TSS, Inc.: Form 10-Q for the period ended Sep 30, 2023

The following discussion should be read in conjunction with, and is qualified in its entirety by reference to, the consolidated financial statements and notes thereto included in Item 1 of this Form 10-Q and the consolidated financial statements and notes thereto and our Management’s Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2022 included in our 2022 Annual Report on Form 10-K. This report contains forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that involve risks and uncertainties. Our expectations with respect to future results of operations that may be embodied in oral and written forward-looking statements, including any forward-looking statements that may be included in this report, are subject to risks and uncertainties that must be considered when evaluating the likelihood of our realization of such expectations. Our actual results could differ materially. The words “believe,” “expect,” “intend,” “plan,” “project,” “will” and similar phrases as they relate to us are intended to identify such forward-looking statements. In addition, please see the “Risk Factors” in Part 1, Item 1A of our 2022 Annual Report on Form 10-K for a discussion of items that may affect our future results.

Overview

TSS, Inc. (‘‘TSS’’, the ‘‘Company’’, ‘‘we’’, ‘‘us’’ or ‘‘our’’) provides comprehensive services for 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, operations 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, systems installation, facilities management and IT procurement and reseller services. Our headquarters and our integration facility are in Round Rock, Texas.

Our business is concentrated in the data center infrastructure and services market. This market continues to grow and remains highly competitive as commerce moves to cloud-based solutions and as data storage requirements continue to escalate for many industries. The demand for AI solutions is also fueling demand for higher performance computing capability.These underlying macroeconomic trends are continuing to drive demand for more information technology equipment and more efficient data center design and operation, resulting in continued 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 or a material decline in volume from such customers would have a material negative effect on our results.

The majority 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 revenue reflects 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 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 services allow us to develop relationships with new hardware, software and professional service providers and allow us to generate higher profits on integration projects by broadening our revenue and customer base.

Our facilities business rebounded in the latter part 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, and we have since seen a decrease of $3.5 million in revenues from MDC deployments in the first nine months of 2023 compared to the same period in 2022. This whiplash impact has altered the underlying demand and delivery of MDC deployments, and we expect that the number of MDC deployments will 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 revenue. We believe that these constraints will be as bad as during the pandemic period and are optimistic that increases in demand for AI solutions will create more opportunity for our integration business. As this technology evolves including direct liquid-cooled solutions, we believe that this will present new growth opportunity for our integration business. Despite these ongoing challenges, overall, there has been an improvement in supply chain issues since the second half of 2022 that has helped our integration services revenues grow by 31% during the first nine months of 2023 compared to the same period in 2022.

RESULTS OF OPERATIONS

Revenue

Revenue consists of fees earned from the planning, design and project management for mission-critical facilities and information infrastructures, as well as fees earned from providing maintenance services for these facilities. We also earn revenue from providing system configuration and integration services, including procurement and 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 the customers’ equipment (excluding IT equipment) at a facility during the contract period. Where customer requirements are clear, we prefer to enter into 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 and project-management services in a concentrated number of high-value contracts for the construction of new data centers. In addition to contributing to large quarterly fluctuations in revenue depending upon project timing, these projects required higher levels of working capital and generated lower margins than our maintenance and integration services. We re-focused our design and project management services towards smaller scaled jobs typically connected with addition/move/retrofit activities rather than new construction, to obtain better margins. We have also focused on providing maintenance services for modular data center applications as this market continues to expand. We continue to focus on increasing our systems integration revenues through more consistent revenue streams that will better utilize our assets in that business, and through adding services such as procurement and reseller services, to help drive volume through the integration facility.

Revenues of $8.9 million for the three-month period ended September 30, 2023 represented an increase of $0.8 million or 10% compared to the third quarter of 2022. The increase was primarily driven by an increase in our procurement and reseller services where our revenues increased by $2.3 million compared to the third quarter of 2022, driving a total increase of $2.3 million in our systems integration segment. Revenues in our facilities segment decreased by $1.5 million compared to the third quarter of 2022 due to a $1.5 million decrease in revenues from MDC deployments. In 2022 we were fulfilling the backlog of MDC deployments we had accumulated during the COVID pandemic, and due to a combination of lower demand and component shortages, the volume of MDC activity has decreased since late 2022.

On a year-to-date basis, for the nine-month period ended September 30, 2023, our total revenue of $30.0 million has increased by $10.3 million or 52% compared to the first nine months of 2022 when we recorded revenue of $19.7 million. This was driven by a $13.7 million increase in revenues from our systems integration segment attributable to a 31% increase in integration services and $12.1 million increase in revenues from procurement and reseller activities. This was offset by a $3.4 million decrease in our facilities revenues as the number of MDC deployments decreased compared to 2022.

Although we have seen an improvement in recent quarters in the supply chain constraints that prevented our partners and customers from delivering all of the products needed for us to complete and perform integration services, we are still being impacted by ongoing supply issues. These supply chain disruptions cause delays in the timing of systems integration and MDC deployment revenue for us as we await delivery of required components, and our vendors and partners expect these supply-chain issues to continue for at least the next several quarters.

