ONE STOP SYSTEMS, INC. You should read the following discussion and analysis of our financial condition and operating results together with our financial statements and related notes included elsewhere in this Quarterly Report. This discussion and analysis contains forward-looking statements based upon current beliefs, plans and expectations that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under "Risk Factors" or in other parts of this Quarterly Report.
Overview
OSS designs, manufactures and markets custom high speed computing systems for high performance computing (HPC) applications. These applications require ultra-fast processing power and the ability to quickly access and store ever-growing data sets. Systems are built using the latest GPU (graphical processing unit) and solid-state flash (memory) technologies. We are a niche provider of HPC custom servers, compute accelerators, and flash storage arrays. We deliver this technology to customers through sale of equipment and software to customers.
Bressner Technology GmbH , (Bressner) which was acquired onOctober 31, 2018 , provides standard and customized servers, panel PCs, and PCIe expansion systems. Bressner provides manufacturing, test, sales and marketing services for customers throughoutEurope .
Business Developments
OnAugust 31, 2018 , the Company acquiredConcept Development Inc. (CDI) located inIrvine, California for cash of$646,759 , and common stock of$4,194,673 . CDI specializes in the design and manufacture of custom high-performance computing systems for airborne in-flight entertainment systems. OnOctober 31, 2018 , the Company's wholly-owned German subsidiary,OSS GmbH , acquired 100% of the outstanding stock ofBressner Technology GmbH , aGermany limited liability company located nearMunich, Germany , from its principal owners for cash consideration of €4,725,000 (US$5,374,582 ) and stock consideration of 106,463 newly-issued restricted shares of the Company's common stock with an estimated fair value of$228,779 . OnDecember 31, 2018 , as a result of changes in the competitive landscape and downward pressure on pricing from large competitors, the members to the joint venture agreement agreed to begin the dissolution of SkyScale. InApril 2019 , certain members of the Company's Board of Directors executed definitive agreements to commit funds of up to$4,000,000 as a credit facility. The Company initially borrowed$1,150,000 from members of the Board of Directors and$350,000 from other shareholders for a two year period at an interest rate of 9.5% which requires the Company to make monthly principal and interest payment of$69,000 per month. In connection with these loans, the Company issued the note holders warrants to purchase shares of the Company's common stock equal to 10% of the original principal as a price per share equal to$2.15 per share. Accordingly, the Company issued to the note holders warrants to purchase 69,766 share of the Company's common stock. The relative fair value of the warrants issued was$60,158 . OnJune 26, 2019 , the Company filed a prospectus supplement relating to its common stock, par value$0.0001 per share, whereby under the prospectus supplement, the Company may offer and sell common stock having an aggregate offering price of up to$10,000,000 through Noble acting as the Company's agent. As such, the Company entered into an Equity Distribution Agreement with Noble dated as ofJune 26, 2019 . During the year endedDecember 31, 2019 , the Company sold 1,554,832 shares of common stock for total gross proceeds of$2,700,714 , which resulted in net proceeds to the Company of$2,488,148 , after deducting compensation payable to Noble of$55,127 and other expenses of$157,439 . 32 -------------------------------------------------------------------------------- OnFebruary 15, 2020 ,Steve Cooper was terminated as President and CEO ofOne Stop Systems, Inc. , and was replaced byDavid Raun who has become interim CEO of the Company. OnApril 24, 2020 , the Company consummated the initial closing of the offering (the "Initial Closing") under the Purchase Agreement and issued a Senior Secured Convertible Promissory Note with an aggregate of$3,000,000 to an institutional investor ("Initial Note"). The investors purchased the Initial Note for an aggregate purchase price of$2,700,000 , at the Initial Closing after a 10% original issue discount. The Initial Note bears no interest rate (except upon event of default) and, unless earlier converted or redeemed, will mature on the date that is the twenty-three (23) month anniversary of the last day from the Initial Closing. Our Business Model OSS designs, manufactures and sells specialized high performance computing (HPC) systems to customers world-wide. We differentiate ourselves from other suppliers of HPC solutions by utilizing our expertise in custom systems design and PCIe expansion to build systems with a greater quantity of PCIe add-in slots, GPU-based compute cards and/or flash cards. Our systems offer industry leading capabilities that occupy less physical space and power consumption.Concept Development, LLC focuses on engineering innovative products and solutions that enhances success for our clients in their design, manufacturing and life support cycle, with in-flight entertainment and connectivity of their processes enabling efficiencies and cost savings.Bressner Technology GmbH is a leading provider of industrial IT solutions with long standing international contact to assist in leveraging markets around the world to our customers benefit and give them early access to innovative new products. By continuing to forge strategic partnerships, we have significantly expanded our range of services. With this, we offer consistent product portfolio at all integration levels, superior product quality, efficient logistics and excellent support.
Components of Results of Operations
Revenue
OnJanuary 1, 2019 , the Company adopted the new accounting standard update ASC 606, Revenue from Contracts with Customers, which superseded nearly all existing revenue recognition guidance under GAAP, to all contracts using the modified retrospective method. For a more detailed description of our revenue recognition policies see the Company's consolidated financial statements Note 2 - Significant Accounting Policies.
