GSE SYSTEMS INC - Quarter Report: 2020 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes [ X ]   No [   ]

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such period that the registrant was required to submit such files). Yes [ X ]   No [   ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company or an emerging growth company. See the definitions of "large accelerated filer", "accelerated filer", and "smaller reporting company" and "emerging growth company" in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.[  ]

Indicate by check mark whether the registrant is a shell company (as defined in rule 12(b)-2 of the Exchange Act).    Yes  [  ]  No [X]

Securities registered pursuant to Section 12(b) of the Act:

There were 20,551,080 shares of common stock, with a par value of $0.01 per share outstanding as of June 30, 2020.

The filing of GSE’s Quarterly Report on Form 10-Q for the three months ended March 31, 2020 was delayed due to circumstances related to the COVID-19 pandemic. We experienced delays in completing the impairment analysis of our long-lived assets, due to a COVID-19 triggering event. Additional disclosures required to the pandemic caused delays in our preparation of these financial statements. As a result of federal, state and local government continuing measures to further prevent the spread of COVID-19, Management has encouraged employees work remotely. We were unable to file our financial statements on a timely basis and expected to file by June 29, 2020.

We relied on the SEC’s Order under Section 36 of the Securities Exchange Act of 1934 Modifying Exemptions from the Reporting and Proxy Delivery Requirements for Public Companies (Release No. 34-88465) and dated March 25, 2020 to delay the filing of our quarterly report.

GSE SYSTEMS, INC.

QUARTERLY REPORT ON FORM 10-Q

INDEX

PART I - FINANCIAL INFORMATION

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

The accompanying notes are an integral part of these consolidated financial statements.

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

(in thousands)

(Unaudited)

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

GSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Basis of Presentation

GSE Systems, Inc. is a leading provider of professional and technical engineering, staffing services and simulation software to clients in the power and process industries. References in this report to “GSE” or "we” and "our" are to GSE Systems, Inc. and our subsidiaries, collectively.

The consolidated interim financial statements included herein have been prepared by GSE and are unaudited. In the opinion of the management, all adjustments and reclassifications of a normal and recurring nature necessary to present fairly the financial position, results of operations and cash flows for the periods presented, have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP") have been condensed or omitted.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. The accompanying balance sheet data for the year ended December 31, 2019 was derived from our audited financial statements, but it does not include all disclosures required by U.S. GAAP.

The results of operations for interim periods are not necessarily an indication of the results for the full year. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2019, filed with the Securities and Exchange Commission on June 11, 2020.

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as reported amounts of revenues and expenses during the reporting period. Our most significant estimates relate to revenue recognition on contracts with customers, allowance for doubtful accounts, product warranties, valuation of goodwill and intangible assets acquired including the determination of fair value in impairment tests, valuation of long-lived assets to be disposed of, valuation of contingent consideration issued in business acquisitions, valuation of stock-based compensation awards and the recoverability of deferred tax assets. Actual results of these, and other items not listed, could differ from these estimates and those differences could be material.

COVID-19

We began working remotely at the period end, due to the COVID-19 impact and continue to do so, available, and mandated by local, state and federal regulations. As a result, employees almost entirely work from home for the Performance Solutions segment, but for when required to be at the client site for essential project work. Performance Projects, since they are essential, for the most part continue without pause. For our staff augmentation, we have seen certain contract for NITC customers paused and or delayed as clients shrink their own on-premise workforces to the bare minimum in response to the pandemic; as a result the NITC business has seen its deployed billable employee base contract since the start of the pandemic. Although we cannot fully estimate the length or gravity of the impact of the COVID-19 outbreak at this time, we have experienced delays in commencing new projects, which has delayed or ability to recognize revenue. In addition, we have had order reductions or changes due to the pandemic. We expect the financial results for the fiscal year 2020 to be lower as a result of COVID-19.

Going Concern Consideration

Accounting pronouncements recently adopted

In January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2017-04, Simplifying the Test for Goodwill Impairment ("ASU 2017-04"). ASU 2017-04 simplifies the accounting for goodwill impairment by eliminating Step 2 of the current goodwill impairment test, which required a hypothetical purchase price allocation. Goodwill impairment will now be the amount by which the reporting unit's carrying value exceeds its fair value, limited to the carrying value of the goodwill. ASU 2017-04 is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2019.

We adopted the new standard and began using the simplified approach on January 1, 2020.

Accounting pronouncements not yet adopted

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses, which introduces new guidance for credit losses on instruments within its scope. The new guidance introduces an approach based on expected losses to estimate credit losses on certain types of financial instruments, including, but not limited to, trade and other receivables, held-to-maturity debt securities, loans and net investments in leases. The new guidance also modifies the impairment model for available-for-sale debt securities and requires the entities to determine whether all or a portion of the unrealized loss on an available-for-sale debt security is a credit loss. The standard also indicates that entities may not use the length of time a security has been in an unrealized loss position as a factor in concluding whether a credit loss exists. The ASU is effective for public companies for fiscal years beginning after December 15, 2019 and interim periods within those fiscal years. Early adoption is permitted for all entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. On October 16, 2019 the FASB voted to defer the deadlines for private companies and certain small public companies, including smaller reporting companies, to implement the new accounting standards on credit losses. The new effective date is January 1, 2023. We are currently evaluating the effects, if any, that the adoption of this guidance will have on our consolidated financial position, results of operations and cash flows.

Basic (loss) income per share is computed by dividing net (loss) income by the weighted average number of outstanding shares of common stock for the period. Diluted net (loss) income per share adjusts the weighted average shares outstanding for the potential dilution that could occur if outstanding vested stock options were exercised and restricted stock units ("RSU") were vested, unless the impact of potential dilutive common shares outstanding are anti-dilutive. Since we experienced a net loss in each period presented, basic and diluted net loss per share are the same. The diluted loss per share, in each period presented, excludes the impact of 59,421 and 237,834 potentially dilutive securities during the three months ended March 31, 2020 and 2019, since they would have an anti-dilutive effect.

On February 15, 2019, we acquired 100% of the membership interests in DP Engineering for $13.5 million, subject to certain earn out provisions. We funded the acquisition by borrowing $14.3 million under our term loan agreement with Citizens Bank.

The following table summarizes the calculation of adjusted purchase price as of the acquisition date:

The following table summarizes the consideration we paid to acquire DP Engineering, and the fair value of the assets acquired and liabilities assumed on February 15, 2019.

(in thousands)

The fair value of the assets acquired includes gross trade receivables of $2.9 million, of which we have collected in full. We did not acquire any other class of receivable as a result of the acquisition of DP Engineering.

The goodwill was primarily attributable to value-added technical engineering solutions and consulting services to nuclear power plants with an emphasis on preparation and implementation of design modification during plant outages, the workforce of the acquired business and the significant synergies expected to arise after the acquisition of DP Engineering. The total amount of goodwill is expected to be tax deductible. All of the $5.8 million of goodwill was assigned to our Performance Improvement Solutions segment.

We identified other intangible assets of $6.8 million, including customer contracts and relationships, tradename and non-compete agreements, with amortization periods of five years to fifteen years.

Approximately one week following our acquisition of DP Engineering, an adverse event occurred at one of DP Engineering’s major customer's locations that affected plant operations. We received a Notice of Suspension from that customer. This event adversely impacted the relationship between DP Engineering and this customer. We concluded this event represented a triggering event requiring an interim assessment of the intangible assets we acquired to determine if they had been impaired. As a result of the impairment analysis, we recognized the impairment charges of $5.6 million related to the acquired goodwill in our March 31, 2019 consolidated financial statements. On August 6, 2019, we received a Notice of Termination from this customer, notifying us they were terminating their Engineer of Choice consulting service agreement with DP Engineering. We concluded this represented a new triggering event and during the third quarter of 2019 we evaluated whether any additional impairment existed. We concluded, based on our analysis that no additional impairment was necessary.

