Business Context and Reporting Period
Data Storage Corporation (DSC) filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2021. DSC provides subscription-based disaster recovery, Infrastructure as a Service, cybersecurity, managed services, cloud, equipment, software, and VoIP solutions to commercial and government customers.
On May 31, 2021, DSC acquired Flagship Solutions, LLC, an IBM solutions, managed services, data analytics, cybersecurity, and cloud-services provider. Flagship's results were consolidated from the acquisition date. Management expects integration efficiencies, cross-selling opportunities, and expanded multicloud offerings.
Financial Performance and Position
| Metric | Three Months Ended September 30, 2021 | Three Months Ended September 30, 2020 | Nine Months Ended September 30, 2021 | Nine Months Ended September 30, 2020 |
|---|---|---|---|---|
| Revenue | $3.86 million | $2.72 million | $9.96 million | $6.83 million |
| Revenue growth | 42% | — | 46% | — |
| Gross profit | $1.69 million | $1.10 million | $4.35 million | $2.85 million |
| Gross margin | 43.9% | 40.5% | 43.7% | 41.8% |
| Operating income (loss) | $(331,668) | $84,661 | $(391,669) | $(32,434) |
| Operating margin | (8.6%) | 3.1% | (3.9%) | (0.5%) |
| Net income attributable to DSC | $135,630 | $46,218 | $276,842 | $202,554 |
| Net income attributable to common stockholders | $135,630 | $9,568 | $213,159 | $96,677 |
| Diluted EPS | $0.02 | $0.00 | $0.05 | $0.03 |
Revenue growth was driven primarily by the Flagship acquisition and higher subscription and managed-services revenue. Nine-month revenue included $5.21 million from infrastructure, disaster recovery, and cloud services; $2.51 million from managed services; $1.54 million from equipment and software; and $588,889 from Nexxis VoIP services.
Despite higher gross profit, operating results weakened because selling, general and administrative expense increased substantially. The financial statements report SG&A of $2.02 million for the quarter and $4.75 million for the nine months, compared with $1.02 million and $2.88 million, respectively, in the prior-year periods. The filing's MD&A contains a nine-month SG&A figure of $4.80 million, which should be reconciled to the financial statements.
Reported net income benefited from $481,977 of third-quarter and $789,277 of year-to-date gains from forgiveness of PPP debt. Accordingly, reported profitability does not solely reflect recurring operating performance. Adjusted EBITDA was $104,985 for the quarter and $801,788 for the nine months, compared with $386,608 and $838,366, respectively, in the prior-year periods.
Cash Flow, Debt, and Liquidity
- Cash and cash equivalents were $12.89 million at September 30, 2021, compared with $893,598 at December 31, 2020.
- Working capital was $12.34 million, versus a working-capital deficiency of $2.67 million at December 31, 2020.
- Operating activities generated $153,045 of cash during the first nine months, compared with $696,087 in the prior-year period.
- Investing activities used $6.36 million, including $6.15 million of cash consideration for the Flagship acquisition and $418,422 of capital expenditures.
- Financing activities provided $18.20 million, principally from $16.94 million of common-stock and warrant issuance proceeds and $3.38 million from warrant exercises. These inflows were partly offset by $1.18 million of preferred-dividend repayments and $998,184 of finance-lease repayments.
- At September 30, 2021, the company had $50,000 outstanding under Flagship's revolving credit facility, $1.59 million of total finance-lease liabilities, and $479,300 of operating-lease liabilities. The company reported no outstanding note payable.
- The original DSC revolving credit line was terminated during the period, and the Flagship revolving line was terminated after September 30, 2021.
Material Changes Versus the Prior Comparable Period
- Revenue increased 42% in the third quarter and 46% for the first nine months, mainly from Flagship and subscription growth.
- Managed-services revenue increased 768% in the quarter and 350% year to date, while equipment and software revenue decreased 66% in the quarter and was approximately flat year to date.
- SG&A increased 99% in the quarter and approximately 65% year to date, reflecting additional personnel, merger-related and public-company professional fees, marketing, software, and other costs.
- Operating income shifted to a loss in both the quarter and nine-month period despite improved gross margins.
- Cash and equity increased significantly following the May public offering, July private placement, warrant exercises, and the Flagship acquisition.
- All 1,401,786 shares of Series A preferred stock were converted into 43,806 common shares in May 2021, and $1.18 million of accrued preferred dividends was paid.
- Common shares outstanding increased to 6,692,742 at November 11, 2021, from 3,213,486 at December 31, 2020. The company also had 2,419,193 warrants outstanding at September 30, 2021, creating potential dilution.
Outlook, Risks, Contingencies, and Unusual Items
Management did not provide quantitative revenue, earnings, or cash-flow guidance. Management stated that it intends to expand sales and marketing distribution, increase its presence in IBM Power infrastructure and business-continuity markets, pursue synergistic acquisitions, and integrate Flagship's operations. The company reported subscription contract value exceeding $10 million based on existing contracts, but this is not presented as a forecast of revenue.
- Management cautioned that future liquidity depends on business performance and financing conditions. If conditions deteriorate, DSC may need to renegotiate related-party equipment leases, reduce marketing, renegotiate arrangements with Nexxis, or reduce executive salaries.
- The company identified a material weakness in internal control over financial reporting and concluded that its disclosure controls and procedures were not effective because it lacked sufficient internal accounting expertise to ensure GAAP-compliant financial reporting. A new CFO was hired in 2021, but remediation was not complete as of the filing.
- COVID-19 may affect operations, employees, suppliers, customers, access to capital, cybersecurity, and asset impairment. Remote work may increase cybersecurity and confidentiality risks.
- Customer concentration exists: three customers represented 47% of accounts receivable at September 30, 2021, and one customer represented 14% of nine-month revenue.
- Goodwill and intangible assets increased materially following the Flagship acquisition. Goodwill was $6.61 million and net goodwill and intangible assets totaled $8.97 million at September 30, 2021, subject to impairment risk and acquisition-accounting refinements.
- The Flagship purchase price was provisional and could be adjusted during the measurement period. The transaction included potential additional stock consideration of up to $4.95 million, subject to valuation and other adjustments.
- The filing reports no material litigation and no defaults upon senior securities.
Investor Verification Points
- Reconcile the MD&A's nine-month SG&A figure of $4.80 million with the financial statement amount of $4.75 million.
- Assess recurring operating profitability excluding the $789,277 year-to-date PPP-debt forgiveness gain and other nonrecurring items.
- Review whether Flagship integration produces the anticipated efficiencies and whether the acquisition generates sufficient cash flow relative to its $6.15 million cash purchase price and potential additional consideration.
- Evaluate liquidity after recurring lease payments, acquisition-related obligations, and continued operating cash generation of only $153,045 for the first nine months.
- Consider dilution from 2.42 million outstanding warrants, 224,666 outstanding options, and the substantial increase in common shares during 2021.
- Monitor remediation of the material weakness in internal controls and the risk of future reporting errors or restatements.
- Review customer concentration, goodwill and intangible-asset impairment exposure, related-party lease obligations, and the effects of COVID-19 and cybersecurity risks.