Cost of revenue
Cost of revenue primarily consists of costs of materials, costs paid to third-party contract manufacturers (which may include the costs of components), and personnel costs associated with manufacturing and support operations. Personnel costs consist of wages, bonuses, benefits, stock-based compensation expenses. Cost of revenue also includes freight, allocated overhead costs and inventory write-offs and changes to our inventory and warranty reserves. Allocated overhead costs consist of certain facilities and utility costs. We expect cost of revenue to increase in absolute dollars, as product revenue increases.
Operating expenses
Our operating expenses consist of general and administrative, sales and marketing and research and development expenses. Salaries and personnel-related costs, benefits, and stock-based compensation expense, are the most significant components of each category of operating expenses. Operating expenses also include allocated overhead costs for facilities and utility costs.
General and Administrative - General and administrative expense consists primarily of employee compensation and related expenses for administrative functions including finance, legal, human resources and fees for third-party professional services, as well as allocated overhead.
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Sales and Marketing - Sales and marketing expense consists primarily of employee
compensation and related expenses, sales commissions, marketing programs, travel
and entertainment expenses as well as allocated overhead. Marketing programs
consist of advertising, tradeshows, events, corporate communications and
brand-building activities. We expect sales and marketing expenses to increase in
absolute dollars as we expand our sales force, increase marketing resources, and
further develop sales channels.
Research and Development - Research and development expense consists primarily
of employee compensation and related expenses, prototype expenses, depreciation
associated with assets acquired for research and development, third-party
engineering and contractor support costs, as well as allocated overhead. We
expect our research and development expenses to increase in absolute dollars as
we continue to invest in new and existing products.
Other Income (Expense), net
Other income consists of income received for activities outside of our core business. This includes interest income from investments and finance charges from customers. Other expense includes expenses for activities outside of our core business. These expenses consist primarily of loan amortization and interest expense. Provision for Income Taxes Provision for income taxes consists of estimated income taxes due tothe United States and German governments and to the state tax authorities in jurisdictions in which we conduct business, as well as the change in our deferred income tax assets and liabilities. Results of Operations Results of operations for the three month periods endedMarch 31, 2020 and 2019 include the following businesses: Magma, the purchase of the Ion assets from Western Digital,Concept Development LLC , andBressner Technology GmbH . The following tables set forth our results of operations for the three month periods endedMarch 31, 2020 and 2019 respectively, presented in dollars and as a percentage of net revenue. For the Three Months Ended March 31, 2020 2019 Revenue$ 13,359,637 $ 10,057,899 Cost of revenue 9,963,950 7,646,277 Gross profit 3,395,687 2,411,622 Operating expenses: General and administrative 2,514,065 2,043,934 Marketing and selling 1,189,351 1,137,932 Research and development 1,203,425 1,261,964 Total operating expenses 4,906,841 4,443,830 Loss from operations (1,511,154 ) (2,032,208 ) Other income (expense): Interest income 24,637 3,107 Interest expense (68,784 ) (6,268 ) Other income (expense), net (8,029 ) (11,271 ) Total other income (expense), net (52,176 ) (14,432 ) Loss before income taxes (1,563,330 ) (2,046,640 ) Benefit for income taxes (467,298 ) (1,101,911 ) Net loss attributable to common stockholders$ (1,096,032 ) $ (944,729 ) 34
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For the Three Months Ended March 31,
2020 2019
Revenue 100.0% 100.0%
Cost of revenue 74.6% 76.0%
Gross profit 25.4% 24.0%
Operating expenses:
General and administrative 18.8% 20.3%
Marketing and selling 8.9% 11.3%
Research and development 9.0% 12.5%
Total operating expenses 36.7% 44.2%
Loss from operations -11.3% -20.2%
Other income (expense):
Interest income 0.2% 0.0%
Interest expense -0.5% -0.1%
Other income (expense), net -0.1% -0.1%
Total other income (expense), net -0.4% -0.1%
Loss before income taxes -11.7% -20.3%
Benefit for income taxes -3.5% -11.0%
Net loss attributable to common stockholders -8.2% -9.4%
Non-GAAP Financial Measures
Adjusted EBITDA
We believe that the use of adjusted earnings before interest, taxes,
depreciation and amortization, or adjusted EBITDA, is helpful for an investor to
assess the performance of the Company. The Company defines adjusted EBITDA as
income (loss) attributable to common stockholders before interest, taxes,
depreciation, amortization, acquisition expenses, impairment of long-lived
assets, financing costs, fair value adjustments from purchase accounting,
stock-based compensation expense and expenses related to discontinued
operations.
Adjusted EBITDA is not a measurement of financial performance under generally
accepted accounting principles in the United States , or GAAP. Because of varying
available valuation methodologies, subjective assumptions and the variety of
equity instruments that can impact a company's non-cash operating expenses, we
believe that providing a non-GAAP financial measure that excludes non-cash and
non-recurring expenses allows for meaningful comparisons between our core
business operating results and those of other companies, as well as providing us
with an important tool for financial and operational decision making and for
evaluating our own core business operating results over different periods of
time.
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Our adjusted EBITDA measure may not provide information that is directly
comparable to that provided by other companies in our industry, as other
companies in our industry may calculate non-GAAP financial results differently,
particularly related to non-recurring, unusual items. Our adjusted EBITDA is not
a measurement of financial performance under GAAP, and should not be considered
as an alternative to operating income or as an indication of operating
performance or any other measure of performance derived in accordance with GAAP.
