021 we gained access to blockchain and encryption algorithm technology. Gray Matters specializes in the supply chain management (“SCM”) industry and in United States intelligence, national security and diplomatic organizations. Gray Matters uses a “Zero Trust” product and is designed to secure and monitor the lifecycle of manufacturing through destruction and recycling.

Our Strategy

Our strategy is to grow our business organically as well as through acquisitions.

Through the acquisitions of Tellenger and Gray Matters in 2021, we began to reposition our legacy professional services business by allocating resources away from third-party product reselling and toward professional services, which management viewed as higher margin, including within the SCM sector. In assessing the Company’s repositioning, management observed cybersecurity practices as evolving toward a zero-trust approach, the integration of blockchain as enhancing SCM, and the proliferation of Internet of Things (“IoT”) devices that were taking organizational networks to the edge. Additionally, we have been seeking to purchase other technology companies whose businesses complement the Company’s existing business and whose personnel would better enable us to compete for engagements in our focus areas.

To grow organically, we have hired and plan to continue to hire, business development personnel and intend to become more proactive in bidding as a prime contractor on government proposals and in expanding our outreach to larger prime contractors for subcontract and teaming opportunities.

Results of Operations – Three Months Ended September 30, 2022 and 2021

Revenue

Total revenue was $2,306,379 for the three months ended September 30, 2022, compared with $4,299,925 in the prior year quarter, a decrease of $1,993,546, or 46.4%. All of the decrease is from our Tellenger segment since we did not recognize revenue for Blockchain SCM this quarter and did not have the segment last year.

Tellenger

The decrease in revenue of $1,993,546 consists of lower professional services revenue totaling $684,093 and lower third-party software sales of $1,309,453. The decline in professional services revenue is driven primarily by one software modernization project where we had deployed more resources, and billed more overtime, in 2021 in order to achieve a particular milestone whereas in the third quarter of 2022 we had fewer resources and less overtime from those resources. The reduction in sales of third-party software is the result of our decision to de-emphasize these sales since they generate gross margins in the low single digits.

Gross Profit

Gross profit decreased by $497,253 or 50.8%, to $481,622 for the three months ended September 30, 2022 as compared to $978,875 in the prior year quarter.

Tellenger

The decrease in gross profit includes a decrease from professional services of 317,261, partially offset by an increase in margin on third-party software sales of $78,068. The reduced margin on professional services is driven by the reduced revenues discussed above as well as a change in the mix of contracts generating revenue and the related billing rates resulting in a reduction in our gross profit rate to 30.7% from 34.5%.

Blockchain SCM

We recorded a negative gross profit of $258,060 in our Blockchain SCM operating segment. As noted above, we experienced delays in receiving approval from our government customer of certain milestone achievements specified in our contract with that customer. However, we continued to incur costs supporting the contract resulting in negative gross profit.

Selling, General and Administrative Expenses

Selling, general and administrative (“SG&A”) expenses have increased significantly since the second half of 2021 when we began to implement our transformative strategy described in the Our Strategy section above and in our Annual Report. The following table shows the major elements of SG&A expenses for the three months ended September 30, 2022 and 2021 and the increases between periods:

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Acquisition Costs

We incurred acquisition expenses totaling $38,617 in the three months ended September 30, 2022 as compared to $39,245 in the corresponding quarter in 2021. These expenses include fees for legal, tax and audit professional services as well as other costs to conduct due diligence and finalize a transaction.

Goodwill Impairment

During the third quarter of 2022, our Gray Matters reporting unit, which is in our Blockchain SCM segment, experienced delays in receiving approval from its government customer of certain milestone achievements specified in our contract with that customer. This delay, in turn, results in a decline in the reporting unit’s estimated future cash flows. Accordingly, we performed an interim goodwill impairment test in accordance with the amended goodwill guidance for this reporting unit prior to our annual impairment test.

