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

The following discussion and analysis of our financial conditions and results of operations should be read together with our condensed consolidated financial statements and notes thereto included in Part I, Item 1, “Financial Statements,” of this Quarterly Report on Form 10-Q, and with the condensed consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2023. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods. Any forward-looking statements in this discussion and analysis should be read in conjunction with the information set forth in “Note Regarding Forward-Looking Statements” elsewhere herein. In this Quarterly Report, we sometimes refer to the three month period ended March 31, 2024 as the first quarter 2024, and to the three month period ended March 31, 2023 as the first quarter 2023.

Company Overview

We are a document services and software solutions company serving both the small-to-medium business and governmental sectors with their digital transformation and process automation initiatives. Our digital transformation products and services are provided through two reporting segments: Document Management and Document Conversion. Our Document Management segment consists primarily of solutions involving our software platform, allowing customers to capture and manage their documents across operations such as scanned hard-copy documents and digital documents including those from Microsoft Office 365, digital images, audio, video and emails. Our Document Conversion segment provides assistance to customers as a part of their overall document strategy to convert documents from one medium to another, predominantly paper to digital, including migration to our software solutions, as well as micrographics conversions and long-term storage and retrieval services. Our solutions create value for customers by making it easy to connect business-critical documents to the people who need them by making those documents easy to find and access, while also being secure and compliant with the customers’ audit requirements. Solutions are sold both directly to end-users and through resellers.

Our customers use our software by one of two methods: purchasing our software and installing it onto their own equipment, which we refer to as a “premise” model, or licensing and accessing our platform via the Internet, which we refer to as a “software as a service” or “SaaS” model and also as a “cloud-based” model. Licensing of our software through our SaaS model has become increasingly popular among our customers, especially in light of the increased deployment of remote workforce policies, and is a key ingredient in our revenue growth strategy. Our SaaS products are hosted with Amazon Web Services, Expedient, and Corespace, providing our customers with reliable hosting services that we believe are consistent with industry best practices in data security and performance.

We operate a U.S.-based business with concentrated sales to the State of Michigan for our Document Conversion segment, complemented by our diverse set of document management software solutions and services. We hold or compete for leading positions regionally in select markets and attribute this leadership to several factors including the strength of our brand name and reputation, our comprehensive offering of innovative solutions, and the quality of our service support. Net growth in sales of software as a service in recent years reflects market demand for these solutions over traditional sales of on-premise software. We expect to continue to benefit from our select niche leadership market positions, innovative product offerings, growing customer base, and the impact of our sales and marketing programs. Examples of these programs include identifying and investing in growth and expanded market penetration opportunities, more effective products and services pricing strategies, demonstrating superior value to customers, increasing our sales force effectiveness through improved guidance and measurement, and continuing to optimize our lead generation and lead nurturing processes.

For further information about our consolidated revenue and earnings, please see our condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report.

How We Evaluate our Business Performance and Opportunities

There has been no material change during the first quarter 2024 to the major qualitative and quantitative factors we consider in the evaluation of our operating results as set forth in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — How We Evaluate our Business Performance and Opportunities” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2023.

Executive Overview of Results

Revenues were up $320,251, or 7.6%, primarily driven by software as a service and professional services more than offsetting expected weakness in storage and retrieval and sales of direct premise software. In expenses, we recorded $397,901 in stock compensation expense related to our restricted stock awards to employees, without which our operating expenses (excluding cost of revenues) would have increased 7.4% year over year.

Below are our key financial results for the first quarter 2024 (consolidated unless otherwise noted):

• Revenues were $4,507,084, representing revenue growth of 7.6% year over year.
• Cost of revenues was $1,607,440, an increase of 4.3% year over year.
• Operating expenses (excluding cost of revenues) were $2,934,124, an increase of 24.2% year over year. This amount includes a 2024 stock compensation expense of $397,901 related to restricted stock awards to employees.
• Loss from operations was $34,480, compared to income from operations $283,999 in the first quarter 2023.
• Net loss was $174,714 with basic and diluted net loss per share of $0.04, compared to net income of $112,563 with basic and diluted net income per share of $0.03 in the first quarter 2023.
• Q1 2024 included $397,901 of stock compensation expense related to our restricted stock awards to employees.
• Net cash provided by operating activities was $611,766, compared to $174,357 used in operations in the first quarter 2023.
• Capital expenditures were $127,932 including capitalized software costs of $109,621, compared to $134,569 in the first quarter 2023, including capitalized software costs of $112,208.
• As of March 31, 2024, we had 180 employees, including 36 part-time employees, compared to 167 employees as of March 31, 2023.