We do not consider adjusted EBITDA to be a substitute for, or superior to, the
information provided by GAAP financial results.
For The Three Months Ended March 31,
2020 2019
Net loss attributable to common stockholders $ (1,096,032 ) $ (944,729 )
Depreciation and amortization 395,825 464,727
Amortization of debt discount 7,520 -
Amortization of deferred gain (41,479 ) (16,479 )
Stock-based compensation expense 207,761 167,474
Interest expense 68,784 6,268
Interest income (24,637 ) (3,107 )
Acquisition expense - 3,975
Benefit for income taxes (467,298 ) (1,101,911 )
Adjusted EBITDA $ (949,556 ) $ (1,423,782 )
Adjusted EPS
Adjusted EPS excludes the impact of certain items and, therefore, has not been
calculated in accordance with GAAP. We believe that exclusion of certain
selected items assists in providing a more complete understanding of our
underlying results and trends and allows for comparability with our peer company
index and industry. We use this measure along with the corresponding GAAP
financial measures to manage our business and to evaluate our performance
compared to prior periods and the marketplace. The Company defines Non-GAAP
(loss) income attributable to common stockholders as (loss) or income before
amortization, stock-based compensation, expenses related to discontinued
operations, impairment of long-lived assets and non-recurring acquisition
costs. Adjusted EPS expresses adjusted (loss) income on a per share basis using
weighted average diluted shares outstanding.
Adjusted EPS is a non-GAAP financial measure and should not be considered in
isolation or as a substitute for financial information provided in accordance
with GAAP. These non-GAAP financial measures may not be computed in the same
manner as similarly titled measures used by other companies. We expect to
continue to incur expenses similar to the adjusted income from continuing
operations and adjusted EPS financial adjustments described above, and investors
should not infer from our presentation of these non-GAAP financial measures that
these costs are unusual, infrequent or non-recurring.
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The following table sets-forth Non-GAAP net loss attributable to common stockholders and basic and diluted earnings per share:
For The Three Months Ended March 31,
2020 2019
Net loss attributable to common stockholders $ (1,096,032 ) $ (944,729 )
Amortization of intangibles 174,525 349,419
Stock-based compensation expense 207,761 167,474
Non-GAAP net loss attributable to common stockholders $ (713,746 ) $ (427,836 )
Non-GAAP net loss per share attributable to common
stockholders:
Basic $ (0.04 ) $ (0.03 )
Diluted $ (0.04 ) $ (0.03 )
Weighted average common shares outstanding:
Basic 16,332,898 14,239,711
Diluted 16,332,898 14,239,711
Free Cash Flow
Free cash flow, a non-GAAP measure for reporting cash flow, is defined as cash
provided by or used in operating activities less capital expenditures for
property and equipment, which includes capitalized software development costs.
We believe free cash flow provides investors with an important perspective on
cash available for investments and acquisitions after making capital investments
required to support ongoing business operations and long-term value creation.
We believe that trends in our free cash flow can be valuable indicators of our
operating performance and liquidity.
Free cash flow is a non-GAAP financial measure and should not be considered in
isolation or as a substitute for financial information provided in accordance
with GAAP. This non-GAAP financial measure may not be computed in the same
manner as similarly titled measures used by other companies.
We expect to continue to incur expenditures similar to the free cash flow
adjustments described above, and investors should not infer from our
presentation of this non-GAAP financial measure that these expenditures reflect
all of our obligations which require cash. The following table reconciles cash
provided by or used in operating activities, the most directly comparable GAAP
financial measure, to free cash flow:
For the Three Months Ended
March 31, Change
Cash flow: 2020 2019
Cash used in operating activities $ (721,773 ) $ (200,017 ) $ (521,756 )
Capital expenditures (200,049 ) (803,243 ) 603,194
Free cash flow $ (921,822 ) $ (1,003,260 ) $ 81,438 Comparison of the three months ended
Revenues, cost of revenues and gross profit:
For the Three Months Ended March 31, 2020 For the Three Months Ended March 31, 2019
Gross Gross
Cost of Gross Margin Cost of Gross Margin
Entity: Revenue Revenue Profit % Revenue Revenue Profit %
OSS - (inclusive of
SkyScale) $ 7,818,278 $ (5,621,751 ) $ 2,196,527 28.1%
621,946 (499,158 ) 122,788 19.7% 299,454 (345,727 ) (46,273 ) -15.5%
Bressner Technology
GmbH 4,919,413 (3,843,041 ) 1,076,372 21.9% 4,528,359 (3,571,377 ) 956,982 21.1%
$ 13,359,637 $ (9,963,950 ) $ 3,395,687 25.4% $ 10,057,899 $ (7,646,277 ) $ 2,411,622 24.0%
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Revenue
For the three month period endedMarch 31, 2020 , total revenue increased$3,301,738 or 32.8%, as compared to the same period in 2019. The increase was primarily driven by revenue from OSS' core media and entertainment business and other products which provided an incremental$2,588,191 or 25.7 percentage points of the increase. Bressner contributed$391,054 or 3.9 percentage points and CDI contributed$322,493 or 3.2 percentage points of the total increase in revenue.
