TSS, Inc.: Form 10-Q for the period ended Mar 31, 2024

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, 2023 included in our 2023 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 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 (MDCs), 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. Enterprise and data center operators are facing immense pressure to rapidly integrate and deploy the latest AI equipment and GPUs, and will need to adapt 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 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 business 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 OEM customer or a material decline in volume from such customer could have a material negative effect on our results.

Most of the components used in our systems integration business are consigned to us by our original equipment manufacturer (OEM) or its 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 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 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.

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 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 services, to help drive volume through the integration facility.

Revenues of $15.9 million for the three-month period ended March 31, 2024 represented an increase of $9.3 million or 142% compared to $6.6 million of revenue that we recorded in the first quarter of 2023. The increase was primarily driven by an increase in our procurement services where our revenues increased by $9.9 million compared to the first quarter of 2023, driving a total increase of $9.4 million in our systems integration segment. Revenues in our facilities segment decreased by $0.1 million compared to first quarter of 2023 where a $1.1 million decrease in revenues from deployment of modular data centers (MDC) was offset by a $1 million increase in revenue from annual maintenance contracts and revenues from refurbishment and refresh activities.

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 for different components. These supply chain disruptions cause delays in the timing of systems integration 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 procurement revenues involve 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 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 a substantial increase in the value of procurement transactions we completed in the first quarter of 2024 compared to the first quarter of 2023, including a large increase in agent-type transactions, that allowed us to increase revenue from procurement activities from $1.7 million in the first quarter of 2023 to $11.6 million in the first quarter of 2024.

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 83% for the three-month period ended March 31, 2024 compared to 74% for the first quarter of 2023. This increase from the first quarter of 2023 reflects the higher proportion of our total revenue that is from procurement services in 2024 and higher costs, including labor costs, in our integration business compared to the prior year. Absent the reseller business, the profit margin from our core integration and maintenance services was 42% in the first quarter of 2024 compared to 30% in the first quarter of 2023.

Our procurement revenues were 73% of our total revenue in the first quarter of 2024, compared to 26% of our total revenue in the first quarter of 2023. 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 also 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 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 March 31, 2024 was 17% compared to a gross profit margin of 26% in the first quarter of 2023. This decrease in margin as a percentage of revenues compared to the first quarter of 2023 was primarily attributable to the higher percentage of our total revenue that came from procurement services. As the percentage of total revenue from procurement 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 2023 allowed us to increase our overall gross profit by $1 million or by 59%, to $2.7 million in the first quarter of 2024 compared to the first quarter of 2023.

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 March 31, 2024, our selling, general and administrative expenses increased by $127,000 or 6% compared to the first quarter of 2023 primarily due to higher compensation costs and from higher professional fees.

Operating Income (Loss)

Because of the growth in revenue and gross profits, and despite higher selling, general and administrative expenses, we were able to improve our operating income by $0.9 million or 138% compared to the first quarter of 2023. We recorded operating income of $253,00 during the first quarter of 2024, compared to an operating loss of $665,000 in the first quarter of 2023.

Interest expense, net

For the three-month period ended March 31, 2024, we recorded interest expense, net, of $228,000. This compares to $112,000 in the three-month period ended March 31, 2023. The increase in interest expense was due to an increase in the value of transactions that were factored which was approximately $22.1 million in the quarter ended March 31, 2024, compared to an amount factored of $10.9 million in the first quarter of 2023. This increase in amounts factored was because of a higher number of agent-type transactions that were factored in our procurement business compared to 2023. We were also able to offset this increase in interest expense with $100,000 of interest income during the three-month period ended March 31, 2024 as we managed cash flows from our procurement transactions and were able to invest surplus funds until required.

Net Income (Loss)

After net interest expense and income taxes we recorded a net income of $15,000 or $0.00 per share for the three-month period ended March 31, 2024. This compares to a net loss of $786,000 or $(0.04) per share for the three-month period ended March 31, 2023.

LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity at March 31, 2024 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 March 31, 2024, the Company had an accumulated deficit of $66.3 million. We have recorded operating and net income in our four most recent quarters but have a history of annual operating or 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 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 or 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. 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 March 31, 2024 and December 31, 2023, we had cash and cash equivalents of $14.4 million and $11.8 million, respectively.

Significant Uses of Cash

Operating Activities:

Cash provided by operating activities was $2.6 million for the three-month period ended March 31, 2024, compared to cash used in operating activities of $13.5 million for the three-month period ended March 31, 2023. This change in cash from operating activities was primarily attributable to the timing and financial impacts of our procurement services. The volume of procurement and reseller activities was higher at the end of our first quarter in 2024 compared to the first quarter of 2023 and the end of fiscal 2022. At the end of fiscal 2022 we were able to be paid by our customers for multiple large procurement projects, but we had yet to pay our 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 the vendors, and both our cash and accounts payable decreased by over $14 million. Changes in our receivables, inventory, accounts payable and deferred revenues during 2024 are attributable to the timing of procurement transactions. 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 2024 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 $39,000 in the three-month period ended March 31, 2024 which was primarily spent on leasehold improvements for our integration facility, compared to cash used in the same period of 2023 of $185,000 for purchases of property and equipment and leasehold improvements to expand and upgrade our integration facility.

Financing Activities:

Cash used in financing activities was $55,000 in the three-month period ended March 31, 2024, compared to $1 cash used in financing activities in the three-month period ended March 31, 2023. The cash used in financing activities in 2024 was for the purchase of stock related to tax obligations around vesting of restricted stock by our employees.

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 2024 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 March 31, 2024 and December 31, 2023, 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, 2023 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 March 31, 2024. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, as of March 31 2024, 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 March 31, 2024 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.