Intellinetics, Inc.: Form 10-Q for the period ended Sep 30, 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 and nine-month periods ended September 30, 2024 as the third quarter 2024 and the nine-month period 2024 respectively, and to the three and nine-month periods ended September 30, 2023 as the third quarter 2023 and the nine-month period 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 nine-month period 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 for the third quarter and nine-month period 2024 compared to the same periods in 2023 by $341,196, or 8.0%, and $1,044,610, or 8.2%, respectively, 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. Operating expenses for the nine-month period 2024 increased 28.2%, primarily driven by share based compensation. In the nine month period 2024, we recorded $669,937 in share based compensation expense related to our restricted stock awards to employees and $245,023 in new stock option grants in the third quarter to employees and directors. The balance of our operating expenses (excluding cost of revenues) increased 15.6% year over year, primarily driven by intentional investments in sales and marketing to accelerate revenue growth and investments in general and administrative to build structure in order to better scale, as well as expanding our development team to bring product enhancements to market more swiftly.

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

• Revenues were $4,589,625, representing revenue growth of 8.0% year over year.
• Cost of revenues was $1,783,771, an increase of 8.6% year over year.
• Operating expenses (excluding cost of revenues) were $3,104,065, an increase of 37.3% year over year. This amount includes share based compensation expense of $136,019 related to restricted stock awards to employees and $245,023 related to stock option grants to employees and directors in the third quarter 2024.
• Loss from operations was $298,211, compared to income from operations of $345,555 in third quarter 2023.
• Net loss was $392,850 with basic and diluted net loss per share of $0.09, compared to net income of $209,331 in third quarter 2023 with basic and diluted net income per share of $0.05.
• Operating cash provided was $1,933,562, compared to $1,427,945 in third quarter 2023.
• Investing activities, including both capitalization of internal use software and purchases of property and equipment, were $296,593, compared to $140,952 in third quarter 2023.

Below are our key financial results for the nine-month period 2024 (consolidated unless otherwise noted):

• Revenues were $13,738,302, representing revenue growth of 8.2% year over year.
• Cost of revenues was $5,029,825, an increase of 3.7% year over year.
• Operating expenses (excluding cost of revenues) were $8,869,062, an increase of 28.2% year over year. This amount includes share based compensation expense of $669,937 related to restricted stock awards to employees and $245,023 related to stock option grants to employees and directors the nine-month period 2024.

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• Loss from operations was $160,585, compared to income from operations of $925,942 for the nine-month period 2023.
• Net loss was $492,514 with basic and diluted net loss per share of $0.12, compared to net income of $457,628 with basic and diluted net income per share of $0.11 and $0.10, respectively, for the nine-month period 2023.
• Net cash provided by operating activities was $3,652,417, compared to $1,128,314 for the nine-month period 2023.
• Investing activities, including both capitalization of internal use software and purchases of property and equipment, were $695,359, compared to $432,053 for the nine-month period 2023.
• As of September 30, 2024, we had 199 employees, including 32 part-time employees, compared to 165 employees, including 29 part-time employees, as of September 30, 2023.

Financial Impact of Current Economic Conditions

Our overall performance depends on economic conditions, and our continuing growth will be due in part to continued growth in the US economy and continued stability of state and local governmental spending in the US. Our performance will also continue to be affected by uncertainty in the inflationary environment and uncertainty in interest rates, as well as slowing-to-modest global growth rates.

Employee wages, our largest expense, have recently increased due to wage inflation. These increased labor costs have been mitigated by appropriately increasing customer renewal rates whenever we have the contractual ability to do so, as well as improved margins from growth in the software as a service revenue line. We anticipate that the inflationary effect on our wages has stabilized.

Other volatility, particularly from global supply chain disruptions, has had and is expected to continue to have a minimal impact on us as we consume relatively little in raw materials. Any macroeconomic downturn could affect our customers’ and potential customers’ budgets for technology procurement. However, absent 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 Part I, Item IA, “Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2023, and Part II, Item IA, “Risk Factors” of our Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2024 filed on May 14, 2024, 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 table sets forth our revenues by revenue source and segment for the periods indicated:

Revenues were up for the third quarter and nine-month period 2024 by $341,196, or 8.0%, and $1,044,610, or 8.2%, respectively, primarily driven by software as a service and professional services in the Document Conversion segment more than offsetting weakness in storage and retrieval, which is expected to continue in the near term, and normal volatility in sales of direct premise software.