Included in the purchase price of DP Engineering was the estimated fair value of an earn-out totaling $1.2 million, which we initially recorded as contingent consideration. Subsequent to the acquisition, primarily as a result of the events described above, we determined the conditions related to the contingent consideration would not be met and therefore we reversed this amount through our statement of operations in the first quarter of 2019.

On August 27, 2019, we made a demand for indemnification, pursuant to the DP Engineering Purchase Agreement. On December 30, 2019, we entered into a settlement agreement pursuant to which the sellers agreed to release the full escrow account balance to us, plus additional funds, in the total amount of $2.0 million. We received these funds on December 31, 2019.

Unrelated to the event described above, during the three months ended March 31, 2020, we concluded, as a result of the COVID-19 virus that a triggering event occurred requiring an interim assessment for impairment of our intangible assets, including those associated with DP Engineering. As a result of this analysis, we recorded an impairment charge of $4.3 million related to DP Engineering's definite-lived intangible assets in our March 31, 2020 consolidated financial statements.

DP Engineering recognized $1.4 million of revenue during the three months ended March 31, 2020.

Unaudited Pro Forma Financial Information

The unaudited pro forma financial information for the quarter ended March 31, 2019 in the table below summarizes the combined results of operations for GSE and DP Engineering as if the business combinations had occurred on January 1, 2019 (in thousands).

The pro forma financial information has been calculated after applying GSE's accounting policies and includes pro forma adjustments resulting from our acquisition of DP Engineering, including amortization charges related to the intangible assets acquired, interest expenses related to the financing transaction in connection with the acquisition of DP Engineering, and the related tax effects as if aforementioned companies were combined as of January 1, 2019.

For the three months ended March 31, 2019, we incurred $600 thousand of selling, general and administrative costs related to the acquisition of DP Engineering. Due to the Q1 2019 triggering events described above, we also recorded a $5.6 million impairment of DP Engineering's goodwill during the three months ended March 31, 2019.

The pro forma financial information is not intended to reflect the actual results of operations that would have occurred if the acquisition had been completed on January 1, 2019, nor is it intended to be an indication of future operating results.

Contract receivables represent our unconditional rights to consideration due from a broad base of both domestic and international customers. All contract receivables are considered to be collectible within    .

The components of contract receivables are as follows:

Management reviews collectability of receivables periodically and records an allowance for doubtful accounts to reduce its receivables to their net realizable value when it is probable that we will not be able to collect all amounts according to the contractual terms of the receivable. The allowance for doubtful accounts is based on historical trends of past due accounts, write-offs, specific identification and review of customer accounts. During the three months ended March 31, 2020 and 2019, we recorded bad debt expense of $93 thousand and $0, respectively.

During April 2020, we invoiced $4.5 million of the March 31, 2020 unbilled amounts.

As of March 31, 2020, we had one customer that accounted for 20% of our consolidated contract receivables. As of December 31, 2019, we had two customers that accounted for 13% and 10% of our consolidated contract receivables.

Intangible Assets Subject to Amortization

Amortization of intangible assets other than goodwill is recognized on a straight-line basis over the estimated useful life of the intangible assets, except for customer relationships, which are recognized in proportion to the related projected revenue streams. Intangible assets with definite lives are reviewed for impairment if indicators of impairment arise. GSE does not have any intangible assets with indefinite useful lives other than goodwill.

During the three months ended March 31, 2020, we determined the impact of the COVID-19 virus on our operations was an indicator of a triggering event that could result in an impairment of our long-lived assets. As such, we performed an interim analysis to determine if an impairment existed at March 31, 2020 by its individual asset groupings, which management determined to be at the subsidiary level. We used a discounted cash flow analysis to test for impairment and concluded that the carrying value of the definite-lived intangible assets of DP Engineering exceeded its carrying value by $4.3 million, and we recorded an impairment for this amount as of March 31, 2020. No impairment was identified related to any other asset groupings.

Changes in the gross carrying amount, accumulated amortization, addition and impairment of definite-lived intangible assets was as follows:

Amortization expense related to definite-lived intangible assets totaled $670 thousand and $570 thousand for the three months ended March 31, 2020 and 2019, respectively. The following table shows the estimated amortization expense of the definite-lived intangible assets for the next five years and thereafter:

Goodwill

We review goodwill for impairment annually as of December 31 and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. We test goodwill at the reporting unit level. A reporting unit is an operating segment, or one level below an operating segment, as defined by U.S. GAAP. We have determined that we have two reporting units, which are the same as our two operating segments: (i) Performance Improvement Solutions ("Performance") and (ii) Nuclear Industry Training and Consulting ("NITC").

We reviewed our goodwill for impairment, due to the COVID-19 interim triggering event noted above. Based upon our analysis, we determined the fair value of our goodwill at the reporting unit level exceeded the carrying value and determined no impairment charge was required during the three months ended March 31, 2020.

ASC 820, Fair Value Measurement, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The levels of the fair value hierarchy established by ASC 820 are:

Level 1:  inputs are quoted prices, unadjusted, in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2:  inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. A Level 2 input must be observable for substantially the full term of the asset or liability. The Monte Carlo model was used to calculate the fair value of level 2 instrument liability award. The inputs used are current stock price, expected term, risk-free rate, number of trials, volatility and interest rates.

Level 3:  inputs are unobservable and reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability. The contingent consideration was based on EBITDA.

At March 31, 2020 and December 31, 2019, we considered the recorded value of certain of its financial assets and liabilities, which consist primarily of cash equivalents, accounts receivable and accounts payable, to approximate fair value based upon their short-term nature.

As of March 31, 2020, we had four standby letters of credit totaling $1.2 million, which represent performance bonds on four contracts.

For the three months ended March 31, 2020, we did not have any transfers between fair value Level 1, Level 2 or Level 3. We did not hold any non-financial assets or non-financial liabilities subject to fair value measurements on a recurring basis at March 31, 2020.

The following table presents assets and liabilities measured at fair value at March 31, 2020:

Money market funds at both March 31, 2020 and December 31, 2019 are included in cash and cash equivalents in the respective consolidated balance sheets.

The following table presents assets and liabilities measured at fair value at December 31, 2019:

In the normal course of business our operations are exposed to fluctuations in foreign currency values and interest rate changes. We may seek to control a portion of these risks through a risk management program that includes the use of derivative instruments.

Foreign Currency Risk Management

We utilize forward foreign currency exchange contracts to manage market risks associated with fluctuations in foreign currency exchange rates and to minimize credit exposure by limiting counterparties to nationally recognized financial institutions.

As of March 31, 2020, we had no foreign exchange contracts outstanding.

Interest Rate Risk Management

We reports all derivatives at fair value. These contracts are recognized as either assets or liabilities, depending upon the derivative’s fair value. The estimated net fair values of the derivative contracts on the consolidated balance sheets are as follows:

We have not designated any of its derivative contracts as hedges. Changes in the fair value of the derivative contracts are included in gain (loss) on derivative instruments, net in the consolidated statements of operations.

The foreign currency denominated contract receivables, billings in excess of revenue earned and subcontractor accruals that are related to the outstanding foreign exchange contracts are remeasured at the end of each period into our functional currency, using the current exchange rate at the end of the period. The gain or (loss) resulting from such remeasurement is also included in gain (loss) on derivative instruments, net in the consolidated statements of operations.