Cost of revenue and gross margin
Cost of revenue increased by$2,317,673 or 30.3%, for the three month period endedMarch 31, 2020 as compared to the same period in 2019. The increase in cost of revenue was primarily driven by cost of revenue from OSS' core business which contributed$1,892,578 or 24.7 percentage points of the increase. Bressner contributed$271,664 or 3.6 percentage points and CDI contributed$153,431 or 2.0 percentage points of the total increase in cost of revenue. The overall gross margin percentage increased from 24.0% for the three month period endedMarch 30, 2019 to 25.4% for the three month period endedMarch 31, 2020 , an increase of 1.4 percentage points. The gross margin for the core OSS business for the three month period endedMarch 31, 2020 was 28.1%, which was 0.6 percentage points less in comparison to the prior year period of 28.7%. The majority of the improvement in overall gross margin is attributable to CDI which improved margins from a negative contribution of (15.5%) to a favorable contribution of 19.7% in the current year. Bressner contributed gross margin at a rate of 21.9% as compared to 21.1% in the same year ago period.
Operating expenses
General and administrative expense
General and administrative expense increased$470,131 or 23.0 %, for the three month period endedMarch 31, 2020 as compared to same period in 2019. The increase in general and administrative expenses is primarily attributable to the accrual for severance benefits attributable to the termination of our former president and chief executive officer. Overall general and administrative expenses decreased as a percentage of revenue to 18.8% during the three month periods endedMarch 31, 2020 as compared to 20.3% during the same period in 2019.
Marketing and selling expense
Marketing and selling expense increased$51,418 or 4.5% during the three month periods endedMarch 31, 2020 as compared to the same period in 2019. The increase in marketing and selling expenses is primarily attributable to increased personnel costs. Marketing and selling expense decreased as a percentage of revenue to 8.9% during the three month period endedMarch 31, 2020 as compared to 11.3% during the same period in 2019.
Research and development expense
Research and development expense decreased by$58,539 or 4.6% during the three month period endedMarch 31, 2020 as compared to same period in 2019. The majority of the decrease is attributable to reductions of$110,942 in the activities of the core OSS business attributable to reductions in outside engineering and contract labor fees, and prototypes, and a reduction at Bressner of$8,982 . These reductions were offset by increases at CDI of$61,385 attributable to on-going projects. Overall, total research and development expense decreased as a percentage of revenue to 9.0% during the three month period endedMarch 31, 2020 as compared to 12.5% during the same period in 2019. 38
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Interest income
Interest income increased$21,530 for the three month period endedMarch 31 , 20209 as compared to same period in 2019. The increase is attributable to increased finance charges on outstanding accounts receivable balances from our largest customer in the media and entertainment industry.
Interest expense
Interest expense increased$62,516 for the three month period endedMarch 31, 2020 as compared to same period in 2019. OnApril 4, 2019 , the Company borrowed$1,500,000 from individuals and related parties at an annual interest rate of 9.5%, additionally, warrants of 10% of the value of the borrowing were also granted. The fair value of the warrants is amortized over the life of the loans and such costs are included as interest expense. The increase in increase expenses is mainly attributable to this increase in borrowings.
Other income (expense), net
Other income (expense), for the three month period endedMarch 31, 2020 resulted in a net decrease in other income and expense of$3,242 and compared to the same period in 2019.
Provision for income taxes / Income tax benefits
We have recorded an income tax benefit of$467,298 and$1,101,911 , respectively, for the three month periods endedMarch 31, 2020 and 2019. This benefit is attributable to projected annual taxable income for 2020 with a projected tax rate of 28.2%. The projected effective tax rate for the quarter differs from the statutory rate mainly due to permanent non-deductible goodwill amortization forBressner Technology GmbH , income from the Global Intangible Low-Taxed Income inclusion, as well as projecting federal, foreign and state tax liabilities for the year. In determining the periodic income tax expense, GAAP requires us to forecast our annual effective income tax rate ("AETR") for the yearsDecember 31, 2020 and 2019. Based on management's projections, the Company expects income tax benefits related to research and development credits and equity compensation benefits to exceed our pretax earnings in 2020 and 2019.