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 $110,197, or 8.5%, in the third quarter 2024 compared to the third quarter 2023 and increased by $399,591, or 10.5% in the nine-month period 2024 compared to the nine-month period 2023. This increase was primarily the result of new cloud-based solution sales, primarily our IntelliCloud Payables Automation Solution, as well as expanded data storage, user seats, and hosting fees for existing customers. Those growth areas were partially offset by weakness in the YellowFolder growth in K-12, which was impacted by higher than normal churn rate in those 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 professional services revenues during the third quarter 2024 and nine-month period 2024, $2,456,456 and $7,457,389, respectively, were derived from our Document Conversion operations and $143,774 and $284,877, respectively, were derived from our Document Management operations. Our overall professional services revenues increased by $267,140, or 11.5%, in the third quarter 2024 compared to the third quarter 2023 and increased by $811,571, or 11.7%, in the nine-month period 2024 compared to the nine-month period 2023. This increase is the result of a significant project in our Document Conversion segment, along with realized price increases in late 2023, more than offsetting fewer projects in our Document Management segment, which can be more volatile with its significantly smaller volumes. However, we believe that our largest Document Conversion 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 next 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:

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

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Our total cost of revenues during the third quarter 2024 increased by $140,933, or 8.6%, over third quarter 2023 and increased by $177,996, or 3.7%, during the nine-month period 2024 over the nine-month period 2023. Our cost of revenues for our Document Management segment decreased by $13,320, or 4.7%, in the third quarter 2024 compared to the third quarter 2023 and decreased $137,489, or 15.1%, in the nine-month period 2024 compared to the nine-month period 2023 following the reduced volume in sales of software and professional services in that segment. Our cost of revenues for our Document Conversion segment increased by $154,253, or 11.3%, in the third quarter 2024 compared to the third quarter 2023 and increased by $315,485, or 8.0%, during the nine-month period 2024 compared to the nine-month period 2023 due to the staffing ramp up to accommodate more work volume, as well as a higher cost project mix in the third quarter 2024.

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Our overall gross profit decreased to 61.1% in the third quarter 2024 from 61.3% in the third quarter 2023, and increased to 63.4% for the nine-month period 2024 from 61.8% for the nine-month period 2023. The revenue mix between segments did not shift significantly, leading to stability in margins. Price increases in the Document Conversion segment offset a less profitable project mix in professional services within that segment, and margins were further bolstered by a strong performance leading to a more profitable project mix in Document Management professional services.

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 third quarter 2024 increased by $28,819, or 14.4%, from the third quarter 2023 and decreased by $16,625, or 2.4%, during the nine-month period 2024 over the nine-month period 2023. While our cost to support SaaS is generally stable and consistent, in the third quarter 2024 we hired two additional personnel, a help desk support and an implementations project manager, in order to meet growing demand. Our gross margin in the third quarter 2024 decreased to 83.7% compared to 84.5% in the third quarter 2023 and increased to 84.3% in the nine-month period 2024 compared to 82.2% during the nine-month period 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 and related third-party costs. Cost of professional services during the third quarter 2024 increased by $92,715, or 6.9%, over the third quarter 2023 and increased in the nine-month period 2024 by $226,862, or 5.9%, over the nine-month period 2023, primarily due to growing the Document Conversion staff to process the growing revenues. Our gross margins in professional services increased to 45.0% in the third quarter 2024 compared to 42.6% in the third quarter 2023 and increased to 47.6% during the nine-month period 2024 compared to 44.7% in the nine-month period 2023. Price increases in the Document Conversion segment offset a less profitable project mix in professional services within that segment in the third quarter 2024, and was strengthened by an overall solid project mix in the segment for the nine month period 2024. Gross margins related to professional services projects may vary widely, depending upon the nature of the digital conversion or consulting project and the amount of labor it takes to complete a project.

Operating Expenses

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

General and Administrative Expenses

General and administrative expenses during the third quarter 2024 increased by $597,833, or 39.4%, over the third quarter 2023, and increased in the nine-month period 2024 by $1,635,572, or 35.3%, over the nine-month period 2023, primarily related to new share based compensation expense of $381,041 and $914,960, respectively, attributable to awards of restricted stock and stock options during 2024. The nine-month period 2024 amount of $914,960 of share based compensation expense for 2024 stock awards is comprised of $669,937 related to restricted stock awards to employees and $245,023 related to stock option grants to employees and directors, as described in the following table:

Excluding the share based compensation expense, total general and administrative expenses increased by $216,792, or 14.3% in the third quarter 2024 over 2023 and $1,038,181, or 15.0% in the nine-month period 2024 over 2023, related to investments made in order to scale, such as development, finance, and our SOC2 process, as well as wage increases. These increases in investments were reflected in both our reportable segments. Our Document Management segment, which includes the share based compensation expense, reported a general and administrative expenses of $1,189,789 and $3,539,330 in the third quarter 2024 and the nine-month period 2024, respectively, from $794,177 and $2,392,023 in the third quarter 2023 and the nine-month period 2023, respectively. In our Document Conversion segment, our general and administrative expenses increased to $924,053 and $2,728,801, and $721,832 and $2,240,536, in the third quarter and nine-month period 2024 and 2023, respectively.