As a result of the test, the estimated fair value of this reporting unit was determined to be lower than the carrying value and we recorded a non-cash charge of $2,254,624 to impair the carrying value of this reporting unit’s goodwill.

(Loss) Income from Operations

Loss from operations was $4,737,862 in the third quarter of 2022 compared to a loss from operations of $84,267 in the corresponding quarter in 2021, an increase in the loss of $4,653,595. The increase in the loss from operations is primarily the result of the decrease in gross profit of $497,253 and the increase in SG&A expenses of $1,902,346, all as discussed above, and approximately $3.3 million of the increased loss is attributable to the Blockchain SCM operating segment that was acquired with GMI in December 2021.

Results of Operations – Nine Months Ended September 30, 2022 and 2021

Revenue

Total revenue was $9,619,273 for the nine months ended September 30, 2022, as compared to $12,451,467 in the comparable period in 2021, a decrease of $2,832,194, or 22.7%. The decrease includes $3,399,057 from the Tellenger operating segment, partially offset by the $566,862 of year-to-date revenue from the Blockchain SCM operating segment for which there is no prior year amount since this operating segment is the GMI business acquired in December 2021.

Tellenger

The $3,399,057 revenue decrease comprises a decrease in professional services revenue of $2,107,105 and a decrease in third-party software sales of $1,291,951. The professional services revenue decrease includes three primary declining items: 1) one contract for which much of 2021 included a greater number of resources deployed and more overtime billed in connection with meeting an accelerated milestone as compared to 2022 when we have not had as many resources deployed nor overtime billed ($1,635 thousand); 2) one contract that has transitioned to a maintenance phase where in 2021 we had revenues associated with systems conversion ($335 thousand); and 3) one contract that ended in 2021 ($563 thousand). These declining items were partially offset by increased revenues from having a full nine months of the Tellenger, Inc. acquisition in 2022 versus just over 6 months in 2021 ($421 thousand). The reduction in sales of third-party software is the result of our decision to de-emphasize these sales since they generate gross margins in the low single digits.

Gross Profit

Gross profit was $1,787,468 for the nine months ended September 30, 2022, as compared to $2,954,453 in the comparable period in 2021, a decrease of $1,166,985 or 39.5%. The decrease includes $615,545 from the Tellenger operating segment and $551,440 of year-to-date negative gross margin from the Blockchain SCM operating segment for which there is no prior year amount since this operating segment is the GMI business acquired in December 2021.

Tellenger

The $615,545 gross profit decrease comprises a decrease in gross profit from professional services of $692,062, partially offset by increased gross profit from third-party software sales of $76,517. The decline in gross profit from professional services includes two primary declining items: 1) one contract for which much of 2021 included a greater number of resources deployed and more overtime billed in connection with meeting an accelerated milestone as compared to 2022 when we have not had as many resources deployed nor overtime billed ($706 thousand); and 2) one contract that has transitioned to a maintenance phase where in 2021 we had revenues associated with systems conversion ($209 thousand). These declining items were partially offset by increased gross profit from having a full nine months of the Tellenger acquisition in 2022 versus just over three months in 2021 ($269 thousand).

Selling, General and Administrative Expenses

SG&A expenses have increased significantly since the second half of 2021 when we began to implement our transformative strategy described in the Our Strategy section above and in our Annual Report. The following table shows the major elements of SG&A expenses for the nine months ended September 30, 2022 and 2021 and the increases between periods:

Acquisition Costs

We incurred acquisition expenses totaling $829,478 for the nine months ended September 30, 2022 as compared to $192,530 for the nine months ended September 30, 2021. The current year's expenses were incurred primarily in connection with the terminated acquisition of Knowmadics. These expenses include fees for legal, tax and audit professional services as well as other costs to conduct due diligence and finalize a transaction.