Liquidity and capital resources
Given our recent operating losses, the Company's primary sources of liquidity have been provided by (i) the Company'sFebruary 2018 initial public offering (net proceeds were approximately$16,100,000 ), (ii)March 2019 notes payable from members of the Board of Directors and others of$1,500,000 , (iii) theJune 2019 sale of 1,554,832 shares of the Company's common stock for net cash proceeds of$2,488,148 and (iv) theApril 24, 2020 sale of$3,000,000 of Senior Secured Convertible Promissory Notes issued at a 10% original issue discount. As ofMarch 31, 2020 , the Company's cash and cash equivalents were$3,038,006 and working capital of$11,938,554 . Cash and cash equivalents held by Bressner totaled$504,103 (USD) atMarch 31, 2020 , and Bressner's debt covenants do not permit the use of those funds by its parent company. During the three months endedMarch 31, 2020 , the Company experienced an operating loss of$1,511,154 with cash used in operating activities of$721,773 . Our largest customer who is engaged in the media and entertainment industry is having significant financial hardships attributable to the COVID-19 pandemic and as a result has been slow in paying its outstanding accounts receivables. The Company has formulated a plan whereby extended terms have been made available, and our customer is presently honoring those terms. The Company's revenue growth, inclusive of two acquisitions made in 2018, has resulted in growth of the Company as a whole, but has been offset by increased spending in all areas of operating expenses: general and administrative, marketing and selling, and research and development. 39 -------------------------------------------------------------------------------- The recent outbreak of the novel strain of coronavirus, or COVID-19, which has been declared by theWorld Health Organization to be a "public health emergency of international concern," has spread across the globe and is impacting worldwide economic activity. A public health pandemic, including COVID-19, poses the risk that we or our employees, contractors, suppliers, and other partners may be prevented from conducting business activities for an indefinite period of time, including due to shutdowns that may be requested or mandated by governmental authorities. While it is not possible at this time to estimate the impact that COVID-19 could have on our business, the continued spread of COVID-19 and the measures taken by the governments of countries affected could disrupt the supply chain and adversely impact our business, financial condition or results of operations. The COVID-19 outbreak and mitigation measures may also have an adverse impact on global economic conditions which could have an adverse effect on our business and financial condition. The extent to which the COVID-19 outbreak impacts our results will depend on future developments that are highly uncertain and cannot be predicted, including new information that may emerge concerning the severity of the virus and the actions to contain its impact. The Company's operations team is closely monitoring the potential impact to the Company's business, including its cash flows, supply chains, customers and employees. Though management has been successfully managing through the current known impacts, if the situation further deteriorates or the outbreak results in further restriction on both supply and demand factors, our cash flows, financial position and operating results for fiscal year 2020 and beyond will be negatively impacted. Neither the length of time nor the magnitude of the negative impacts can be presently determined.
Management's plans with respect to the above is to continue its efforts to
restructure the Company with the primary objectives of reducing costs,
conserving cash, strengthening margins, and improving company-wide
execution. Specific actions already implemented by management include the
deferral of certain executive and Board compensation payments, a freeze on
hiring and minimizing overtime, travel and entertainment, and contractor
costs. On
While management expects these actions to result in prospective cost reductions, management is also committed to securing debt and/or equity financing to ensure that liquidity will be sufficient to meet the Company's cash requirements through at least a period of the next twelve months. Management believes potential sources of liquidity include at least the following:
? In
has been drawn through
management expects that
available to the Company.
? In
and Exchange Commission which became effective on June 19, 2019 , and
allows the Company to offer up to $100,000,000 aggregate dollar amount
of shares of its common stock, preferred stock, debt securities,
warrants to purchase its common stock, preferred stock or debtsecurities, subscription rights to purchase its common stock, preferred
stock or debt securities andor units consisting of some or all of these
securities, in any combination, together or separately, in one of more
offerings, in amounts, at prices and on the terms that the Company will
determine at the time of the offering and which will be set forth in a
prospectus supplement and any related free writing prospectus.
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? On April 24, 2020 , the Company consummated the initial closing of the
offering (the "Initial Closing") under the Purchase Agreement and issued
a Senior Secured Convertible Promissory Note with an aggregate ofpurchased the Initial Note for an aggregate purchase price of
discount. The Initial Note bears no interest rate (except upon event of
default) and, unless earlier converted or redeemed, will mature on the
date that is the twenty-three (23) month anniversary of the last day
from the Initial Closing.
? On
(PPP) loan in the amount of
As a result of management's cost reduction plans, the Company's potential sources of liquidity and management's most recent cash flow forecasts, management believes that the Company has sufficient liquidity to satisfy its anticipated cash requirements for at least the next twelve months. However, there can be no assurance that management's cost reduction efforts will be effective, the forecasted cash flows will be achieved, or that external sources of financing, including the issuance of debt and/or equity securities, will be available at times and on terms acceptable to the Company, or at all. The following table summarizes our cash flows for the three month periods endedMarch 31, 2020 and 2019: For the Three Months Ended March 31, Cash flows: 2020 2019 Net cash used in operating activities $ (721,773 ) $
(200,017 )
Net cash used in investing activities $ (198,507 ) $
(802,193 )
Net cash used in financing activities $ (1,214,119 ) $
(817,272 ) Operating Activities During the three month period endedMarch 31, 2020 we used$721,773 in cash from operating activities, a decrease in cash of$521,756 when compared to the cash used in operating activities of$200,017 during the same period in 2019. The increase in cash used in operating activities was primarily a result of a reduction in working capital of$1,145,361 , an increase in net loss of$151,303 , which was offset by an increase in non-cash adjustments of$774,908 . Non-cash adjustments include increases of$977,611 comprised of deferred benefit for income taxes, warranty reserves, depreciation, and debt discount, inventory reserves and stock-based compensation expense. These increases were offset by$(202,703) in decreases in non-cash adjustments attributable to gain on disposal of property and equipment, provision for bad debt, amortization of deferred gain and amortization of intangibles.
Working capital decreased overall by
Our ability to generate cash from operations in future periods will depend in large part on our profitability, the rate and timing of collections of our accounts receivable, our inventory turns and our ability to manage other areas of working capital including accounts payable.