Financial Impact of Current Economic Conditions

Our overall performance depends on economic conditions, including the current inflationary environment, increased interest rates, and slowing global growth rates.

Employee wages, our largest expense, have recently increased due to wage inflation. These increased labor costs have slightly decreased our profit margin over 2023 and continuing into the first quarter of 2024, but we continue to mitigate this by appropriately increasing customer renewal rates whenever we have the contractual ability to do so. We anticipate that the inflationary effect on our wages has stabilized.

Other volatility, particularly from global supply chain disruptions, has had and are expected to continue to have a minimal impact on us as we consume relatively little in raw materials. A global recession may affect our customers’ and potential customers’ budgets for technology procurement, but as of the date of this report, we have not experienced diminished customer demand due to adverse economic conditions. Absent global economic disruptions, and based on the current trend of our business operations and our continued focus on strategic initiatives to grow our customer base, we believe in the strength of our brand and that our focus on our strategic priorities will deliver consistent growth.

Uncertainties, Trends, and Risks that can cause Fluctuations in our Operating Results

Our operating results have fluctuated significantly in the past and are expected to continue to fluctuate in the future due to a variety of factors, in addition to economic conditions, that are discussed in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Uncertainties, Trends, and Risks that can cause Fluctuations in our Operating Results” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2023. Due to all these factors and the other risks discussed in Part II, Item 1 of this Quarterly Report, and Part I, Item IA, “Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2023, our past results of operations should not be relied upon as an indication of our future performance. Comparisons of our operating results with prior periods is not necessarily meaningful or indicative of future performance.

Reportable Segments

We have two reportable segments: Document Management and Document Conversion. These reportable segments are discussed above under “Company Overview.”

Results of Operations

Revenues

The following table sets forth our revenues by reportable segment for the periods indicated:

The following table sets forth our revenues by revenue source for the periods indicated:

The following tables sets forth our revenues by revenue source and segment for the periods indicated:

Our total revenues in the first quarter 2024 increased by $320,251, or 7.6%, over our first quarter 2023 revenues, driven primarily by software as a service, which grew 13.5% year over year for the first quarter 2024. Our strong professional services, which grew 7.8%, also contributed. Growth was partially offset by continued softer demand for the transactional portion of our storage and retrieval services from a significant customer in the home mortgage lending industry, which decreased 9.1% year over year.

Software as a Service Revenues

We provide access to our software solutions as a service, accessible through the internet. Our customers typically enter into our software as a service agreement for periods of one year or more. Under these agreements, we generally provide access to the applicable software, data storage and related customer assistance and support. Revenues from the sale of software as a service, which are reported as part of our Document Management segment increased by $166,721, or 13.5% in the first quarter 2024 compared to 2023. This increase was primarily the result of new cloud-based solution sales, as well as expanded data storage, user seats, and hosting fees for existing customers.

Professional Services Revenues

Professional services revenues primarily consist of revenues from document scanning and conversion services, plus consulting, discovery, training, and advisory services to assist customers with document management needs. These revenues include arrangements that do not involve the sale of software. Of our $2,479,678 in professional services revenues during the first quarter 2024, $2,428,173 was derived from our Document Conversion operations and $51,505 was derived from our Document Management operations. Our overall professional services revenues increased by $180,389, or 7.8%, in the first quarter 2024 compared to 2023. This increase is the result of as strong pipeline in our Document Conversion segment, along with realized price increases in late 2023. However, we believe that our largest customer intends to renegotiate, and accordingly reduce, our pricing on a significant portion of our work for this customer, which could have a significant adverse impact on our future professional services revenues as well as our overall revenues, margins, net income and cash flows beginning later this year.

Costs of Revenues and Gross Profits

The following table sets forth our cost of revenues by reportable segment for the periods indicated:

The following table sets forth our cost of revenues, by revenue source, for the periods indicated:

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The following tables sets forth our cost of revenues by revenue source and segment for the periods indicated:

Our total cost of revenues during the first quarter 2024 increased by $66,446 or 4.3%, over 2023. Our cost of revenues for our Document Management segment decreased by $43,586, or 14.2%, primarily due to scale and efficiencies. Our cost of revenues for our Document Conversion segment increased by $110,042, or 8.9%, in the first quarter 2024 compared to 2023 primarily due to the increased demand, resulting in higher revenues and more labor to complete projects, as well as wage increases.

Our overall gross profit increased to 64.3% in the first quarter 2024 from 63.2% in 2023. The increase in the mix of software as a service revenue was the principal driver of the increase, due to the addition of Yellow Folder and overall strong margins in the Document Management segment, partially offset by margin erosion in the Document Conversion segment, driven by reduced margins in the storage and retrieval services, as well as wage increases.