Our reseller and procurement revenues involve us procuring third-party hardware, software and services on our customers’ behalf that are then typically used in our integrated services as we integrate those 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 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 an increase in volume of reseller and procurement business during the third quarter of 2023 compared to 2022, and our total revenues from reseller and procurement services was approximately $5.4 million in 2023 compared to $3.1 million in the third quarter of 2022. For the nine-month period ended September 30, 2023, our total revenues from reseller and procurement business was approximately $17.7 million, up 216% or $12.1 million from $5.6 million in the comparable period of 2022.

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 68% for the three-month period ended September 30, 2023 compared to 66% for the third quarter of 2022. This increase from the third quarter of 2022 reflects higher costs, including labor costs, in our integration business compared to the prior year and the impact of higher reseller and procurement activities. Absent the reseller business, the profit margin from our core integration and maintenance services was 34% in the third quarter of 2023 compared to 41% in the third quarter of 2022.

For the nine-month period ended September 30, 2023, our cost of revenue as a percentage of revenue was 74%. This compares to 64% in the comparable period of 2022. This increase is primarily due to the higher proportion of our total revenue that is from procurement and reseller services in 2023.

The level of expected revenue from our reseller services 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 reseller services is higher than cost of revenue for our integration and maintenance services.

Since we earn higher profits when using our own labor services, we expect gross margins to improve when our labor services mix increases relative to the use of subcontracted labor 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 improves our overall profitability by increasing income, broadening our revenue base and generating a favorable return on invested capital. As we increase the level of IT 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 three-month period ended September 30, 2023 was 32% compared to a gross profit margin of 34% in the third quarter of 2022. This decrease in margin as a percentage of revenues compared to the third quarter of 2022 was primarily attributable to an increase in costs, particularly labor costs, in our integration business and from the higher percentage of our total revenue that came from procurement and reseller services. As the percentage of total revenue from procurement and reseller services increases, our gross margin will decrease as the cost of sales is higher for this revenue than our traditional integration and facilities revenues. The growth in our total revenues compared to 2022 allowed us to increase our overall gross profit by 2%, to $2.8 million in the third quarter of 2023 compared to the third quarter of 2022. The 52% increase in our total revenues for the first nine-months of 2023 compared to the first nine months of 2022 has allowed us to increase our gross profits by $0.7 million in 2023 compared to 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 three-month period ended September 30, 2023, our selling, general and administrative expenses increased by $217,000 or 12% compared to the third quarter of 2022 primarily due to higher compensation costs and from higher professional fees. For the nine-month period ended September 30, 2023, our selling, general and administrative expenses increased by $1.3 million or 25% compared to the first nine months of 2022, primarily due to higher compensation costs and selective new hires to drive customer demand.

Income (Loss) from Operations

For the three-month period ended September 30, 2023, we recorded operating income of $715,000. This compares to operating income of $871,000 that we had in the third quarter of 2022. For the nine-month period ended September 30, 2023, we recorded operating income of $1,025,000, compared to operating income of $1,637,000 that we recorded in the first nine months of 2022.

Interest expense, net

For the three-month period ended September 30, 2023, we recorded interest expense of $661,000. This compares to $263,000 in the three-month period ended September 30, 2022. The increase in interest expense was due to an increase in the value of transactions that were factored which was approximately $61.4 million in the quarter ended September 30, 2023, compared to an amount factored of $27.4 million in the third quarter of 2022. This increase in amounts factored was because of a higher number of agent-type transactions that were factored in our procurement and reseller business compared to 2022. For the nine-month period ended September 30, 2023, we recorded interest expense of $1,473,000, compared to $554,000 in the same period of 2022. The increase in interest expense was due to both an increase in interest rates in 2023 and an increase in the value of transactions that were factored which was approximately $109.9 million in the nine-month period ended September 30, 2023, compared to an amount factored of $53 million in the same period of 2022. This increase in amounts factored was because of a higher number of agent-type transactions that were factored. This increase in interest attributable to factoring was partially offset by 2023 not having any interest expense for related party debt which was extinguished in July 2022. We were also able to offset this increase in expense with $179,000 of interest income during the three-month period ended September 30, 2023 as we managed cash flows from reseller transactions and were able to invest surplus funds until required.

Net Income (Loss)

After net interest expense and income taxes we recorded net income of $209,000 or $0.01 per share for the three-month period ended September 30, 2023. This compares to net income of $605,000 or $0.03 per share for the three-month period ended September30, 2022. For the nine-month period ended September 30, 2023, we recorded a net loss of $262,000 or $(0.01) per share. This compares to net income of $1,068,000 or $0.05 per share that we recorded in the first nine-months of 2022.

LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity at September 30, 2023 are our cash and cash equivalents on hand, funds available to us under our revolving line of credit, vendor trade-credit and projected cash flows from operating activities.