Investing Activities
During the three month period endedMarch 31, 2020 , we used cash of$198,507 in investing activities as compared to$802,193 used during the same period in 2019, a decrease of$603,686 . In the prior reporting period, the Company was expanding and remodeling its facility for increased capacity. Such costs were not incurred in the current period. Additionally, in the prior year, the Company was implementing phase I of its ERP system which included a team of external resources for which the costs were capitalized. Though phase II is currently in process, the implementation team is significantly smaller and as a result we are not incurring comparable costs. We do not anticipate any other significant purchases of equipment beyond that which is anticipated for use in the normal course of our core business activity. 41
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Financing Activities
During the three month period endedMarch 31, 2020 , we used$1,214,119 in financing activities as compared to the cash used of$817,272 during the same period in 2019. During the three month period endedMarch 31, 2020 , in addition to payments on term loans and outstanding lines of credit, the Company received proceeds of$57,000 through the exercise of stock options which was offset by a payment for taxes of$656,845 that was paid on behalf of those that exercised options and RSU's on a net cashless basis. For the three month period endedMarch 31, 2019 , the Company received proceeds from the exercise of options of$14 ,201and paid net$831,473 on the outstanding debt obligations.
Contractual obligations and commitments
The following table sets forth our non-cancellable contractual obligations as ofMarch 31, 2020 . Contractual Obligations: Total Less than 1 year 1-3 years 3-5 years More than 5 Years Notes payable$ 1,689,977 $ 1,622,316 $ 67,661 $ - Operating leases 1,740,468 635,693 972,442 132,333 - Total$ 3,430,445 $ 2,258,009 $ 1,040,103 $ 132,333 $ - We have made certain indemnities, under which the Company may be required to make payments to an indemnified party, in relation to certain transactions. We indemnify our directors, officers, employees and agents to the maximum extent permitted under the laws of theState of Delaware . In connection with our facilities leases, we indemnify our lessors for certain claims arising from the use of our facilities. The duration of the indemnities varies, and in many cases is indefinite. These indemnities do not provide for any limitation of the maximum potential future payments we could be obligated to make. Historically, we have not been obligated to make any payments for these obligations and no liabilities have been recorded for these indemnities.
Off balance sheet arrangements
Other than lease commitments incurred in the normal course of business and certain indemnification provisions, we do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets, or any obligation arising out of a material variable interest in an unconsolidated entity.
We do not have any majority-owned subsidiaries that are not consolidated in the financial statements. Additionally, we do not have an interest in, or relationships with, any special purpose entities.
Stockholder transactions
InApril 2019 , certain members of the Company's Board of Directors executed definitive agreements to commit funds of up to$4,000,000 as a credit facility. The Company initially borrowed$1,150,000 from members of the Board of Directors and$350,000 from other shareholders for a two year period at an interest rate of 9.5% which requires the Company to make monthly principal and interest payment of$69,000 per month. In connection with these loans, the Company issued the note holders warrants to purchase shares of the Company's common stock equal to 10% of the original principal at a price per share equal to$2.15 per share. Accordingly, the Company issued to the note holders warrants to purchase 69,766 shares of the Company's common stock. The relative fair value of the warrants issued was$60,158 .
Critical accounting policies and estimates
Our consolidated financial statements are prepared in accordance withU.S. generally accepted accounting principles (GAAP). The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. The critical accounting estimates, assumptions and judgments that we believe have the most significant impact on our consolidated financial statements are described below. 42
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Revenue Recognition OnJanuary 1, 2019 , the Company adopted the new accounting standard update ASC 606, Revenue from Contracts with Customers, which superseded nearly all existing revenue recognition guidance under GAAP, to all contracts using the modified retrospective method. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The Company's performance obligations are satisfied over time as work is performed or at a point in time. The majority of the Company's revenue is recognized at a point in time when products ship and control is transferred to the customer. The Company determines revenue recognition through the following steps: (1) identification of the contract with a customer; (2) identification of the performance obligations in the contract; (3) determination of the transaction price; (4) allocation of the transaction price to the performance obligations in the contract; and (5) recognition of revenue when, or as, a performance obligation is satisfied. The Company's contracts are executed through a combination of written agreements along with purchase orders with all customers including certain general terms and conditions. Generally, purchase orders entail products, quantities and prices, which define the performance obligations of each party and are approved and accepted by the Company. The Company's contracts with customers do not include extended payment terms. Payment terms vary by contract type and type of customer and generally range from 30 to 60 days from invoice. Additionally, taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer and deposited with the relevant government authority, are excluded from revenue. The transaction price is determined based on the consideration to which the Company will be entitled in exchange for transferring goods or services to the customer adjusted for estimated variable consideration, if any. Variable consideration may include discounts, rights of return, refunds, and other similar obligations. The Company allocates the transaction price to each distinct product and service based on its relative standalone selling price. The standalone selling price for products primarily involves the cost to produce the deliverable plus the anticipated margin and for services is estimated based on the Company's approved list price. In the normal course of business, the Company does not accept product returns unless the items are defective as manufactured. The Company establishes provisions for estimated returns and warranties. In addition, the Company does not typically provide customers with the right to a refund and does not transact for noncash consideration. Customer agreements include one vendor managed inventory program. The Company recognizes revenue under this arrangement when all of the following criteria are met: (i) the goods have been identified separately as belonging to the customer; (ii) the goods are ready for physical shipment to the customer; (iii) the Company does not have the ability to direct the goods to another customer; and (iv) the arrangement was requested by the customer and the customer has sufficiently explained a substantial business purpose for the arrangement. Management also considers whether the customer's custodial risks are insured and whether modifications to the Company's normal billing and credit terms were required. Revenues on certain fixed-price contracts where we provide engineering services, prototypes and completed products are recognized based upon percentage of completion or based upon milestones delivered that are provided during the period and compared to milestone goals to be provided over the entire contract. These services require that we perform significant, extensive and complex design, development, modification or implementation of our customers' systems. Performance will often extend over long periods of time, and our right to receive future payment depends on our future performance in accordance with the agreement. 43
