Data Storage Corporation — Form 10-K Summary
Reporting period: Fiscal year ended December 31, 2018; filed April 1, 2019. The filing is an annual report, not a standalone fourth-quarter report. DSC provides subscription-based disaster recovery, Infrastructure as a Service, managed services, VoIP, email archival, equipment, software and maintenance solutions. The company operates through its majority-owned Nexxis subsidiary and serves primarily U.S. commercial and government customers.
Financial performance and position
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Revenue | $8.887 million | $8.257 million | +7.6% |
| Gross profit | $3.459 million | $3.347 million | +3.4% |
| Gross margin | 39% | 41% | Down 2 percentage points |
| Operating income/(loss) | $335,360 | $(84,757) | Improved |
| Net income/(loss) | $236,671 | $(188,493) | Improved |
| Net income/(loss) available to common shareholders | $146,781 | $(298,620) | Improved |
| Net cash from operating activities | $541,305 | $478,679 | +13.1% |
| Cash and cash equivalents | $228,790 | $105,139 | +$123,651 |
| Working capital deficit | $2.202 million | $2.951 million | Improved by $749,158 |
| Total liabilities | $4.368 million | $4.815 million | Down $447,127 |
| Total stockholders’ equity | $1.776 million | $1.579 million | Improved |
Revenue growth was driven primarily by increased equipment and software sales. Revenue by major line was $4.711 million from infrastructure and disaster recovery, $2.592 million from equipment and software, and $1.621 million from managed services. More than 35% of revenue is derived from equipment sales. Cost of sales increased 10.5% to $5.428 million, outpacing revenue growth and reducing gross margin.
Operating expenses declined to $3.124 million from $3.431 million. Staffing salaries, officer compensation, professional fees and travel decreased, while commissions increased partly because of a reclassification from professional fees. Interest expense declined to $98,788 from $106,906. No income tax expense was recorded because deferred tax assets were fully reserved.
Cash flow, debt and liquidity
- Operating cash flow was $541,305, including $602,532 of depreciation and amortization.
- Capital expenditures were $69,783, and financing cash outflows were $347,871, primarily for capital lease repayments.
- Capital lease obligations totaled $1.728 million, including $509,487 current and $1.219 million long term. The leases are related-party obligations and carry a 5% interest rate under a refinancing completed in 2018.
- The company had a $350,000 note payable related to the Message Logic acquisition. Interest-only payments stopped in October 2018, and the company was negotiating a final settlement; no default notice had been received as of the filing.
- Preferred dividends accrued during 2018 were $113,012; accrued preferred dividends totaled $861,744 at year-end. Common dividends have not been paid and are not expected in the foreseeable future.
- Management disclosed substantial doubt regarding going-concern capability because of the working capital deficit and limited cash. Management concluded the doubt was alleviated based on expected cash flow, more than $8 million of remaining subscription contract value, improving EBITDA, expense controls, customer collections and potential related-party refinancing. The financial statements nevertheless remain dependent on these assumptions and plans.
Material changes and unusual items
- DSC adopted ASC 606 using the modified retrospective method on January 1, 2018. The company recorded a $41,971 cumulative adjustment related to deferred setup fees; prior-period results were not restated.
- In 2018, the company consolidated data centers and renegotiated vendor agreements, which management said should reduce costs and support growth without significant additional technical staffing or capital expenditures.
- In November 2018, Nexxis agreed to acquire Broadsmart Florida. The transaction was rescinded and unwound in February 2019, with consideration returned and mutual releases executed.
- In January 2019, DSC entered into two new related-party equipment leases with total scheduled payments based on 60-month and 36-month terms.
- The company had $5.005 million of federal and $4.478 million of state net operating loss carryforwards, but recorded a full valuation allowance against related deferred tax assets.
- Goodwill and intangible assets were material at year-end, including $3.016 million of goodwill and $846,713 of net intangible assets on the balance sheet. These assets are subject to impairment testing and management estimates.
Outlook, risks and contingencies
Management planned to expand cloud, IBM Power i, disaster recovery, business continuity and VoIP offerings and continued to pursue synergistic acquisitions. The business operates in highly competitive markets with rapid technological change, pricing pressure and larger, better-funded competitors. Results depend on retaining customers, maintaining service quality, expanding distribution and achieving expected economies of scale.
Key financial risks include the substantial working capital deficit, dependence on related-party financing and leases, the overdue Message Logic note, customer concentration, reliance on future subscription collections and potential dilution from outstanding options and warrants. One customer represented 10.6% of accounts receivable at year-end.
Management reported that disclosure controls and internal control over financial reporting were not effective as of December 31, 2018. Material weaknesses included insufficient internal accounting expertise and inadequate segregation of duties. The company intended to add finance personnel. The independent auditor audited the financial statements but was not engaged to provide an opinion on internal control effectiveness.
No material litigation was reported. The company had no off-balance-sheet arrangements, derivatives or hedging activities. The revolving credit facility was undrawn at year-end and was secured by company assets and personally guaranteed by the principal shareholder.
Most important facts for investors to verify
- Whether operating cash flow and subscription collections are sufficient to fund approximately $2.202 million of working capital deficit and scheduled debt and lease payments.
- The status, amount and settlement terms of the $350,000 Message Logic note after interest payments stopped in October 2018.
- Whether the company’s going-concern assessment remains supportable, including the claimed $8 million-plus remaining subscription contract value and improving EBITDA.
- Progress in remediating the disclosed material weaknesses in accounting expertise, segregation of duties and ineffective disclosure controls.
- The sustainability of revenue growth given that equipment and software sales drove much of the increase while gross margin declined from 41% to 39%.
- Potential dilution from 5.766 million outstanding options, 133,334 warrants and convertible Series A preferred stock.
- The carrying values and impairment sensitivity of $3.016 million of goodwill and other intangible assets.
- The impact of related-party transactions, including capital leases with Systems Trading and future financing or refinancing arrangements.