Business Context and Reporting Period
Data Storage Corporation filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2011. The company provides hybrid-cloud, cloud-storage, SaaS, infrastructure-as-a-service, disaster-recovery, data-backup, business-continuity, and related professional services through three data centers in the United States and serves customers in the United States and Canada. Results include the operations and assets acquired from SafeData, LLC in 2010.
Financial Performance and Position
| Metric | Three Months Ended September 30 | Nine Months Ended September 30 |
|---|---|---|
| Sales | $1.089 million, versus $0.886 million | $2.860 million, versus $1.644 million |
| Gross profit | $0.394 million, versus $0.439 million | $0.982 million, versus $0.688 million |
| Gross margin | 36.2%, versus 49.6% | 34.3%, versus 41.8% |
| Operating loss | $0.622 million, versus $0.177 million | $1.281 million, versus $0.622 million |
| Net loss | $0.599 million, versus $0.275 million | $1.535 million, versus $0.739 million |
| Net loss available to common shareholders | $0.612 million | $1.573 million |
| Basic and diluted loss per share | $0.03 | $0.08 |
Sales increased 22.9% year over year in the third quarter and 74.0% for the first nine months, primarily due to SafeData-related managed services and increased backup capacity. Cost of sales grew faster than quarterly revenue, reducing gross margin. Selling, general and administrative expense increased to $1.016 million in the quarter and $2.263 million for the nine months, driven principally by higher salary, marketing, rent, depreciation, and amortization costs associated with the expanded business.
Other income for the nine-month period included a $176,497 gain from the settlement of contingent consideration related to the SafeData acquisition. Interest expense and debt-discount amortization totaled $433,228 for the nine months, including $230,013 of debt-discount amortization. No income-tax provision was recorded.
Cash and cash equivalents were $127,454 at September 30, 2011, compared with $50,395 at December 31, 2010. The company used $403,654 in operating activities and $54,983 in investing activities, while financing activities provided $535,696, including $1.5 million from common-stock issuance. Working-capital deficiency was $2.103 million at September 30, 2011, compared with $2.544 million at year-end 2010.
Total liabilities were $4.249 million and stockholders’ equity was $0.721 million at September 30, 2011. Significant obligations included $790,293 of capital-lease obligations, $174,221 of note payable, $614,628 owed to the CEO, $476,079 of convertible debt including related-party convertible debt, and $673,782 of deferred revenue. The company also reported $1.181 million of accounts payable and accrued expenses.
Material Changes Versus the Prior Comparable Period
- Revenue grew substantially, but quarterly and year-to-date gross margins declined by 13.4 and 7.5 percentage points, respectively.
- Operating losses and net losses increased despite higher revenue, reflecting increased operating costs and financing-related expenses.
- Salary expense increased by $654,359 for the nine months, and marketing expense increased by $104,636.
- Depreciation and amortization increased to approximately $515,459 for the nine months, versus $246,706 in the prior period.
- Common shares outstanding increased to 22,572,410 from 17,127,541 at year-end 2010. The company issued 3,640,777 shares for $1.5 million in cash and 428,571 shares in connection with the SafeData agreement.
- Contingent consideration related to SafeData declined from $805,087 at December 31, 2010 to zero at September 30, 2011, with a corresponding $176,497 gain recognized during 2011.
- Operating cash use increased to $403,654 from $128,458 in the prior nine-month period, while financing cash provided declined to $535,696 from $1.397 million.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
Management stated that it intended to expand its presence in the IBM marketplace by using the additional technical expertise, storage capacity, and managed-services capabilities obtained through SafeData. Management also expected to rely on additional stock issuances, financing, and continued funding from the CEO and largest shareholder to meet liquidity needs and potentially fund acquisitions.
The financial statements were prepared on a going-concern basis. Management identified continued sales growth, expense reductions, access to financing, and profitable operations as necessary to meet obligations. The filing states that the CEO intends to continue funding the company as needed, but does not establish committed financing terms or amounts.
Disclosure controls and procedures were deemed ineffective because the company lacks sufficient size and complexity to adequately segregate duties. Management reported no material change in internal control over financial reporting during the quarter.
The company reported exposure to interest-rate and currency-exchange risks and stated that it does not undertake specific actions to limit those exposures. Management reported no material litigation, no defaults upon senior securities, and no separately identified risk factors in Part II of the filing. The company reported no off-balance-sheet arrangements.
Potential dilution included 2,281,576 outstanding options and 3,225,865 outstanding warrants at September 30, 2011. One customer represented approximately 9.3% of nine-month sales.
Investor Verification Points
- Verify the company’s ability to fund recurring operating cash deficits and satisfy near-term lease, debt, and other obligations.
- Assess whether revenue growth from SafeData and managed services can continue without further deterioration in gross margin.
- Review the accounting and final settlement of SafeData contingent consideration, goodwill, and intangible assets for potential impairment risk.
- Evaluate dilution from common-stock issuances, options, warrants, and convertible debt.
- Review related-party financing and the $614,628 amount owed to the CEO, including the absence of stated repayment terms.
- Consider the implications of ineffective disclosure controls and limited segregation of duties.
- Confirm the filing’s reported year-to-date operating expense figure, which is presented inconsistently in the source text as $2,262,939 in the financial statements and $2,262,959 in management’s discussion.