-------------------------------------------------------------------------------- The percentage-of-completion methodology involves recognizing probable and reasonably estimable revenue using the percentage of services completed, on a current cumulative cost to estimated total cost basis, using a reasonably consistent profit margin over the performance period. Due to the long-term nature of these projects, developing the estimates of costs often requires significant judgment. Factors that must be considered in estimating the progress of work completed and ultimate cost of the projects include, but are not limited to, the availability of labor and labor productivity, the nature and complexity of the work to be performed and the impact of delayed performance. If changes occur in delivery, productivity or other factors used in developing the estimates of costs or revenues, we revise our cost and revenue estimates, which may result in increases or decreases in revenues and costs, and such revisions are reflected in earnings in the period in which the revision becomes known. On certain contracts with several of the Company's significant customers, the Company receives payments in advance of manufacturing. Advanced payments are recorded as deferred revenue until the revenue recognition criteria described above has been met. Related billings that are in excess of revenue earned are deferred and recorded as a liability on the consolidated balance sheet until the related services are provided. Stock-Based Compensation We measure and recognize compensation expense for all stock-based awards granted to our employees and other service providers, including stock options granted under the 2017 Plan and 2015 Stock Option Plan that was approved inDecember 2015 (the "2015 Plan"), based on the estimated fair value of the award. We use the Black-Scholes option pricing model to estimate the fair value of stock option awards granted under the 2017 Plan and 2015 Plan. We recognize the fair value of stock options granted under the 2017 Plan and 2015 Plan as stock-based compensation on a straight line basis over the requisite service period. We record expense net of anticipated forfeitures and adjust the annual expense based upon actual experience. Compensation cost for stock awards, which include restricted stock units ("RSUs") is measured at the fair value on the grant date and recognized as expense, net of estimated forfeitures, over the related service period. The fair value of stock awards is based on the quoted price of our common stock on the grant date less the present value of expected dividends not received during the vesting period. Our use of the Black-Scholes option pricing model requires the input of highly subjective assumptions, including the fair value of the underlying common stock, expected term of the option, expected volatility of the price of our common stock, risk-free interest rates and the expected dividend yield of our common stock. The assumptions used in our option pricing model represent management's best estimates. These estimates involve inherent uncertainties and the application of management's judgment. If factors change and different assumptions are used, our stock-based compensation expense could be materially different in the future.
These assumptions and estimates are as follows:
• Fair Value of Common Stock. Since the completion of our IPO, we use the
closing quoted price of our common stock on the date of grant.
• Expected Term. The expected term represents the period that our
stock-based awards are expected to be outstanding. The expected termassumptions were determined based on the vesting terms and contractual
lives of the options, using the simplified method.
• Expected Volatility. Since we do not have sufficient trading history of
our common stock, the expected volatility was determined based on the
historical stock volatilities of comparable companies. Comparable
companies consist of public companies in our industry that is similar in
size, stage of life cycle and financial leverage. We intend to continue
to apply this process using the same or similar public companies until asufficient amount of historical information regarding the volatility of
our own share price becomes available, or unless circumstances change
such that the identified companies are no longer similar to us, in which
case, more suitable companies whose share prices are publicly available
would be used in the calculation.
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• Risk-Free Interest Rate. The risk-free interest rate is based on the
implied yield available on U.S. Treasury zero-coupon issues with
remaining terms similar to the expected term on the options.
• Dividend Rate. We have never declared or paid any cash dividends and do
not plan to pay cash dividends in the foreseeable future, and,
therefore, use an expected dividend yield of zero.
We will continue to use judgment in evaluating the assumptions related to our stock-based compensation on a prospective basis. As we continue to accumulate additional data related to our common stock, we may refine our estimation process, which could materially impact our future stock-based compensation expense.
Inventory Valuation
We value our inventory at the lower of cost or its estimated net realizable value. We use the average cost method for purposes of determining cost, which approximates the first-in, first-out method. We write down inventory for excess and obsolescence based upon a review of historical usage and assumptions about future demand, product mix and possible alternative uses. Actual demand, product mix and alternative usage may be lower than those that we project and this difference could have a material adverse effect on our gross margin if inventory write-downs beyond those initially recorded become necessary. Alternatively, if actual demand, product mix and alternative usage are more favorable than those we estimated at the time of such a write-down, our gross margin could be favorably impacted in future periods.
We evaluate our goodwill, intangible and long-lived assets for impairment when events or circumstances arise that indicate our goodwill, intangible and long-assets may be impaired. Indicators of impairment include, but are not limited to, a significant deterioration in overall economic conditions, a decline in our market capitalization, the loss of significant business, significant decreases in funding for our contracts, or other significant adverse changes in industry or market conditions. Regardless, goodwill is tested for potential impairment at least annually.
Income Taxes
The determination of income tax expense requires us to make certain estimates
and judgments concerning the calculation of deferred tax assets and liabilities,
as well as the deductions and credits that are available to reduce taxable
income. We recognize deferred tax assets and liabilities for the expected future
tax consequences of events that have been included in our consolidated financial
statements. Under this method, deferred tax assets and liabilities are
determined based on the difference between the financial statement and tax basis
of assets and liabilities using enacted tax rates for the year in which the
differences are expected to reverse.