For the three months ended March 31, 2020 and 2019, we recognized a net (loss) gain on our derivative instruments as outlined below:

During the three months ended March 31, 2020, we realized a gain of $17 thousand for foreign exchange contracts due to their close out during the quarter, and we recorded a gain of $102 thousand related to the change in the fair value of foreign exchange contracts for the three months ended March 31, 2019.

We recognize stock-based compensation expense for all equity-based awards issued to employees, directors and non-employees that are expected to vest. Stock-based compensation expense is based on the fair value of awards as of the grant date. We recognized $147 thousand and $570 thousand of stock-based compensation expense related to equity awards for the three months ended March 31, 2020 and 2019, respectively, under the fair value method. In addition to the stock-based compensation expense recognized, we also recognized $(6) thousand and $27 thousand of expense related to the change in the fair value of cash-settled restricted stock units (RSUs) during the three months ended March 31, 2020 and 2019, respectively.

During the three months ended March 31, 2020, we granted 30,000 time-vesting RSUs to employees with an aggregate fair value of approximately $21 thousand. During the three months ended March 31, 2019, the Company granted approximately 300,000 time-vesting RSUs to employees with an aggregate fair value of approximately $800 thousand. A portion of the time-vesting RSUs vest quarterly in equal amounts over the course of eight quarters, and the remainder vest annually in equal amounts over the course of three years. The fair value of the time-vesting RSUs is expensed ratably over the requisite service period, which ranges from one year to three years.

Our 1995 long-term incentive program (LTIP) provides for the issuance of performance-vesting and time-vesting restricted stock units to certain executives and other employees. Vesting of the performance-vesting restricted stock units (PRSU's) is contingent upon the employee's continued employment, and our achievement of certain performance goals during designated performance period as established by the Compensation Committee of the Board of Directors. We recognize compensation expense, net of estimated forfeitures, for PRSU's on a straight-line basis, over the performance period and based on the probable outcome of achievement of the financial targets. At the end of each reporting period, the Company estimates the number of PRSUs that are expected to vest, based on the probability and extent to which the performance goals will be met, to determine the expense for the period. If the number of shares expected to be earned changes during the period of performance, we make a cumulative adjustment to compensation expense based on the revised number of shares expected to vest.

During the three months ended March 31, 2020, we granted approximately 510,000 performance-vesting RSUs to key employees with an aggregate fair value of approximately $600 thousand. These awards vest over three years based upon certain financial metrics achieved during fiscal 2022. Approximately 50% of these awards are based upon obtaining certain revenue targets, and the remainder are based upon achieving certain Adjusted EBITDA targets. During the three months ended March 31, 2019, we granted approximately 350,000 performance-vesting RSUs. These awards vest over three years based upon achieving certain financial metrics during 2021 for revenue and Adjusted EBITDA.

We did not any grant stock options for the three months ended March 31, 2020 or 2019.

We entered into a 3-year, $5.0 million revolving line of credit facility with Citizens Bank National Association (the “Bank") to fund general working capital needs and acquisitions. We amended this facility on May 11, 2018 with the Amended and Restated Credit and Security Agreement (the “Credit Agreement" or the “Credit Facility”) to (a) expand the $5.0 million revolving line of credit to include a letter of credit sub-facility and not subject to a borrowing base ("the RLOC") and (b) to add a $25.0 million term loan facility, available to finance permitted acquisitions over the following 18 months. The credit facility is subject to certain financial covenants and reporting requirements, matures in five years and bear interest at the one-month USD LIBOR, plus a margin that varies depending on our overall leverage ratio. The RLOC has required monthly payments of only interest, with principal due at maturity, while our term loan draws require monthly payments of principal and interest, based on an amortization schedule. We are not required to maintain a restricted cash collateral account at Citizens Bank for the RLOC. Our obligations under the Credit Agreement are guaranteed by our wholly-owned subsidiaries Hyperspring, Absolute, True North, DP Engineering and by any future material domestic subsidiaries (collectively, "the Guarantors").  

 

On June 28, 2019, we entered into the Fifth Amendment and Reaffirmation Agreement, which changed our fixed charge coverage ratio from 1.25 to (i) 2.75 to 1.00 for the period ending March 31, 2020; (ii) 2.50 to 1.00 for the periods ending June 30, 2020 and September 30, 2020; (iii) 2.25 to 1.00 for the periods ending December 31st, March 31st, June 30th and September 30^th, thereafter.  

 

On January 8, 2020, due to an expected violation of our covenants, we entered into the Sixth Amendment and Reaffirmation Agreement and effective on December 31, with our Bank to relax the fixed charge coverage ratio and leverage ratio and delay testing of both financial covenants. We agreed to an additional covenant, requiring us to maintain a consolidated Adjusted EBITDA target of $4.25 million, tested quarterly as of December 31, 2019, March 31, 2020 and June 30, 2020. Further, we agreed to maintain a minimum USA liquidity of at least $5.0 million in the aggregate, tested bi-weekly as of the fifteenth and the last day of each month, beginning on December 31, 2019 and until June 30, 2020. In addition to the revised covenants, we agreed to make accelerated principal payments of $3.0 million on January 6, 2020; $1.0 million on March 31, 2020; and $1.0 million on June 30, 2020.  

 

On April 17, 2020, we entered into the Seventh Amendment and Reaffirmation Agreement and effective March 31, 2020, which requires us to maintain a minimum fixed charge coverage ratio of 1.25 to 1.00, tested quarterly as of the last day of each quarter, beginning with the quarter ending June 30, 2021. In addition, we agreed to not exceed a maximum leverage ratio, tested quarterly as of the last day of each quarter and beginning with the quarter ending September 30, 2020 as follows:  (i)  3.00 to 1.00 for the period ending on September 30, 2020; (ii) 2.50 to 1.00 for the period ending on December 31, 2020; and (iii) 2.25 to 1.00 for the period ending on March 31, 2021 and for the periods ending December 31, March 31, June 30 and September 30, thereafter. We additionally agreed to make accelerated principal payments of $0.75 million on April 17, 2020 and $0.5 million on June 30, 2020.  

 

We have the option to refinance the term loan facility if certain requirements are met, including certain covenant thresholds. 

 

Revolving Line of Credit 

 

We intend to continue using the RLOC for short-term working capital needs and the issuance of letters of credit in connection with business operations. Letter of credit issuance fees range between 1.25% and 2.00% depending on our overall leverage ratio, and we pay an unused RLOC fee quarterly based on the average daily unused balance. 

 

At March 31, 2020, we had borrowed $3.5 million under the RLOC, and there were four letters of credit totaling $1.2 million outstanding to certain of our customers. The amount available at March 31, 2020, after consideration of letters of credit, was approximately $0.3 million. 

 

Term Loan 

 

As discussed in Note 4, we acquired DP Engineering on February 15, 2019 for approximately $13.5 million in cash and borrowed $14.3 million to finance the acquisition. The loan matures in five years and bears interest at the adjusted USD LIBOR, plus a margin ranging between 2.00% and 2.75% depending on our overall leverage ratio. There were no debt issuance costs or loan origination fees associated with this transaction. 

 

Additionally, to fund the acquisition of True North, we borrowed $10.3 million on May 11, 2018, $0.5 million of which was repaid to the Bank on the same day. The loan matures in five years and bears interest at the adjusted one-month USD LIBOR, plus a margin ranging between 2.00% and 2.75% depending on our overall leverage ratio. We incurred $70 thousand of debt issuance costs and $75 thousand of loan origination fees related to this transaction. Debt issuance costs and loan origination fees are reported as a direct deduction from the carrying amount of the loan and amortized over the term of the loan using the effective interest method. 