Change in Fair Value of Contingent Consideration

Under the terms of the Gray Matters purchase agreement, the Seller is eligible to receive up to $4,000,000 of additional consideration, payable in cash, based on the amounts of revenue and gross profit achieved by GMI during the period from the acquisition date through December 31, 2022. In the purchase accounting for GMI in the fourth quarter of 2021, we recorded a contingent liability of $930,000 based on our estimate for GMI’s expected performance for 2022. Since that initial estimate there have been delays in the timing of realizing revenue that have pushed a material amount of the projected revenue and related gross profit outside of the one-year measurement period of the Seller’s earnout provision. As of September 30, 2022 we estimated that the contingent consideration was no longer probable of being realized by the seller and removed the contingent consideration liability. The result of writing down the contingent liability has been the recognition of non-cash operating income of $930,000 as discussed in Note 5.

Goodwill Impairment

During the third quarter of 2022, our Gray Matters reporting unit, which is the same as our Blockchain SCM operating segment, experienced delays in receiving approval from its government customer of certain milestone achievements specified in our contract with that customer. This delay, in turn, resulted in a decline in the reporting unit’s estimated future cash flows. Accordingly, we performed an interim goodwill impairment test as of September 30, 2022.

As a result of the test, the estimated fair value of this reporting unit was determined to be lower than the carrying value and we recorded a non-cash charge of $2,254,624 to impair the carrying value of this reporting unit’s goodwill.

(Loss) Income from Operations

Loss from operations was $9,247,607 for the nine months ended September 30, 2022 compared to income from operations of $238,583 for the nine months ended September 30, 2021, a decrease of $9,486,190. The decrease in income from operations is the result of the decrease in gross profit of $1,166,985 and the increase in SG&A expenses and acquisition costs totaling $6,994,581, and the goodwill impairment of $2,254,624, partially offset by the income from the change in fair value of contingent consideration recorded in connection with the Gray Matters acquisition of $930,000, all as discussed above. Approximately $4.1 million of the decrease in income from operations is attributable to the Blockchain SCM operating segment that was acquired with GMI in December 2021.

Critical Accounting Estimate

Our accounting policies are described in Note 1 of our consolidated financial statements – Organization and Summary of Significant Accounting Policies. We prepare our consolidated financial statements in conformity with US GAAP, which require us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the year. Actual results could differ from those estimates. We consider the following policies and estimates to be most critical in understanding the judgments involved in preparing our financial statements for the three and nine months ended September 30, 2022 and the uncertainties that could affect our results of operations, financial condition and cash flows.

Goodwill Impairment Testing

As discussed in Note 5 to our interim consolidated financial statements, during the third quarter of 2022, our Gray Matters reporting unit experienced delays in receiving approval from its government customer of certain milestone achievements specified in our contract with that customer. This delay, in turn, results in a decline in the reporting unit’s estimated future cash flows. Accordingly, we performed an interim goodwill impairment test as of September 30, 2022. As a result of the test, the estimated fair value of this reporting unit was determined to be lower than the carrying value and we recorded a non-cash charge of $2,254,624 to impair the carrying value of the Gray Matters reporting unit goodwill.

We believe that the Gray Matters reporting unit may be at risk of failing future quantitative impairment tests if it continues to experience declining estimated future cash flows. Impairment charges are non-cash in nature and, as with current impairment charges, any future impairment charges will not impact our cash needs or liquidity. The key assumptions in the September 30, 2022 goodwill impairment test for the Gray Matters reporting unit are as follows: the unit is expected to begin generating positive cash flows within the next several years, a discount rate of 22.5%, and a terminal cash flow growth rate of 3%.

The estimated fair value of our Tellenger reporting unit significantly exceeded its carrying value as of September 30, 2022.

Liquidity and Capital Resources

On September 30, 2022, the Company had working capital of approximately $1.3 million, including cash and cash equivalents of $1.5 million, generated operating losses in 2022 and at September 30, 2022 had an accumulated deficit of $21.7 million. As discussed below, our ability to generate sufficient cash flows to meet our obligations for the twelve months following the issuance of these financial statements is dependent upon factors which are sufficiently outside of management’s control as to cast substantial doubt about our ability to continue as a going concern.