In evaluating our ability to recover deferred tax assets, we consider all
available positive and negative evidence, including our past operating results,
our forecast of future earnings, future taxable income, and tax planning
strategies. The assumptions utilized in determining future taxable income
require significant judgment. We record a valuation allowance against deferred
tax assets if, based upon the available evidence, it is more likely than not
that some or all of the deferred tax assets will not be realized. If it becomes
more likely than not that a tax asset will be used for which a reserve has been
provided, we reverse the related valuation allowance. If our actual future
taxable income by tax jurisdiction differs from estimates, additional allowances
or reversals of reserves may be necessary.
We use a two-step approach to recognize and measure uncertain tax positions.
First, the tax position must be evaluated to determine the likelihood that it
will be sustained upon external examination. If the tax position is deemed
more-likely-than-not to be sustained, the tax position is then assessed to
determine the amount of benefit to recognize in the financial statements. The
amount of the benefit that may be recognized is the largest amount that has a
greater than 50% likelihood of being realized upon ultimate settlement. We
reevaluate our uncertain tax positions on a quarterly basis and any changes to
these positions as a result of tax audits, tax laws or other facts and
circumstances could result in additional charges to operations.
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Business Combinations
We utilize the acquisition method of accounting for business combinations and allocate the purchase price of an acquisition to the various tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. We primarily establish fair value using the income approach based upon a discounted cash flow model. The income approach requires the use of many assumptions and estimates including future revenues and expenses, as well as discount factors and income tax rates. Other estimates include: • Estimated step-ups or write-downs for fixed assets and inventory; • Estimated fair values of intangible assets; and • Estimated income tax assets and liabilities assumed from the target While we use our best estimates and assumptions as part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at the business acquisition date, our estimates and assumptions are inherently uncertain and subject to refinement. As a result, during the purchase price allocation period, which is generally no longer than one year from the business acquisition date, we record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. For changes in the valuation of intangible assets between preliminary and final purchase price allocation, the related amortization is adjusted in the period it occurs. Subsequent to the purchase price allocation period any adjustment to assets acquired or liabilities assumed is included in operating results in the period in which the adjustment is determined. Should we issue shares of our common stock in an acquisition, we will be required to estimate the fair value of the shares issued.
Recently implemented accounting pronouncements
Per the Company's consolidated financial statements Note 2 - Significant Accounting Policies, we have implemented a number of changes, as required by FASB. See Note 2 for further details.
Recent accounting pronouncements
Per the Company's consolidated financial statements Note 2 - Significant Accounting Policies, we may be implementing a number of changes, as required by FASB. See Note 2 for further details.
Interest rate risk
Our exposure to interest rate risk is primarily associated with borrowing on revolving lines of credit denominated in bothU.S. dollars and Euros. We are exposed to the impact of interest rate changes primarily through our borrowing activities for our variable rate borrowings.
Concentration of credit risk
Financial instruments that potentially expose us to concentrations of credit risk consist principally of cash, cash equivalents and accounts receivable. We place our cash and cash equivalents with financial institutions with high credit quality. AtMarch 31, 2020 andDecember 31, 2019 , we had$2,658,777 and$5,185,321 , respectively, of cash and cash equivalents on deposit or invested with our financial and lending institutions. We provide credit to our customers in the normal course of business. We perform ongoing credit evaluations of our customers' financial condition and limit the amount of credit extended when deemed necessary. 46
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Foreign currency risk
We operate primarily inthe United States . Foreign sales of products and services are primarily denominated inU.S. dollars. We also conduct business outsidethe United States through our foreign subsidiary inGermany , where business is largely transacted in non-U.S. dollar currencies particularly the Euro, which is subject to fluctuations due to changes in foreign currency exchange rates. Accordingly, we are subject to exposure from changes in the exchange rates of local currencies. Foreign currency transaction gains and losses are recorded in other income (expense), net in the consolidated statements of operations.OSS GmbH operates as an extension of OSS' domestic operations and acquiredBressner Technology GmbH inOctober 2018 . The functional currency ofOSS GmbH is the Euro. Transactions denominated in currencies other than the functional currency are remeasured to the functional currency at the average exchange rate in effect during the period. At the end of each reporting period, monetary assets and liabilities are translated using exchange rates in effect at the balance sheet date. Non-monetary assets and liabilities are remeasured at historical exchange rates. Consequently, changes in the exchange rates of the currencies may impact the translation of the foreign subsidiaries' statements of operations intoU.S. dollars, which may in turn affect our consolidated statement of operations. The resulting foreign currency translation adjustments are recorded as a separate component of accumulated other comprehensive income in the consolidated statement of comprehensive income.
Derivative Financial Instruments
We employ derivatives on a periodic basis to manage certain market risks through
the use of foreign exchange forward contracts. We do not use derivatives for
trading or speculative purposes. Our derivatives are designated as a hedge of a
forecasted transaction or of the variability of cash flows to be received or
paid related to a recognized asset or liability (cash flow hedge). We hedge a
portion of the exchange risk involved in anticipation of highly probable foreign
currency-denominated transactions. In anticipation of these transactions, we may
enter into foreign exchange contracts to provide currency at a fixed rate.
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