Cost of Software as a Service

Cost of software as a service, or SaaS, consists primarily of technical support personnel, hosting services, and related costs. Cost of software as a service during the first quarter 2024 decreased by $4,648, or 2.1%, from the first quarter 2023. This decrease in the cost of SaaS was the result of efficiencies in support, including reduced support call volume, as well as some benefits from scale. Our gross margin in the first quarter increased to 84.6% compared to 82.2% in 2023.

Cost of Professional Services

Cost of professional services consists primarily of compensation for employees performing the document conversion services, compensation of our software engineers and implementation consultants when working on billable customer projects, and related third-party costs. Cost of professional services increased in the first quarter 2024 by $96,947, or 8.2%, over 2023, primarily due to increased staffing levels in our Document Conversion segment, to support our corresponding increased revenues, as well as wage increases. Consolidated, our gross margin for professional services decreased to 48.2% during the first quarter 2024 compared to 48.4% in 2023. Gross margins related to consulting services in Document Management and digital transformation services in Document Conversion may vary widely, depending upon the nature of the project and the amount of labor required to complete a project.

Operating Expenses

The following table sets forth our operating expenses for the periods indicated:

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General and Administrative Expenses

General and administrative expenses increased in the first quarter 2024 $573,882 or 36.9%, primarily related to $397,901 in expense related to our restricted stock award grant to employees first quarter 2024. Excluding the restricted stock award expense, total expenses increased by $175,981, or 11.3%, over 2023, related to investments in order to scale, such as development, finance, and our SOC2 process, as well as wage increases and infrastructure investments such as our internal ERP system upgrade from QuickBooks to NetSuite. These increases were reflected in both our Document Management segment, in which our general and administrative expenses increased to $1,145,031 in first quarter 2024 from $800,729 in 2023, and also in our Document Conversion segment, in which our general and administrative expenses increased to $983,462 in first quarter 2024 from $753,882 in 2023.

Sales and Marketing Expenses

Sales and marketing expenses during the first quarter 2024 decreased by $37,890, or 6.5%, from the first quarter 2023, principally related to an open position, as well as normal fluctuations in commissions expense.

Depreciation and Amortization

Depreciation and amortization during the first quarter 2024 increased by $36,292, or 15.9%, over the first quarter 2023 primarily as a result of increased amortization of capitalized software costs.

Other Items of Income and Expense

Interest Expense, Net

Interest expense was $140,234 during the first quarter 2024, net of $9,296 of interest income, as compared with $171,436 during the first quarter 2023, representing a decrease of $31,202 or 18.2%. The decrease resulted from reduced interest resulting from principal repayment of the 2020 Notes on February 28, 2023 and August 31, 2023. The 2022 Notes principal prepayment of $500,000 on March 30, 2024 had a negligible impact on interest expense in the first quarter 2024.

Liquidity and Capital Resources

We have financed our operations primarily through a combination of cash on hand, cash generated from operations, borrowings from third parties and related parties, and proceeds from private sales of equity. Since 2012, we have raised a net total of approximately $24.0 million in cash through issuances of debt and equity securities, net of $2.5 million in debt repayments. As of March 31, 2024, we had approximately $1.2 million in cash and cash equivalents, net working capital of $0.2 million, and an accumulated deficit of $21.3 million. In March 2024, we prepaid $0.5 million in principal of the 2022 Notes.

In 2024 and 2023, we engaged in several actions that significantly improved our liquidity and cash flows, including (i) effective October 1, 2023 through September 30, 2024, securing a renewal contract with our largest customer, containing an estimated net rate increase for all non-fixed pricing projects of approximately 21%, compared to the current rates in effect for the contract period commencing June 1, 2018, and (ii) on March 13, 2024, we agreed with the note holders to amend the Unrelated Notes and Related Notes to extend the maturity date to December 31, 2025, for $1,519,500 of the remaining $2,364,500 in 2022 Unrelated Notes and all $600,000 of the 2022 Related Notes. However, we believe that our largest customer intends to renegotiate our pricing on a significant portion of our work this customer, which could have an adverse impact on our overall revenues, cash flows, liquidity and capital resources.

Our existing debt as of March 31, 2024 is comprised of approximately $0.3 million due March 30, 2025 and approximately $2.1 million due December 31, 2025. Our operating cash flow alone may be insufficient to meet the debt obligations in full in 2025. We believe we could seek additional debt or equity financing on acceptable terms. We believe that our balance sheet and financial statements would support a full or partial refinancing or other appropriate modification of the current promissory notes, such as an extension or conversion to equity. We are confident in our ability to prudently manage our current debt on terms acceptable to us.