Possible violation of debt covenants during Fiscal 2020 

 

As discussed in Note 1, substantial doubt has been raised regarding our ability to continue as a going concern due to a probable debt covenant violation and have classified our debt as current in our consolidated balance sheets as of March 31, 2020 and December 31, 2019. 

 

The Credit Agreement contains customary covenants, as described above, and restrictions typical for a financing of this type, that, among other things, restricts our ability to incur additional debt, pay dividends, make distributions, make certain investments and acquisitions, repurchase our stock and prepay certain indebtedness, create liens, enter into agreements with affiliates, modify the nature of our business, enter into sale-leaseback transactions, transfer and sell material assets and merge or consolidate. Non-compliance with one or more of the covenants and restrictions after any applicable grace period could result in the obligations under the Credit Agreement becoming immediately due and payable and termination of the facilities. If an event of default under the Credit Agreement occurs and is continuing, then the Bank may declare the obligations under the Credit Agreement to be immediately due and payable and may terminate the credit facilities. 

We accrue for estimated warranty costs at the time the related revenue is recognized and based on historical experience and projected claims. Our System Design and Build contracts generally include a one-year base warranty on the systems. The portion of our warranty provision expected to be incurred within 12 months is classified as current within accrued warranty and totals $949 thousand and the remaining $344 thousand is classified as long-term within other liabilities. The activity in the accrued warranty accounts during the current period is as follows:

We generate revenue primarily through three broad revenue streams: 1) System Design and Build ("SDB"), 2) Software and 3) Training and Consulting Services. We recognize revenue from SDB and software contracts mainly through our Performance segment. Training and consulting service contracts are recognized through both our Performance and NITC segments.

The following table represents a disaggregation of revenue by type of goods or services for the three months ended March 31, 2020 and 2019, along with the reportable segment for each category:

(in thousands)

SDB contracts are typically fixed-priced, and we receive payments based on a billing schedule established in our contracts. We generally have 2 main performance obligations: the training simulator build and Post Contract Support ("PCS").

Fees for Post Contract Support ("PCS") are normally paid in advance of the service period.

The training simulator build generally includes hardware, software and labor. We recognize revenue for the training simulator build over the construction and installation period, using the cost-to-cost input method. In applying the cost-to-cost input method, we use the actual costs incurred to date, relative to the total estimated costs, to measure the work progress towards the completion of the performance obligation and recognize revenue accordingly. Estimated contract costs are reviewed and revised periodically during the contract period, and the cumulative effect of any change in estimates is recognized in the period in which the change is identified. Estimated losses are recognized in the period such losses are identified. Uncertainties inherent in the performance of contracts include labor availability and productivity, material costs, change order scope and pricing, software modification and customer acceptance issues. The reliability of these cost estimates is critical to our revenue recognition as a significant change in the estimates can cause our revenue and related margins to change significantly from the amounts estimated in the early stages of the project.

The transaction price for Software contracts is generally fixed and revenue is recognized upon delivery of the software, with fees due in advance of or shortly after delivery of the software.

We recognize Training and Consulting Services revenue as services are performed and bill our customers on a regular basis, such as weekly, biweekly or monthly for services provided and in time with revenue recognition.

Contract liability, which we classify as billing in excess of revenue earned, relates to payments received in advance of performance under the contract. Contract liabilities are recognized as revenue as performance obligations are satisfied.

The following table reflects the revenue recognized in the reporting periods that were included in contract liabilities from contracts with customers:

(in thousands)

As of March 31, 2020, the aggregate amount of transaction price allocated to the remaining performance obligations of SDB, software and fixed-price training and consulting services contracts is $22.8 million. We will recognize the revenue as the performance obligations are satisfied and expected this to occur over the next 12 months.

The following table shows the provision for (benefit from) income taxes and our effective tax rates:

Our income tax benefit for the interim periods presented is determined using an estimate of our annual effective tax rate, adjusted for discrete items arising in that quarter. Total income tax expense for the three months ended March 31, 2020 is comprised mainly of foreign and state tax expense. Total income tax expense for the three months ended March 31, 2019 is comprised mainly of the tax impact of the loss for impairment, federal, foreign and state tax expense.

Our effective tax rate was 2.0% and 30.1% for the three months ended March 31, 2020 and 2019, respectively. For the three months ended March 31, 2020, the difference between our effective tax rate of 2.0% and the U.S. statutory federal income tax rate of 21% was primarily due to accruals related to uncertain tax positions for certain U.S. and foreign tax contingencies, a change in tax valuation allowance in our US and China subsidiaries and discrete item adjustments for U.S. and foreign taxes. For the three months ended March 31, 2019, the difference between the effective tax rate of 30.1% and the U.S. statutory federal income tax rate of 21% was primarily due to permanent differences, accruals related to uncertain tax positions for certain U.S. and foreign tax contingencies, a change in tax valuation allowance in our China subsidiary, discrete item adjustments for the U.S. and foreign taxes, the tax impact of the loss for impairment and the excess book deduction related to stock options and restricted stock units that were exercised or vested during the quarter.

Because of our net operating loss carryforwards, we are subject to U.S. federal and state income tax examinations from the year 2000 and forward. We are subject to foreign tax examinations by tax authorities for years 2014 and forward in Sweden, 2015 and forward in China, 2015 and forward in India and 2016 and forward in the United Kingdom.

An uncertain tax position taken or expected to be taken in a tax return is recognized in the consolidated financial statements when it is more likely than not (i.e., a likelihood of more than 50%) that the position would be sustained upon examination by tax authorities that have full knowledge of all relevant information. A recognized tax position is then measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Interest and penalties related to income taxes are accounted for as income tax expense.

We recognize deferred tax assets to the extent that it is believed that these assets are more likely than not to be realized. We have evaluated all positive and negative evidence and determined that it will continue to assess a full valuation allowance on its U.S., Swedish U.K., Chinese and Slovakian net deferred assets as of March 31, 2020. We have determined that it is not more likely than not that it will realize the benefits of its deferred taxes in the U.S and foreign jurisdictions.

We maintain leases of office facilities and equipment. Leases generally have remaining terms of one year to five years, whereas leases with an initial term of twelve months or less are not recorded on the Consolidated Balance Sheets. We recognize lease expense for minimum lease payments on a straight-line basis over the term of the lease. Certain leases include options to renew or terminate. Renewal options are exercisable based upon our discretion and vary based on the nature of each lease, with renewal periods generally ranging from one year to five years. The term of the lease includes renewal periods, only if we are reasonably certain that we will exercise the renewal option. When determining if a renewal option is reasonably certain of being exercised, we consider several factors, including but not limited to, the cost of moving to another location, the cost of disruption to operations, whether the purpose or location of the leased asset is unique and the terms associated with extending the lease.

Operating lease ROU assets and operating lease liabilities are recognized based on the present value of the future minimum lease payments over the lease term at commencement date. The operating lease ROU assets represent the lease liability, plus any lease payments made at or before the commencement date, less any lease incentives received. Our real estate leases, which are comprised primarily of office spaces, represent a majority of the lease liability. The majority of our lease payments are fixed, although an immaterial portion of payments are variable in nature. Variable lease payments vary based on changes in facts and circumstances related to the use of the ROU and are recorded as incurred. We use an incremental borrowing rate based on rates available at commencement in determining the present value of future payments.

