Data Storage Corporation — Form 10-Q Summary
Reporting period: Quarter and six months ended June 30, 2018, compared with the corresponding 2017 periods. The filing was signed August 14, 2018. DSC is a managed service provider focused on IBM and Intel cloud infrastructure, disaster recovery, managed services, equipment and software, and related telecommunications services.
Financial highlights
| Metric | Three months ended June 30, 2018 | Three months ended June 30, 2017 | Six months ended June 30, 2018 | Six months ended June 30, 2017 |
|---|---|---|---|---|
| Sales | $2.75 million | $2.03 million | $4.70 million | $4.35 million |
| Gross profit | $997,594 | $811,324 | $1.77 million | $1.81 million |
| Gross margin | 36.3% | 40.0% | 37.7% | 41.6% |
| Operating income | $23,258 | $67,188 | $52,565 | $461,979 |
| Net income attributable to DSC | $2,634 | $29,365 | $20,898 | $398,288 |
| Net income (loss) attributable to common stockholders | $(28,522) | $446 | $(41,037) | $341,161 |
| Operating cash flow | Not provided for the quarter | Not provided for the quarter | $113,546 | $384,335 |
- Second-quarter sales increased 36% year over year, primarily from non-recurring equipment and software sales. Six-month sales increased 8%.
- Six-month revenue mix shifted toward equipment and software, which increased to $1.77 million from $1.10 million, while infrastructure and disaster recovery revenue declined to $2.27 million from $2.36 million.
- Gross profit declined 2% for the six months despite higher sales, and gross margin contracted approximately 390 basis points. Management attributed the pressure to the lower margins of equipment and software relative to subscription services.
- Operating expenses increased 27% for the six months, including higher commissions and sales salaries. Six-month operating margin declined to approximately 1.1% from 10.6%.
- Interest expense decreased to $40,142 from $65,902 for the six months, primarily following refinancing of pre-existing leases into a new related-party lease.
- Cash and cash equivalents were $81,976 at June 30, 2018, versus $105,139 at December 31, 2017. Cash decreased $23,163 during the six months.
- Working capital was negative $2.41 million at June 30, 2018, compared with negative $2.95 million at year-end 2017.
- Total liabilities were $5.10 million, including $1.96 million of capital lease obligations, $350,000 payable to Enterprise Bank, $795,608 of accrued dividends and $1.50 million of accounts payable and accrued expenses.
- Accounts receivable increased to $1.01 million from $406,393 at year-end 2017. One customer represented 17% of six-month revenue and 53% of accounts receivable at June 30, 2018.
Material changes versus the prior comparable period
- Revenue growth was driven principally by equipment and software transactions described by management as non-recurring, rather than by the higher-margin subscription businesses.
- Cost of sales grew faster than revenue in both the quarter and six months, reducing gross margins.
- SG&A increased substantially, particularly commissions and sales compensation, causing operating income to fall sharply for the six months.
- Six-month net income fell 97% to $13,139 from $398,288. After preferred dividends, common stockholders reported a six-month loss of $41,037.
- The company adopted ASC 606 using the modified retrospective method on January 1, 2018. Set-up fees became a separate performance obligation recognized when the service is performed; comparative periods were not restated. A $41,000 amount of deferred revenue from 2017 was reclassified to retained earnings.
- Related-party notes and prior leases were refinanced and consolidated into a new capital lease in March 2018. The related-party capital lease carries a 5% interest rate and matures in 2022.
Liquidity, outlook, risks and unusual items
- Management states that conditions that initially raised substantial doubt about going-concern status have been alleviated, but also states that no assurance exists that the risks will remain mitigated. The filing says management is committed to funding operations for the next 12 months and believes related-party leases can be refinanced.
- Management expects profitability to continue through 2018 and the foreseeable future, but provides no quantified revenue, earnings or cash-flow guidance.
- The company may need additional equity or debt financing. Potential financing could dilute existing stockholders, impose restrictive covenants or be unavailable on acceptable terms.
- Liquidity depends on continued sales growth, cost control, implementation of the business plan, possible related-party funding and collection of receivables. Capital leases are owed to a company owned by DSC’s president.
- Enterprise Bank debt of $350,000 was originally due April 30, 2016. The company reports no default notice, has continued interest-only payments and is seeking a self-amortizing arrangement or recognition of payments made to date.
- Disclosure controls and internal control over financial reporting were deemed ineffective because of insufficient accounting expertise and inadequate segregation of duties. Management intends to add financial staff.
- The company reports no pending litigation, no unregistered equity sales, and no defaults upon senior securities during the period.
- Potentially dilutive securities at June 30, 2018 included 133,334 warrants and 2,017,447 options.
- The filing text contains an internal inconsistency: the cash-flow statement reports $113,546 of operating cash flow, while the liquidity discussion states $123,546. The filing also describes the six-month net income as $13,139 while discussing a common-stockholder loss of $41,037; these amounts reflect different attribution levels.
Investor verification items
- Verify the correct six-month operating cash-flow amount and reconcile the liquidity discussion to the audited or filed cash-flow statement.
- Assess the sustainability of revenue given the reliance on non-recurring equipment and software sales and the decline in subscription-related revenue.
- Review customer concentration, particularly the customer representing 53% of accounts receivable, and evaluate collectability of the $1.01 million receivable balance.
- Review the terms, maturity schedule and related-party nature of the $1.96 million capital lease obligations, including the company’s ability to refinance them.
- Confirm the status and potential enforceability of the overdue Enterprise Bank obligation.
- Evaluate the company’s negative working capital, limited cash balance and dependence on additional financing or management support.
- Review remediation of the disclosed material weaknesses in accounting expertise and segregation of duties.
- Assess the impact of ASC 606 adoption and the treatment of onboarding and set-up fees on comparability with prior periods.