Beginning in August 2021 we embarked on a transformative strategy to reposition the Company as a leader in the Zero-Trust, blockchain and Secure Supply Chain marketplace. In December 2021 we acquired Gray Matters, Inc. (“GMI”) whose blockchain and encryption algorithm technology was built to solve real-world problems through purpose-built innovation in secure Supply Chain Management (SCM) in United States government organizations. After closing on the GMI acquisition, we focused on the second of our two intended foundational acquisitions, Knowmadics, Inc. (“KMI”), a leading Internet of Things (IoT) remote device management and monitoring platform company. After announcing a definitive agreement in March of 2022, we terminated the agreement on June 6, 2022 due to our inability to raise the funds required to complete the deal under its original terms. Beginning in late 2021 and through the third quarter of 2022 we have hired salespeople, marketers, and software engineers, developed and implemented sales and marketing programs, and expanded our compliance, governance, and administrative infrastructure to support our long-term strategy. At the same time, we have experienced delays in the adoption of our SCM platform by our primary government customer. The result has been a sharp increase in operating expenses, without growth in revenue and gross margins, and negative operating cash flows. In August 2022 we sold 1,572,506 unregistered shares of our common stock in a private offering at a price of $1.20 per share from which we raised aggregate gross proceeds of $1,887,000.

We intend to continue to invest in our SCM platform and to execute our strategy to become a leading zero trust, blockchain-enabled cybersecurity company and believe strongly in the long-term viability of our strategy. We do not have any material contractual obligations or capital expenditures that we are committed to expend over the next 12 months related to these or other activities. We have no outstanding debt that we are required to repay over the next 12 months and have no off-balance-sheet arrangements that are likely to have a material future effect on our financial condition, or changes in financial condition, liquidity or capital resources or expenditures. We used cash from operating activities of approximately $5 million through the first 9 months of 2022 and anticipate that our operating activities may use in excess of that amount over the next 12 months, including satisfying our current liabilities of approximately $2.1 million as of September 30, 2022 and our other typical operating expenses, including payroll for our workforce and other costs. We may also pursue growth in revenue and profitability via acquisition or merger and we plan to implement measures to reduce our operating expense cost structure. We may consider asset sales and other actions to reshape our business.

However, the Company will require additional capital to support its strategy. Other sources of liquidity include our bank line of credit which had $1 million of availability as of September 30, 2022, as well as the Common Stock Purchase Agreement we entered into with B. Riley Principal Capital II, LLC on July 8, 2022 (the “ELOC”), which will enable us to raise additional capital under an equity line of credit. However, the amount of capital we can raise under the ELOC is a function of our trading volume and the market price of our common shares. Without an increase in our recent share price and trading volumes, we do not anticipate that the ELOC will be able to meaningfully support our capital needs. There can be no assurance that additional capital will be available on terms acceptable to us, or at all.

The accompanying unaudited condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates continuity of operations, realization of assets, and satisfaction of liabilities in the ordinary course of business. The propriety of using the going-concern basis is dependent upon, among other things, the achievement of future profitable operations, the ability to generate sufficient cash from operations and potential other funding sources, in addition to cash on-hand, to meet its obligations as they become due. The Company’s unaudited consolidated financial statements do not include any adjustment that might result from the outcome of this uncertainty.

Disclosure Controls and Procedures

Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, and people performing similar functions, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as of September 30, 2022 (the “Evaluation Date”). Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (ii) is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

Changes in Internal Controls over Financial Reporting

There were no changes in the Company’s internal control over financial reporting during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

Because of the inherent limitations in all control systems, no control system can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of a person, by collusion of two or more people or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected. Notwithstanding these limitations, we believe that our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives.

“Item 1A. Risk Factors” of our annual report on Form 10-K for the year ended December 31, 2021, as amended, includes a discussion of our risk factors. There have been no material changes from the risk factors described in our annual report on Form 10-K for the year ended December 31, 2021.