We have lease agreements with lease and non-lease components, which are accounted for as a single lease component. We apply a portfolio approach to effectively account for the operating lease ROU assets and liabilities.

Lease contracts are evaluated at inception to determine whether they contain a lease and whether we obtain the right to control an identified asset. The following table summarizes the classification of operating ROU assets and lease liabilities on the consolidated balance sheets (in thousands):

We executed a sublease agreement with a tenant to sublease 3,650 square feet from the office space in Sykesville on May 1, 2019. This agreement is in addition to the 3,822 of square feet previously subleased, which was entered into on April 1, 2017. The sublease does not relieve us of our primary lease obligation. The lessor agreements are both considered operating leases, maintaining the historical classification of the underlying lease. We do not recognize any underlying assets for the subleases as a lessor of operating leases. The net amount received from the sublease is recorded within selling, general and administrative expenses.

The table below summarizes the lease income and expenses recorded in the consolidated statements of operations incurred during the three months ended March 31, 2020, (in thousands):

⁽¹⁾ Includes variable lease costs which are immaterial.

⁽²⁾ Include leases maturing less than twelve months from the report date.

⁽³⁾ Sublease portfolio consists of 2 tenants, which sublease parts of our principal executive office located at 1332 Londontown Blvd, Suite 200, Sykesville, MD.

The future minimum lease payments under non-cancellable operating leases are reflected below. This table also reflects the reconciliation of the undiscounted cash flows to the discounted operating lease liabilities as recognized at March 31, 2020 consolidated balance sheet (in thousands):

We calculated the weighted-average remaining lease term, presented in years below and the weighted-average discount rate for our operating leases. As noted in our lease accounting policy, we use the incremental borrowing rate as the lease discount rate.

The table below sets out the classification of lease payments in the consolidated statement of cash flows. The right-of-use assets obtained in exchange for operating lease liabilities represent the new operating leases obtained through our business combinations during the three months ended March 31, 2020.

(in thousands)

We have two reportable business segments. The Performance Improvements Solutions segment provides simulation, training and engineering products and services delivered across the breadth of industries we serve. The Performance segment includes simulation for both training and engineering applications. Examples of engineering services include, but are not limited to, plant design verification and validation, thermal performance evaluation and optimization programs and engineering programs for plants for ASME code and ASME Section XI. We provide these services through GSE, True North and DP Engineering across all market segments. Example training applications include turnkey and custom training services. Contract terms are typically less than two years.

The NITC segment provides specialized workforce solutions primarily to the nuclear industry, working at clients' facilities. This business is managed through our Hyperspring and Absolute subsidiaries. The business model, management focus, margins and other factors clearly separate this business line from the rest of our product and service portfolio.

Our primary measure of segment performance, as shown in the table below, excludes the loss on impairment of intangible assets and goodwill and the change in fair value of contingent consideration, net related to the DP Engineering acquisition, which do not accurately represent the ongoing operations of the Performance Improvements Solutions segment. Excluding these discrete items from the segment measure of performance allows for better period over period comparison.

The following table summarizes the revenue and operating results attributable to our reportable segments and includes a reconciliation of segment revenue to consolidated revenue and segment loss to consolidated loss before income taxes. Inter-segment revenue is eliminated in consolidation and is not significant:

Per ASC 450 Contingencies, we review potential items and areas where a loss contingency could arise. In the opinion of management, we are not a party to any legal proceeding, the outcome of which, in management's opinion, individually or in the aggregate, would have a material effect on our consolidated results of operations, financial position or cash flows. Legal defense costs are expensed as incurred.

Joyce v. Absolute Consulting, Inc.

On March 29, 2019, a former employee of Absolute Consulting, Inc., filed a putative class action against Absolute and us in the United States District Court for the District of Maryland (case number 1:19 cv 00868 RDB). The lawsuit alleged the plaintiff was not properly compensated for overtime hours worked. We have been dismissed from the case, but Absolute remains a party and continues to deny allegations and defend this litigation with GSE’s assistance. In July 2020, mediation occurred between Absolute and the plaintiff, at which the parties reached a tentative understanding but not yet a final settlement or conclusion (see Note 17). The parties will continue to work together to finalize a settlement based on the terms of their understanding, which will then be presented for approval to the court. We are unable to conclude regarding the likelihood of an unfavorable outcome or if this matter is remote or probable.

On July 14, 2020, a mediation session occurred between our legal counsel, Absolute Consulting's management and the plaintiffs in the Joyce v. Absolute Consulting Inc. matter (see Note 16). As a result, the parties have entered into non-binding memorandum of understanding (‘MOU’), which if memorialized in a final settlement agreement that receives court approval, would result in an estimated gross settlement between $861 thousand and $1.5 million. If the case is not settled, then the parties would remain in their pre-MOU positions. We are unable to conclude that the likelihood of an unfavorable outcome in this matter is remote or probable.

CARES Act

On April 24, 2020, we received funds under the Paycheck Protection Program, a part of the CARES Act. The loan is serviced by Citizen’s Bank, and the application for these funds required us to, in good faith, certify that the current economic uncertainty made the loan necessary to support our ongoing operations. We plan to use the funds for payroll and related costs, rent, utilities and other debt obligations incurred before February 15, 2020. The receipt of these funds, and the forgiveness of the loan attendant to these funds, is dependent on our ability to adhere to the forgiveness criteria. The loan bears interest at a rate of 0.98% per annum and matures on April 24, 2022, with the first payment deferred until November 2020. Under the terms of the PPP, certain amounts may be forgiven if they are used in accordance with the CARES Act. The Company believes that the full amount of the $10.0 million Paycheck Protection Program loan will be forgiven.

Cautionary Statement Regarding Forward-Looking Statements

This report and the documents incorporated by reference herein contain "forward-looking" statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act") that are based on management's assumptions, expectations and projections about us, and the industry within which we operate, and that have been made pursuant to the Private Securities Litigation Reform Act of 1995 reflecting our expectations regarding our future growth, results of operations, performance and business prospects and opportunities. Wherever possible, words such as "anticipate", "believe", "continue", "estimate", "intend", "may", "plan", "potential", "predict", "expect", "should", "will" and similar expressions, or the negative of these terms or other comparable terminology, have been used to identify these forward-looking statements. These forward-looking statements may also use different phrases. These statements regarding our expectations reflect our current beliefs and are based on information currently available to us. Accordingly, these statements by their nature are subject to risks and uncertainties, including those listed under Item 1A - Risk Factors in our most recent annual report on Form 10-K, which could cause our actual growth, results, performance and business prospects and opportunities to differ from those expressed in, or implied by, these forward-looking statements. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements we make. Except as otherwise required by federal securities law, we are not obligated to update or revise these forward-looking statements to reflect new events or circumstances. We caution you that a variety of factors, including but not limited to the factors described under Item 1A - Risk Factors in our most recent annual report on Form 10-K, could cause our business conditions and results to differ materially from what is contained in forward-looking statements.

Other factors and assumptions not identified above were also involved in the formation of these forward-looking statements and the failure of such other assumptions to be realized, as well as other factors, may also cause actual results to differ materially from those projected.  Most of these factors are difficult to predict accurately and are generally beyond our control. You should consider the areas of risk described in Item 1A - Risk Factors in our most recent annual report on Form 10-K in connection with any forward-looking statements that may be made by us. You should not place undue reliance on any forward-looking statements. New factors emerge from time to time, and it is not possible for us to predict which factors will arise.

We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any additional disclosures we make in proxy statements, quarterly reports on Form 10-Q and current reports on Form 8-K filed with the SEC.