As of September 30, 2023, the Company had an accumulated deficit of $66.6 million. We have recorded operating and net income in three of our four most recent quarters but have a history of annual operating and net losses over recent years which have been due, in part, to the effects of COVID-19 and related 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 programs, funds available under our bank revolving credit facility and trade credit extended to us by our vendors. 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 would 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 and procurement services. There can be no assurance as to the Company’s ability to scale its business operations on terms upon which additional financing may 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 related supply-chain constraints. Our quarterly results have been impacted during 2023 by transactions being delayed by our customers, but based on our outlook, we believe that we will be profitable in the next quarter and for the year ended December 31, 2023. 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 and meet our debt obligations 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.

At September 30, 2023 and December 31, 2022, we had cash and cash equivalents of $28.7 million and $20.4 million, respectively.

Significant Uses of Cash

Operating Activities:

Cash provided by operating activities was $8.6 million for the nine-month period ended September 30, 2023, compared to cash provided by operating activities of $3.6 million for the nine-month period ended June 30, 2022. This change was primarily attributable to the timing and financial impacts of our procurement and reseller services. The volume of procurement and reseller activities was higher at the end of our third quarter in 2023 compared to both the third quarter of 2022 and the end of fiscal 2022. At the end of this most recent quarter, we were able to be paid by our customers for a number of large procurement projects, but we had yet to recognize revenue or to pay our vendors for these same projects. This resulted in an increase of approximately $11 million in our deferred revenue and approximately $10 million in our outstanding accounts payable at September 2023 compared to September 2022, and our accounts receivable increased by approximately $4 million compared to September 2022 due to these reseller transactions. Compared to our financial year end 2022 balances, our deferred revenues have increased by $11 million and our receivables have increased by $4 million because of the higher level of reseller activities, driving the $8.3 million increase in cash during 2023. 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. However, due to timing it is possible to see fluctuations on a quarterly basis for reseller contracts in progress at the end of a particular reporting period. We believe that we will have adequate trade credit available to us to continue financing our reseller activities as we grow this business during 2023 and beyond. Otherwise, the change in cash provided by operating activities was primarily due to loss from operations.

Investing Activities:

Cash used in investing activities was $240,000 in the nine-month period ended September 30, 2023 which was primarily spent on leasehold improvements for our integration facility, compared to cash used in the same period of 2022 of $213,000 for purchases of property and equipment.

Financing Activities:

Cash used in financing activities was $33,000 in the nine-month period ended September 30, 2023, compared to cash used in financing activities of $1.7 million in the nine-month period ended September 30, 2022. The cash used in financing activities in 2023 was for the purchase of stock related to tax obligations around vesting of restricted stock by our employees. In 2022 we used $80,000 for tax obligations around restricted stock vesting and we received $31,000 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 used $2.045 million to repay all of the company’s outstanding long-term debt upon its maturity in July 2022.

Future Uses of Cash

Our business plans and our assumptions around the adequacy of our liquidity are based on estimates regarding future revenues and costs and our ability to secure sources of funding when needed. However, our revenues may not meet our expectations, or our costs may exceed our estimates. Further, our estimates may change, and future events or developments may also affect our estimates. Any of these factors may change our expectations of cash usage during 2023 or 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. 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 a new line of business or if we seek to acquire additional businesses as a way to increase the scale of our operations.

Off-Balance Sheet Arrangements

As of September 30, 2023 and December 31, 2022, we had no off -balance sheet arrangements.

Critical Accounting Policies and Pronouncements

There have been no material changes to our critical accounting policies and estimates as set forth in the Annual Report for the year ended December 31, 2022 on our consolidated financial statements and disclosures. See also Item 1. Financial Statements Note 1 – Significant Accounting Policies regarding Recent Accounting Pronouncements.

Our management performed an evaluation under the supervision and with the participation of our Chief Executive Officer (principal executive officer) and our Chief Financial Officer (principal financial officer) of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934, as amended) as of September 30, 2023. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, as of September 30, 2023, the Company’s disclosure controls and procedures were effective such that information relating to the Company required to be disclosed in the Company’s SEC reports (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (2) is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding financial disclosures.

Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting for the three-month period ended September 30, 2023 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting as such term is defined in Rule 13a-15 and 15d-15 of the Exchange Act of 1934, as amended.

We have disclosed under "Item 1A - Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2022, the risk factors that may materially affect our business, financial conditions or results of operations. Except as set forth below, there have been no material changes from the risk factors previously disclosed. You should carefully consider the risk factors set forth below and in the Annual Report on Form 10-K, and other information set forth elsewhere in this Quarterly Report on Form 10-Q. You should be aware that these risk factors and other information may not describe every risk facing the Company. In addition, risks and uncertainties not currently known to us or that we currently do not believe are material could also materially and adversely affect our business, financial condition or results of operations.

Our Contracts with the United States Government Could Be Adversely Affected by Budget Cuts or Government “Shutdowns.”

We have entered into contracts with agencies of the U.S. Government. These contracts depend upon annual funding commitments authorized by Congress. In a period of government budget cuts or other political events, such as a prolonged government shutdown, such contracts might not be re-authorized or might be temporarily suspended, adversely affecting our performance and financials.