Data Storage Corporation: Q3 2017 Form 10-Q Summary
Business Context and Reporting Period
Data Storage Corporation provides cybersecurity, hybrid cloud, Infrastructure as a Service, Disaster Recovery as a Service, email archival, compliance, managed services, software, maintenance and equipment solutions to commercial and government customers. The company operates data centers and technical offices primarily in New York, Massachusetts and Rhode Island.
This unaudited Form 10-Q covers the three and nine months ended September 30, 2017, with comparisons to the corresponding 2016 periods. The October 2016 acquisition of ABC Services and ABC Services II materially expanded the reported operating base.
Key Financial Metrics
| Metric | Three Months Ended September 30, 2017 | Three Months Ended September 30, 2016 | Nine Months Ended September 30, 2017 | Nine Months Ended September 30, 2016 |
|---|---|---|---|---|
| Sales | $2.04 million | $0.92 million | $6.39 million | $2.91 million |
| Gross profit | $0.81 million | $0.28 million | $2.62 million | $0.98 million |
| Gross margin | 39.8% | 30.0% | 41.0% | 33.7% |
| Income from operations | $68,366 | $(113,129) | $530,345 | $(303,780) |
| Operating margin | 3.4% | (12.3%) | 8.3% | (10.4%) |
| Net income | $33,620 | $(185,722) | $431,907 | $(509,311) |
| Net income attributable to common stockholders | $3,972 | $(212,560) | $345,133 | $(587,861) |
Basic and diluted earnings per share were reported as $0.00 for the 2017 periods and $(0.01) for the 2016 periods. The September 30, 2017 share count was 128,139,418 common shares outstanding.
Operating cash flow for the first nine months of 2017 was $561,957, compared with $208,577 in the prior-year period. Cash used in financing activities was $661,469, primarily reflecting loan repayments and capital lease repayments. Cash declined by $99,512 during the period, from $255,817 at December 31, 2016 to $156,305 at September 30, 2017.
At September 30, 2017, total assets were $6.96 million, including $1.71 million of net property and equipment and $3.99 million of goodwill. Total liabilities were $4.87 million and stockholders’ equity was $2.08 million. Working capital was negative $2.51 million.
Debt and lease obligations included a $350,000 bank note, a $328,265 related-party note payable, and $1.79 million of capital lease obligations, of which $658,307 was classified as current. The company also reported a $705,912 dividend payable and $695,672 of deferred revenue.
Material Changes Versus the Prior Comparable Period
- Sales increased 120.6% in the third quarter and 119.3% for the first nine months, which management attributed primarily to the ABC acquisition.
- Gross profit increased 192.8% in the third quarter and 167.1% year to date; reported gross margin improved from approximately 30.0% to 39.8% in the quarter and from 33.7% to 41.0% year to date.
- The company moved from operating and net losses to operating income and net income in both comparative periods.
- Interest expense declined to $100,650 for the first nine months from $204,467, which management attributed to conversion agreements for outstanding convertible debt.
- Net property and equipment increased to $1.71 million from $178,660, principally due to approximately $1.82 million of equipment acquired through capital leases and additional data center equipment.
- Cash decreased despite positive operating cash flow because financing outflows exceeded operating cash generation.
- Accounts receivable declined to $582,086 from $807,515, while deferred revenue declined to $695,672 from $919,103.
- Common shares outstanding increased by 100,000 shares during the year, reflecting shares granted to the company’s CTO for services.
Guidance, Outlook, Risks and Unusual Items
Management stated that it expects profitability to continue through November 2018 and the foreseeable future, but also indicated that additional equity or debt financing may be required. Future financing could dilute existing stockholders, impose restrictive covenants or be unavailable on favorable terms.
More than 35% of revenue is derived from equipment sales, which may make reported revenue less recurring than subscription and cloud-service revenue. The company also depends on successful integration and management of acquired operations and continued realization of anticipated operating synergies.
The company is negotiating with Enterprise Bank to modify or extend the $350,000 bank loan and transition from interest-only payments to a self-amortizing arrangement. The filing states that no default notice had been received and that the last interest-only payment was made in September 2017.
Related-party capital leases are payable to Systems Trading, an entity wholly owned by the company’s president and director. Total future capital lease payments were $1.94 million, including $746,880 due in each of the twelve months ending September 30, 2018 and 2019.
Management concluded that disclosure controls and internal control over financial reporting were not effective as of September 30, 2017. Identified material weaknesses were insufficient internal accounting expertise and inadequate segregation of duties. Management intends to add financial staff resources.
The company reported no material litigation, no defaults upon senior securities and no unregistered equity sales during the period. A subsequent event established Nexxis Inc., a majority-owned subsidiary focused on next-generation voice and data services. Data Storage Corporation owns 80% of Nexxis, while a minority stockholder owns 20%. Subsequent agreements provide for potential distributions, acquisition rights and significant compensation and incentive arrangements for Nexxis’s president.
The company will adopt the new revenue recognition standard effective January 1, 2018 and had not yet determined the transition method or quantified the impact. It was also evaluating the effects of other pending accounting standards, including leases, share-based payments, cash flow classification and goodwill impairment.
Important Facts Investors Should Verify
- Whether the reported revenue growth and improved margins are sustainable after separating acquired revenue, equipment sales and recurring subscription revenue.
- The company’s ability to maintain positive operating cash flow while meeting approximately $1.94 million of capital lease payments and other current obligations.
- The outcome and timing of the bank loan renegotiation and whether any payment terms or covenant issues could affect liquidity.
- Whether additional equity or debt financing will be required and the potential dilution or restrictions associated with that financing.
- Remediation of the material weaknesses in accounting expertise and segregation of duties.
- The carrying value and future impairment risk associated with $3.99 million of goodwill and other intangible assets.
- The financial performance, funding requirements, compensation structure and potential acquisition cost associated with the 80%-owned Nexxis subsidiary.
- The effect of adopting the new revenue recognition standard on reported revenue, deferred revenue, earnings and disclosures.