GSE is a leading provider of professional and technical engineering, staffing services and simulation software to clients in the power and process industries. We provide customers with simulation, engineering and plant services that help clients reduce risks associated with operating their plants, increase revenue through improved plant and employee performance, and lower costs through improved operational efficiency. In addition, we provide professional services that systematically help clients fill key vacancies in the organization on a short-term basis, primarily in procedures, engineering, technical support, and training focused on regulatory compliance and certification in the nuclear power industry. Our operations also include interactive computer-based tutorials and simulation software for the refining, chemical, and petrochemical industries.

In December 2019, a novel strain of coronavirus, the COVID-19 virus, was reported in Wuhan, China. On March 11, 2020, the WHO declared the COVID-19 virus a global pandemic and on March 13, 2020, President Donald J. Trump declared the virus a national emergency in the United States. As of the date of this report, both the health and economic aspects of the COVID-19 virus are highly fluid and the future course of each is uncertain. As such, the ultimate impact the pandemic will have on the Company’s financial condition, liquidity and future results of operations is highly uncertain and subject to change. Management is actively monitoring the situation on its financial condition, liquidity, operations, industry, supplies and workforce. The Company expects that financial results for the fiscal year 2020 will be negatively affected as a result of COVID-19.

During the three months ended March 31, 2020, we determined that the COVID-19 virus was an indicator of a triggering event that could result in an impairment of our assets. Based upon this assessment, we performed an interim analysis of our individual asset groupings at the subsidiary level and concluded that the carrying value of the assets of DP Engineering exceeded its fair value. We used the discounted cash flow analysis to test for impairment and calculated that the fair value exceed the carrying value of the DP Engineering definite-lived intangible assets by $4.3 million and recorded an impairment for this amount as of March 31, 2020.

On April 24, 2020, we received funds under the Paycheck Protection Program, a part of the CARES Act. The loan is serviced by Citizen’s Bank, and the application for these funds required us to, in good faith, certify that the current economic uncertainty made the loan necessary to support our ongoing operations. We plan to use the funds for payroll and related costs, rent, utilities and other debt obligations incurred before February 15, 2020. The receipt of these funds, and the forgiveness of the loan attendant to these funds, is dependent on our ability to adhere to the forgiveness criteria. The loan bears interest at a rate of 0.98% per annum and matures on April 24, 2022, with the first payment deferred until November 2020. Under the terms of the PPP, certain amounts may be forgiven if they are used in accordance with the CARES Act. The Company believes that the full amount of the $10.0 million Paycheck Protection Program loan will be forgiven.

General Business Environment

We operate through two reportable business segments: Performance Improvement Solutions and NITC. Each segment focuses on delivering solutions to customers within our targeted markets - primarily the power and process industries. Marketing and communications, accounting, finance, legal, human resources, corporate development, information systems and other administrative services are organized at the corporate level. Business development and sales resources are generally aligned with each segment to support existing customer accounts and new customer development. The business units collaborate to facilitate cross-selling and the development of new solutions. The following is a description of our business segments:

Performance Improvement Solutions (approximately 55% of revenue at March 31, 2020)

Our Performance Improvement Solutions segment primarily encompasses our power plant high-fidelity simulation solutions, engineering services for ASME programs, thermal performance optimization and plan design modifications, and interactive computer-based tutorials/simulation focused on the process industry. This segment includes various simulation products, engineering services, and operation training systems delivered across the industries we serve, primarily nuclear and fossil fuel power generation, as well as natural adjacencies in the process industries. Our simulation solutions include the following: (1) simulation software and services, including operator training systems, for the nuclear power industry, (2) simulation software and services, including operator training systems, for the fossil power industry, and (3) simulation software and services for the process industries used to teach fundamental industry processes and control systems to newly hired employees and for ongoing workforce development and training. GSE and its predecessors have been providing these services since 1976.

Our engineering solutions include the following: (1) in-service testing for engineering programs focused on ASME OM code including Appendix J, balance of plant programs, and thermal performance; (2) in-service inspection for specialty engineering including ASME Section XI; (3) software solutions; and (4) mechanical design, civil/structural design, electrical, instrumentation and controls design, digital controls/cyber security and fire protection for nuclear power plant design modifications.  Our True North and DP Engineering businesses typically work as either the engineer of choice or specialty engineer of choice for our clients under master services agreements.  GSE and its predecessors have been providing these engineering solutions and services since 1995.

On February 15, 2019, through its wholly-owned subsidiary GSE Performance Solutions, Inc., the Company entered into the DP Engineering Purchase Agreement, to purchase 100% of the membership interests in DP Engineering. For reporting purposes, DP Engineering is included in our Performance Improvement Solutions segment due to similarities in services provided including engineering solutions and implementation of design modifications to nuclear power sector.

Nuclear Industry Training and Consulting (approximately 45% of revenue at March 31, 2020)

NITC provides highly specialized, expert-professionals to the nuclear power industry. These employees work at our clients' facilities under client direction. Examples of these highly skilled positions are senior reactor operations instructors, procedure writers, project managers, work management specialists, planners and training material developers. This business is managed through the Hyperspring and Absolute subsidiaries. The business model, management focus, margins and other factors clearly separate the business line from the rest of the Company's product and service portfolio. GSE and its predecessors have been providing these training and consulting services since 1997.

Business Strategy

Our objective has been to create a leading specialty engineering, expert staffing and technology delivery platform focused primarily on the nuclear power industry. We offer our differentiated suite of products and services to adjacent markets such as the defense industry, the fossil power and process industries where our offerings are a natural fit, delivering a clear and compelling value proposition to the market. Our growth strategy had been twofold: (1) seek acquisitions to accelerate our overall growth in a manner that is complementary to our core business and (2) expand organically within our core markets by leveraging our market leadership position and drive increased usage and product adoption via new products and services. To accomplish this objective, we will pursue the following activities:

Strategic pause in our executed roll-up acquisition strategy: Over the past few years we have complemented our organic growth strategy with selective acquisitions including, but not limited to, the following: engineering; training, staffing and consulting service businesses for the power industry, with a particular focus on nuclear power; and software utilized in the power industry, both domestic and international. We had focused our acquisition efforts on opportunities that would enhance our portfolio of products and services, strengthen our relationships with our existing customers, and potentially expand our footprint to include new customers in our core served industries. Following this strategy, we have made three acquisitions since 2017.  Although we believe opportunities still exist to acquire more businesses that would be complementary to ours, given our current desire to focus on cross selling and upselling across our existing business portfolio, we have paused our acquisition of new businesses.  Our current efforts are focused on organic growth across the portfolio while utilizing free cash flow to pay down debt associated with our delayed-draw term loan facility. While our roll-up acquisition strategy is on pause, the Company remains open to transformational opportunities that may present themselves.

Summary of recent acquisitions: In February 2019, we acquired DP Engineering, a specialized provider of high-value engineering services and solutions to the nuclear power industry. In May 2018, we acquired True North, a leading provider of specialty engineering solutions to the nuclear power industry, and in September 2017, we acquired Absolute, a provider of technical consulting and staffing solutions to the global nuclear power industry. The acquisitions of Absolute, True North, and DP Engineering collectively enhanced the Company’s unique capabilities in the nuclear services area. The acquisitions have added new capabilities to the GSE solution offering and bring new highly complementary customers to GSE, while at the same time deepening GSE relationships with existing clients. These acquisitions have added scale and focus to the business, while positioning GSE as a “go to” provider of technical and consulting solutions to the power industry, particularly nuclear power. We feel that now is the time to focus on organic growth opportunities through cross selling and upselling GSE’s full range of products and services to the industry.

