Data Storage Corporation: FY2016 Form 10-K Summary
Business Context and Reporting Period
Data Storage Corporation provides cybersecurity, cloud, compliance, Infrastructure as a Service, Disaster Recovery as a Service, email archiving, managed services, and IBM Power-related equipment and support. The filing covers the fiscal year ended December 31, 2016; it is an annual report rather than a quarterly filing.
In October 2016, DSC acquired specified assets and service agreements of ABC Services, Inc. and ABC Services II, Inc., including the remaining 50% interest in Secure Infrastructure and Services LLC. The acquired operations were included from approximately October 26–27, 2016.
Financial Performance and Position
| Metric | 2016 | 2015 | Change |
|---|---|---|---|
| Net sales | $4.385 million | $3.991 million | Up 10% |
| Gross profit | $1.281 million | $1.489 million | Down $0.208 million |
| Gross margin | 32.7% | 29.2% | Up 3.5 percentage points |
| Operating expenses | $1.881 million | $1.881 million | Essentially unchanged |
| Loss from operations | $(0.601) million | $(0.392) million | Loss widened |
| Net loss | $(0.893) million | $(0.694) million | Loss widened $0.199 million |
| Net loss available to common shareholders | $(0.999) million | $(0.790) million | Loss widened |
| Basic and diluted loss per share | $(0.02) | $(0.02) | No reported change |
| Net cash from operating activities | $57,144 | $88,975 | Down $31,831 |
| Cash and cash equivalents | $255,817 | $67,045 | Up $188,772 |
| Working capital deficit | $2.492 million | $3.177 million | Improved $0.685 million |
Interest expense declined to $228,277 from $287,652. Cash provided by investing activities was $241,583, primarily representing cash acquired in the ABC transaction, while financing activities used $109,955. The filing does not provide a conventional EBITDA or adjusted EBITDA measure.
At December 31, 2016, total assets were $5.843 million, including $3.986 million of goodwill and $329,242 of net intangible assets. Total liabilities were $4.112 million and stockholders’ equity was $1.730 million, compared with a stockholders’ deficit of $1.751 million at December 31, 2015.
Current liabilities included $350,000 owed to Enterprise Bank, $190,000 of related-party notes, $254,078 of current capital lease obligations, $374,762 of accounts payable related to the acquisition, $919,103 of deferred revenue, and $619,138 of accrued preferred dividends. The revolving credit facility was reported at $50,412 on the balance sheet, although the notes state it had been paid in full.
Material Changes Versus the Prior Period
- Revenue increased 10%, primarily due to the ABC acquisition, but cost of sales increased faster than revenue, reducing gross profit despite the reported improvement in gross margin.
- Operating expenses were essentially flat, but the operating loss increased because of the lower gross profit.
- The ABC acquisition added assets, goodwill, customer relationships, service agreements, equipment, and operating capabilities, including full ownership of Secure Infrastructure and Services LLC.
- DSC issued 64,669,936 common shares as consideration for the ABC assets. The preliminary purchase price was approximately $1.75 million, with $1.784 million of goodwill recorded in the preliminary allocation.
- DSC converted $2.678 million of related-party debt into 26,781,242 common shares at $0.10 per share, eliminating the reported convertible debt balances.
- Common shares outstanding increased materially, from 36,588,240 at December 31, 2015 to 128,039,418 at December 31, 2016. The filing reports 132,139,722 shares outstanding as of April 17, 2017.
- Stock-based compensation declined to $48,560 from $126,521, while accounts receivable increased to $807,515 from $118,619 and the allowance for doubtful accounts increased to $90,000 from $15,000.
Guidance, Outlook, Risks, and Unusual Items
Management stated that in 2017 it intended to expand its presence in the IBM Power i and email-compliance markets by using increased technical expertise, storage capacity, and managed-services capabilities. No quantitative revenue, earnings, or cash-flow guidance was provided.
- Going-concern risk: The financial statements depend on continued sales growth, expense reduction, profitable operations, and additional financing. DSC has historically relied on funding from its CEO and private placements, with no assurance that the CEO will continue providing funds.
- Liquidity and dilution: Future equity or convertible-debt financing could materially dilute existing holders; debt financing could impose restrictive covenants. The working capital deficit and recurring losses indicate limited financial flexibility.
- Enterprise Bank note: The bank requested a transition from interest-only payments to a self-amortizing arrangement. Management expected to recommend a new payment schedule in the first half of 2017. The filing states the note’s maturity had been extended to April 30, 2016, creating an item requiring verification.
- Internal controls: Management concluded that disclosure controls and internal control over financial reporting were not effective because of insufficient accounting expertise and inadequate segregation of duties. The independent auditor did not provide an internal-control attestation.
- Acquisition accounting: The ABC purchase-price allocation was preliminary and subject to an independent appraisal and measurement-period adjustments. Goodwill and intangible-asset valuation therefore represent material estimation risks.
- Market and competition: DSC competes with substantially larger companies with greater financial resources and brand recognition. Its common stock trades on the OTCQB with minimal trading activity and no assurance of a liquid market.
- Ownership concentration: Officers and directors collectively beneficially owned approximately 96.18% of common stock as of April 17, 2017, limiting public-float liquidity and concentrating voting control.
- Preferred stock: Series A preferred stock carries a 10% cumulative dividend. Accrued unpaid preferred dividends were $619,138 at December 31, 2016; no preferred dividends had been paid.
- Unusual items: The year included approximately $45,000 of acquisition transaction costs, an $85,800 impairment of employee loans, and substantial non-cash equity issuance activity.
The filing reports no material litigation, no off-balance-sheet arrangements, no derivatives or hedging activities, and no subsequent events. The notes contain an inconsistency regarding net loss attributable to common shareholders: the consolidated statements report $(999,455), while a liquidity note refers to $(1,017,318).
Most Important Facts to Verify
- Reconcile the reported $50,412 revolving credit facility balance with the note stating that the facility was paid in full.
- Confirm the status, maturity, payment schedule, and any default or covenant issues associated with the $350,000 Enterprise Bank note.
- Review the final purchase-price allocation and any subsequent adjustments to the ABC acquisition’s goodwill and intangible assets.
- Reconcile the discrepancy between the $(999,455) net loss available to common shareholders in the financial statements and the $(1,017,318) amount cited in the liquidity note.
- Assess the company’s near-term funding requirements, dependence on related parties, and likelihood of additional dilutive financing.
- Evaluate the material weaknesses in internal controls and whether remediation has been implemented.
- Consider the effect of the 64.7 million acquisition shares, 26.8 million debt-conversion shares, options, warrants, and preferred-stock conversion rights on dilution and control.
- Verify customer retention, recurring subscription revenue, and post-acquisition operating performance, since the filing provides limited separate disclosure for the acquired business.