Business context and reporting period
This is Digital Power Corporation’s unaudited Form 10-Q for the quarter and six months ended June 30, 2017. The filing describes a business designing, manufacturing and selling power supplies and converters, with a lending subsidiary and a growth strategy focused on acquisitions. On June 2, the company acquired 56.4% of Microphase Corporation, a supplier of RF and microwave components to military, aerospace and telecommunications markets. Microphase results are consolidated only from June 3. The filing registrant is Digital Power Corporation; this differs from the company name in the request metadata.
Unless otherwise noted, amounts below are in thousands of U.S. dollars.
Financial performance and position
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Revenue | $1,822 | $2,064 | $3,450 | $3,777 |
| Gross profit | $730 | $754 | $1,438 | $1,374 |
| Gross margin | 40.1% | 36.5% | 41.7% | 36.4% |
| Operating income (loss) | $(1,444) | $11 | $(2,231) | $(189) |
| Net income (loss) | $(1,851) | $66 | $(2,845) | $(127) |
| Loss available to common shareholders | $(2,066) | $66 | $(3,060) | $(127) |
| Basic and diluted loss per share | $(0.20) | $0.01 | $(0.32) | $(0.02) |
- Cash flow: For the first six months, operating cash used was $1,173 (versus $134 provided in 2016); investing cash used was $2,132 (versus $74); financing cash provided was $2,711 (versus zero). Cash declined $553 to $443 at June 30.
- Liquidity: Current assets were $3,964 and current liabilities $5,749, a $1,785 working-capital deficit. The company reported an accumulated deficit of $15,218 and total liabilities of $6,568.
- Debt: At June 30, the balance sheet included a $612 revolving facility, $1,247 of current notes payable, $278 of current related-party notes, $250 of current convertible notes, $569 of long-term notes, $128 of long-term related-party notes, and $122 of related-party convertible notes, net of discount. The filing also reports $2,565 of notes and convertible notes in its Q2 MD&A discussion; reconcile this figure with the balance-sheet categories.
- Other assets and exposure: Total assets were $13,981, including $6,002 of goodwill from the Microphase acquisition and $2,582 of investments in related party AVLP securities. Equity was $7,413, including $833 of non-controlling interest.
Material changes versus prior periods
- Q2 revenue fell $242 year over year; six-month revenue fell $327 (8.7%). European revenue declined as commercial and military shipments weakened and foreign exchange rates moved adversely. Microphase contributed $223 of reported Q2 revenue after acquisition; excluding it, U.S. revenue was $1,093, down 9.8% year over year.
- The MD&A says Q2 revenue declined 5.0%, but the financial statements’ $242 decrease from $2,064 implies an 11.7% decline. The filing text does not reconcile this discrepancy.
- Gross margin improved in both periods, which management attributed to a greater mix of higher-margin U.S. commercial products and lower European sales.
- Operating results deteriorated substantially, principally as general and administrative expense rose to $1,582 in Q2 from $340 and to $2,555 for the first six months from $711. The filing cites stock-based compensation, legal and audit fees, investor-relations and consulting costs, and a change in classification of the CEO’s salary.
- Net interest expense was $407 in Q2 and $614 for the first six months, versus net interest income in the comparable 2016 periods. Non-cash debt-discount amortization was $397 in Q2 and $592 for the first six months; aggregate stock-based compensation was $595 and $752, respectively.
- Common shares outstanding rose from 7,677,637 at December 31, 2016 to 12,304,546 at June 30, 2017. The company also had 7,426,080 warrants and 2,841,000 options outstanding at quarter-end; preferred-stock conversion could add further shares.
Outlook, risks and unusual items
- Going concern: Management expects continued losses and says further capital is required. The filing states that these conditions raise substantial doubt about the company’s ability to continue as a going concern; failure to raise capital could require operating and cost reductions.
- Management outlook: No formal financial guidance is provided. Management cited a three-year, $50 million purchase order from MTIX for manufacture, installation and servicing of its MLSE plasma-laser system, and expects it to generate significant revenue and cash flow. The filing does not establish that the order will be fulfilled or convert to the expected cash flows.
- Borrowing default: Microphase’s $612 revolving facility exceeded its collateral borrowing base by $70. The lender notified Microphase of defaults, primarily related to the change in control and borrowing-base overadvance; the parties entered a forbearance agreement on July 14, 2017. Separately, two $250 of 7% convertible notes matured unpaid and were in default at June 30; the filing says they were repaid in July.
- Related-party exposure: AVLP is controlled by an existing major shareholder. Digital Power held $2,582 of AVLP investments at quarter-end and had advanced $970 beyond the stated $1,500 net loan amount under the AVLP notes; additional terms for those advances were still being finalized. The filing also describes other related-party financing and transactions.
- Subsequent financing and transactions: The company reported $1,505 of net cash proceeds from debt and equity issuances between July 1 and August 17, 2017, and $268 of convertible notes exchanged for common shares. Subsequent events also include a sale of future receipts for $780,000 against $1,091,220 of receipts, additional equity and debt financing, and a proposed $850,000 acquisition of Power-Plus Technical Distributors, expected to close around September 1 subject to conditions.
- Other risks and items: A former Microphase noteholder had sued to collect a debt; the outstanding principal was $152 at quarter-end, although Part II states “Legal Proceedings: None.” Shareholder approval was still required for certain preferred-stock conversions. Management stated disclosure controls were effective and reported no significant changes in internal control over financial reporting.
Most important facts for investors to verify
- Resolve the Q2 revenue decline inconsistency (5.0% in MD&A versus 11.7% implied by the statements) and reconcile the debt figures and classifications.
- Assess cash runway, the terms and availability of future financing, and the implications of the explicit going-concern warning and subsequent high-cost financing.
- Confirm the status of Microphase’s lender forbearance, collateral borrowing base and repayment obligations, as well as repayment of the matured convertible notes.
- Evaluate the collectability, documentation and related-party governance of the $2,582 AVLP investment and additional advances, including the still-unfinalized note terms.
- Verify the MTIX purchase order’s enforceability, delivery schedule, funding and expected margins and cash conversion; also check the status and financing of the proposed Power-Plus acquisition.
- Review potential dilution from outstanding warrants, options and preferred-stock conversions, required shareholder approvals, and the disclosed litigation versus the “None” legal-proceedings statement.