Expand our total addressable market: Our focus on organic growth means enhancing our product capabilities or new product and introduce new service categories that create value for our customers and therefore expand our total addressable market. Currently we are working on initiatives to expand our solution offerings in both of our business segments that may include, but are not limited to, the following: expanding our software product portfolio to include enhanced power and process simulation tools and systems that are complementary to our core offerings; delivering enhanced learning management systems/solutions; offering fully outsourced training solutions to our customers; adding work flow process improvement solutions; tailoring operational reporting and business intelligence solutions to address the unique need of our end user markets; and adding new services to broaden our market reach. With the pause of our roll-up acquisition strategy, our current expansion efforts are primarily organic in nature.

We are unique among engineering firms in the nuclear market in ability to serve the entire lifecycle of a plant through a combination of expert service not found in other Engineers of Choice. We offer clients the ability to perform the upfront engineering design, address and optimize regulatory compliance, optimize designs through simulation assisted engineering, and provide all of the professional temporary staffing needed for a wide variety of specialized engineering projects.

Initiatives such as these will broaden our scope and enable us to engage more deeply with the segments we serve and to address the needs of customers in adjacent segments. We have delivered a compelling solution, the GSE GPWRTM Generic Pressurized Water Reactor simulation technology, proving that our modeling technology can be sold in generic form via traditional license terms and conditions to the nuclear industry ecosystem. We have both upgraded and expanded the EnVision™ library of simulation and eLearning tutorials for the process industries with specific new products for training clients in the upstream segment of the oil and gas industry including launching a new cloud-based training platform, EnVision™ Learning On-Demand, that significantly extends the capabilities of its industry leading EnVision™ tutorials and simulations. We continue to provide cutting edge training systems by adapting our technology to systems that meet the specific needs of customers such as U.S. government laboratories.

Research and development (R&D): We invest in R&D to deliver unique solutions that add value to our end-user markets. We have delivered nuclear core and Balance-of-Plant modeling and visualization systems to the industry. To address the nuclear industry's need for more accurate simulation of both normal and accident scenarios, we provide our DesignEP® and RELAP5-HD® solutions. Our entire JADETM suite of simulation software, including industry leading JTOPMERET® and JElectricTM software, provides the most accurate simulation of balance of plant and electrical systems available to the nuclear and fossil plant simulation market. The significant enhancements we have made to our SimExec® and OpenSimTM platforms enables customers to be more efficient in the daily operation of their simulators. We are bringing SimExec® and OpenSimTM together into a next generation unified environment that will add new capabilities as requested by clients and driven by market need.

We intend to continue to make pragmatic and measured investments in R&D that first and foremost are driven by the market and complement our growth strategy. Such investments in R&D may result in on-going enhancement of existing solutions as well as the creation of new solutions to serve our target markets, ensuring that we add greater value that is easier to use, at lower total cost of ownership than any alternative available to customers. GSE has pioneered a number of industry standards and intends to continue to be one of the most innovative companies in our industry.

Strengthen and develop our talent while delivering high-quality solutions: Our experienced employees and management team are our most valuable resources. Attracting, training, and retaining top talent is critical to our success. To achieve our talent goals, we intend to remain focused on providing our employees with entrepreneurial opportunities to increase client contact within their areas of expertise and to expand and deepen our service offerings. We will also continue to provide our employees with training, personal and professional growth opportunities, performance-based incentives including opportunities for stock ownership, bonuses and competitive benefits as benchmarked to our industry and locations. We have developed a strong reputation for quality services based upon our industry-recognized depth of experience, ability to attract and retain quality professionals, and exceptional expertise across multiple service sectors. We have received numerous industry certificates and awards over the years for outstanding service.

Employees:  As of March 31, 2020, we had approximately 394 employees, which includes approximately 195 in our Performance Improvement Solutions segment and approximately 183 in our NITC segment. To date, we have been able to locate and engage highly qualified employees as needed and we expect our growth efforts to be addressed through attracting top talent.

Backlog:  As of March 31, 2020, we had approximately $54.0 million of total gross revenue backlog, which included $32.2 million of Performance Improvement Solutions backlog and $21.8 million of NITC backlog. With respect to our backlog, it includes only those amounts that have been funded and authorized and does not reflect the full amounts we may receive over the term of such contracts. Our backlog includes future expected revenue at contract rates, excluding contract renewals or extensions that are at the discretion of the client.  We calculate backlog without regard to possible project reductions or expansions or potential cancellations unless and until such changes may occur.

Backlog is expressed in terms of gross revenue and, therefore, may include significant estimated amounts of third-party or pass-through costs to subcontractors and other parties.  Because backlog is not a defined accounting term, our computation of backlog may not necessarily be comparable to that of our industry peers.

Products and Services

Performance Improvement Solutions

To assist our clients in creating world-class internal training and engineering improvement processes, we offer a set of integrated and scalable products and services that provide a structured program focused on continuous skills improvement for experienced employees to engineering services, including plant design verification and validation, ASME code compliance, and design plant modification work. We provide the right solutions to solve our clients’ most pressing needs.

For workforce development and training, students and instructors alike must have a high degree of confidence that their power plant simulator truly reflects plant behavior across the entire range of operations. To earn this confidence, GSE’s simulation solution starts with the most robust engineering approach possible. Using state-of-the-art modeling tools combined with our leading nuclear power modeling expertise, GSE provides simulation solutions that achieve unparalleled fidelity and accuracy. The solutions that GSE provides are also known for ease of use, resulting in increased productivity for end-users. For these reasons, GSE has delivered more nuclear power plant simulators than any other company in the world.

For virtual commissioning, designers of first-of-a-kind plants or existing plants need a highly accurate dynamic simulation platform to model a wide variety of design assumptions and concepts from control strategies to plant behavior to human factors. Because new builds and upgrades to existing plants result in deployment of new technology, often involving the integration of disparate technologies for the first time, a high-fidelity simulator enables designers to model the interaction between systems in advance of construction. With our combination of simulation technology and expert engineering, GSE was chosen to build first-of-a-kind simulators for the AP1000, PBMR, and small modular reactors such as those being built by NuScale.

Examples of the types of simulators we sell include the following:

Nuclear Industry Training and Consulting

As our customers’ experienced staff retire, access to experts that can help operate and train existing and new employees in how to operate their plants is essential to ensure safe ongoing plant operations. In addition, operating and training needs change over time and sometimes our clients require fixed priced discrete projects or specialized courses in contrast to straight staff augmentation. The industry needs operating personnel, including procedure writers, engineers, operators and instructors who can step in and use as well as update the client’s operating methods, procedures, training material and more. Finding technical professionals and instructors, who know the subject, can perform the work or teach it to others and can adapt to the client’s culture, is critical. GSE provides qualified professionals, instructors and turnkey projects/courses that work within the client’s system and complement the operating or training methods they already have in place. Examples of our training program courses include senior reactor operator certification, generic fundamentals training, and simulation supervisor training. In addition, we also provide expert support through consulting or turnkey projects for procedure writing, technical engineers, project managers, training material upgrade and development, outage execution, planning and scheduling, corrective actions programs, and equipment reliability.

We bring together the collection of skills we have amassed over more than 40 years beginning with its traditional roots in custom high-fidelity simulation and training solutions for the power industries, extended through the acquisition of specialized engineering capabilities, enhanced by the entry and intermediate level training solutions of EnVision and the extensive nuclear industry training and consulting services of Absolute and Hyperspring.