Sales and Marketing Expenses

Sales and marketing expenses during the third quarter 2024 increased by $206,211, or 41.6%, over the third quarter 2023 and increased by $206,457, or 13.2%, during the nine-month period 2024 compared to the nine-month period 2023. The increases were primarily driven by the expansion of our sales team as part of our investments intended to accelerate our sales. Additionally, these increases resulted from an increased focus on our marketing efforts, such as an increase in our marketing expense on select campaigns and increased travel and trade show materials and attendance.

Depreciation and Amortization

Depreciation and amortization during the third quarter 2024 increased by $39,985, or 16.1%, over the third quarter 2023 and increased by $111,112, or 15.5%, during the nine-month period 2024 over the nine-month period 2023 primarily as a result of increased amortization of capitalized software costs.

Other Items of Income and Expense

Interest Expense, Net

Interest expense decreased by $41,585, or 30.5%, in the third quarter 2024 as compared to the third quarter 2023, and decreased by $136,385, or 29.1% during the nine-month period 2024 as compared to nine-month period 2023. The decrease resulted from reduced interest resulting from principal repayments as follows: the 2020 Notes principal payments of $263,000 on February 28, 2023 and $717,500 on August 31, 2023, and the 2022 Notes principal repayments of $500,000 on March 30, 2024, $325,000 on June 30, 2024 and $800,000 on August 30, 2024. The reduced interest on lower principal balances year over year was partially offset by accelerating amortization of debt issue costs corresponding with the prepaid notes principal.

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 $22.9 million in cash through issuances of debt and equity securities, net of $3.6 million in debt repayments. In March, June and August 2024, we prepaid an aggregate of $1.65 million of the principal balances of the 2022 Notes, respectively.

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 the remaining $807,331 in 2022 Unrelated Notes and $532,169 of the 2022 Related Notes. However, we believe that our largest customer intends to renegotiate our pricing on a significant portion of our work for this customer, which could have an adverse impact on our overall revenues, cash flows, liquidity and capital resources.

At September 30, 2024, we had $2.5 million in cash and cash equivalents, working capital deficit of $0.2 million, and long-term debt relating to our notes payable of approximately $1.3 million due December 31, 2025. 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 flow needs for at least the next 12 months, including to satisfy our expected working capital needs and our capital and debt service commitments over that period.

However, our future cash resources and capital requirements may vary materially from those now planned. For example, from time to time we evaluate opportunities to expand our current or to develop new products and services and technology or to acquire or invest in complementary businesses, which could increase our capital needs. 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 continuing uncertainty regarding inflation and economic growth, the impact of contract renegotiations with our largest customer, the timing of sales, the success of our new business partners expanding our product and service lines, the mix of products and services, unanticipated events over which we have no control increasing our operating costs or reducing our revenues beyond our current expectations, and other factors discussed in this Quarterly Report.

We believe we could seek additional debt or equity financing on acceptable terms. While we are confident in our ability to satisfy our current debt requirements, we also believe that our capital resources, business operations and financial results would allow us to seek a full or partial refinancing or other appropriate modification of the current notes payable, such as an extension or conversion to equity, if we deem necessary or desirable. However, our ability to obtain additional capital, or to modify our existing debt arrangements, when needed or desired, will depend on many factors, including general economic and market conditions, our operating performance and investor and lender sentiment, and thus cannot be assured.

Indebtedness

As of September 30, 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 $1,339,500 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 September 30, 2024.

Cash Provided by Operating Activities

Net cash provided by operating activities during the nine-month period 2024 was $3,652,417, primarily attributable to the net income adjusted for non-cash expenses of $2,203,699, a decrease in operating assets of $780,011 and an increase in operating liabilities of $1,161,221. Net cash provided by operating activities during the nine-month period 2023 was $1,128,314, primarily attributable to the net income adjusted for non-cash expenses of $1,312,276, an increase in operating assets of $1,037,575 and an increase in operating liabilities of $395,985.

Cash Used by Investing Activities

Net cash used in investing activities in the nine-month period 2024 was $695,359, including $302,396 in capitalized software and $203,900 in servers to replace end-of-life Yellow Folder software as a service servers. Net cash used in investing activities in the nine-month period 2023 was $432,053, including $348,051 in capitalized software.

Cash Used in and Provided by Financing Activities

Net cash used by financing activities during the nine-month period 2024 amounted to $1,625,000 in repayment of notes payable and $45,577 in the principal portion of a finance lease liability. Net cash used by financing activities during the nine-month period 2023 amounted to $700,000 in earnout liability payments, $980,450 in repayment of notes payable, and $23,167 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 have been no material changes to our critical accounting policies and estimates since our Annual Report on Form 10-K for the fiscal year ended December 31, 2023.

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 Quarterly Report.

Based on this evaluation, we concluded that, as of September 30, 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 set forth in Part II, Item IA, “Risk Factors,” of our Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2024, filed on May 14, 2024.