Our ability to meet our capital needs in the short term will depend on many factors, including maintaining and enhancing our operating cash flow and successfully retaining and growing our client base in the midst of global inflation and general economic uncertainty.

Based on our current plans and assumptions, we believe our capital resources, including our cash and cash equivalents, along with funds expected to be generated from our operations and potential financing options, will be sufficient to meet our anticipated cash needs arising in the ordinary course of business for at least the next 12 months, including to satisfy our expected working capital needs and capital and debt service commitments.

Our ability to meet our capital needs further into the future will depend primarily on strategically managing the business and successfully retaining our client base.

Indebtedness

As of March 31, 2024, our outstanding long-term indebtedness consisted of the 2022 Notes issued to accredited investors on April 1, 2022, with an aggregate outstanding principal balance of $2,464,500 and accrued interest of $0.

See Note 7 and Note 8 to our condensed consolidated financial statements included in Part 1, Item 1 of this Quarterly Report for further information on the 2022 notes.

Capital Expenditures

There were no material commitments for capital expenditures at March 31, 2024.

Cash Provided by and Used in Operating Activities

Net cash provided by operating activities during the first quarter 2024 was $611,766, primarily attributable to the net income adjusted for non-cash expenses of $770,617, an increase in operating assets of $40,447 and a decrease in operating liabilities of $56,310. Net cash used in operating activities during the first quarter 2023 was $174,357, primarily attributable to the net income adjusted for non-cash expenses of $434,066, an increase in operating assets of $383,039 and a decrease in operating liabilities of $337,947, primarily deferred revenues of $571,788.

Cash Used in Investing Activities

Net cash used in investing activities in the first quarter 2024 was $127,932, including $109,621 related to capitalized internal use software. Net cash used in investing activities in the first quarter 2023 was $134,569, including $112,208 related to capitalized internal use software.

Cash Used in Financing Activities

Net cash used in financing activities during 2024 amounted to $500,000 in repayment of notes payable, and $14,138 in the principal portion of finance lease liabilities. Net cash used in financing activities during 2023 amounted to $700,000 in earnout liability payments, $262,950 in repayment of notes payable, and $5,467 in the principal portion of a finance lease liability.

Critical Accounting Policies and Estimates

The preparation of our condensed consolidated financial statements in accordance GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses in the reporting period. We monitor and analyze these items for changes in facts and circumstances, and material changes in these estimates could occur in the future. We base our estimates and assumptions on current facts, historical experience and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the accrual of costs and expenses that are not readily apparent from other sources. Changes in estimates are reflected in reported results for the period in which they become known. The actual results experienced by us may differ materially from our estimates. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected.

Our critical accounting policies and estimates are set forth in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2023. There were no material changes to our critical accounting policies and estimates during the first quarter 2024.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) at the end of the period covered by this this Quarterly Report.

Based on this evaluation, we concluded that, as of March 31, 2024, our disclosure controls and procedures were effective to provide reasonable assurance that the information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

In designing and evaluating our disclosure controls and procedures, management recognizes that any controls system, no matter how well designed and operated, can provide only reasonable assurance of achieving its desired objectives. In addition, the design of disclosure controls and procedures must reflect resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the period covered by this Quarterly Report that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act).

We regularly review our internal control over financial reporting and, from time to time, we have made changes as we deemed appropriate to maintain and enhance the effectiveness of our internal controls over financial reporting, although these changes do not have a material effect on our overall internal control.

Our business and operating results are subject to many risks, uncertainties and other factors. If any of these risks were to occur, our business, affairs, assets, financial condition, results of operations, cash flows and prospects could be materially and adversely affected. There have been no material changes to the risk factors set forth in Part I, Item 1A, “Risk Factors,” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2023, except as follows:

Our largest customer may renegotiate the pricing on a significant portion of our work with the customer, which could materially and adversely affect our business, operating results and cash flows.

We believe that our largest customer, may seek a reduction on the pricing on a significant portion of our work with them, which could take effect beginning in the fourth quarter of 2024. While we have not received any formal or written notice from this customer as of the date of this Quarterly Report, in the event of any such renegotiation resulting in a reduction on the pricing of our work, we intend to take actions with respect to other work with this customer that could mitigate the overall effects of any such pricing reduction, although there is no assurance that we will be able to mitigate the effects of any pricing reduction or how effective any such mitigation will be. This customer may terminate any contract or any portion thereof without cause, so it has the ability to renegotiate pricing even outside any stated contract term. The loss of revenue from this customer due to any such pricing reduction could materially and adversely affect our business, operating results and cash flows.