Results of Operations

The following table sets forth the results of operations for the periods presented expressed in thousands of dollars and as a percentage of revenue.

Results of Operations - three months ended March 31, 2020 versus three months ended March 31, 2019

Revenue

Revenue for the three months ended March 31, 2020 totaled $17.7 million, which was 20.2% less than the $22.2 million of revenue for the three months ended March 31, 2019. The decrease in revenue over the prior fiscal period was due to a decrease in both of our reporting segments, Performance Improvement Solutions and NITC, as shown below:

Performance Improvement Solutions revenue decreased 20.3% to $9.7 million for the three months ended March 31, 2020 from $12.2 million for the three months ended March 31, 2019. The change was mainly driven by a decrease of $2.2 million in Performance due to major simulator project completions in the first quarter of 2019, which have not been replaced. In addition, we experienced a reduction in international revenue of $0.3 million for the three months ended March 31, 2020, as compared to the same period in 2019. We recorded total Performance orders of $5.4 million and $4.6 million for the three months ended March 31, 2020 and 2019, respectively. For the three months ended March 31, 2020 and 2019, our revenue on training and consulting services through time and material or fixed-price contracts accounted for 51% and 41% of the segment's revenue, respectively.

Nuclear Industry Training and Consulting revenue decreased 20.1% to $8.0 million for the three months ended March 31, 2020 from $10.0 million, for the three months ended March 31, 2019. The decrease in sales was attributed to lower demand for staff augmentation support from two major customers, and the completion of a large project on December 31, 2019. NITC orders totaled $14.3 million and $9.8 million for the three months ended March 31, 2020 and 2019, respectively. In the first quarter of 2019, we increased the business development team to grow sales and to make us more responsive to the needs of our new and existing customers.

At March 31, 2020, backlog was $54.0 million, of which $32.2 million was attributed to the Performance segment and $21.8 million was attributed to the NITC segment. At December 31, 2019, our backlog was $52.7 million, of which $37.2 million was attributed to the Performance segment and $15.5 million was attributed to the NITC segment.

Gross profit

Gross profit was $4.1 million or 23.2%, for the three months ended March 31, 2020, compared to $4.7 million or 21.3%, for the same period in 2019.

The decrease in our gross profit of $621 thousand was primarily driven by decreased gross profit margins in our Performance segment, due to completion of higher margin projects in our True North and DP Engineering subsidiaries during fiscal 2019.

Selling, general and administrative expenses

Selling, general and administrative (SG&A) expenses totaled $4.9 million and $4.4 million for the three months ended March 31, 2020 and 2019, respectively. Significant changes in the components of SG&A spending were as follows:

Corporate charges

Corporate charges decreased $446 thousand during the three months ended March 31, 2020 due primarily to a reduction of $600 thousand in acquisition costs paid during the three months ended March 31, 2019 for DP Engineering.

Contingent consideration

Change in fair value of contingent consideration initially recorded for DP Engineering with no similar charge in the three months ended March 31, 2020.

Bad debt expense

We recorded bad debt expense of $93 thousand and $0 for the three months ended March 31, 2020 and 2019, respectively. We record bad debt allowance based on historical trends of past due amounts, write-offs and specific identification and review of customer accounts.

Research and development

Research and development costs consist primarily of software engineering personnel and other related costs. Research and development costs, net of capitalized software, totaled $210 thousand and $240 thousand for the three months ended March 31, 2020 and 2019, respectively. Before capitalization of software development costs, research and development costs totaled $272 thousand and $350 thousand for three the months ended March 31, 2020 and 2019, respectively.

Restructuring charges

For the three months ended March 31, 2020, we incurred $10 thousand of restructuring charges, due primarily to restoration of a leased space due to abandonment. For the three months ended March 31, 2019, we recorded $0 of restructuring charges.

Depreciation

Depreciation expense totaled $108 thousand and $91 thousand for the three months ended March 31, 2020 and 2019, respectively. Depreciation expense relates primarily to computers and related equipment for employees for both years.

Amortization of definite-lived intangible assets

Amortization expense related to definite-lived intangible assets totaled $670 thousand and $570 thousand for the three months ended March 31, 2020 and 2019, respectively. The amortization recorded in both years relates to definite-lived intangible assets acquired in recent fiscal years and predominately consists of customer related intangibles and trademarks.

Impairment on goodwill and definite-lived intangible assets

We determined that the COVID-19 pandemic was a triggering event, requiring an interim impairment test to be performed on our long-lived assets. Management determined that the lowest level of separately, identifiable assets was at the subsidiary level. Based upon our analysis, we determined that the carrying value of the definite-lived intangible assets of DP Engineering exceeded its fair value and recognized a $4.3 million impairment during the three months ended March 31, 2020. In the prior year, we recognized an impairment charge of $5.6 million related to goodwill, upon the acquisition of DP Engineering during the three months ended March 31, 2019 (see Note 4 to the consolidated financial statements).

Gain (Loss) on derivative instruments, net

Gain (loss) on derivative instruments, net relates to our foreign exchange contracts and remeasurement of foreign currency-denominated contract receivables, billings in excess of revenue earned and subcontractor accruals. These amounts are remeasured into the functional currency, using the current exchange rate at the end of the period. For the three months ended March 31, 2020, we recognized a gain of $17 thousand on the change in fair value of foreign exchange contracts and a gain of $37 thousand from the remeasurement of contract receivables, billings in excess of revenue earned and subcontractor accruals. For the three months ended March 31, 2019, we recognized a gain of $102 thousand on the change in fair value of foreign exchange contracts and a gain of $17 thousand from the remeasurement of contract receivables, billings in excess of revenue earned and subcontractor accruals.

Interest expense (income), net

Interest expense totaled $241 thousand and $222 thousand for the three months ended March 31, 2020 and 2019, respectively. Interest income totaled $0 and $14 thousand for the three months ended March 31, 2020 and 2019, respectively.

Other (expense) income, net

We recognized $29 thousand of other income, net and $22 thousand of other income, net for the three months ended March 31, 2020 and 2019, respectively.

Income tax benefit

Income tax benefits were $130 thousand, or an effective income tax rate of 2.0%, for the three months ended March 31, 2020, compared to $1.8 million, or an effective income tax rate of 30.1%, for the three months ended March 31, 2019. Our income tax provision for interim periods is determined using an estimate of our annual effective tax rate, adjusted for discrete items arising in that quarter. Tax expense in 2020 is comprised mainly of foreign income tax expense and state tax expense. Tax expense in 2019 is comprised mainly of the tax impact of the loss for impairment, federal income tax expense, foreign income tax expense and state tax expense.

Our effective tax rate was 2.0% and 30.1% for the three months ended March 31, 2020 and 2019, respectively. For the three months ended March 31, 2020, the difference between the effective tax rate of 2.0% and the U.S. statutory federal income tax rate of 21% was primarily due to accruals related to uncertain tax positions for certain U.S. and foreign tax contingencies, a change in tax valuation allowance in our US and China subsidiaries and discrete item adjustments for the U.S. and foreign taxes. For the three months ended March 31, 2019, the difference between the effective tax rate of 30.1% and the U.S. statutory federal income tax rate of 21% was primarily due to permanent differences, accruals related to uncertain tax positions for certain U.S. and foreign tax contingencies, a change in valuation allowance in our China subsidiary, discrete item adjustments for the U.S. and foreign taxes, including the tax impact of the loss for impairment, and the excess book deduction related to stock options and restricted stock units that were exercised or vested during the quarter.

Because of our net operating loss carryforwards, we are subject to U.S. federal and state income tax examinations from the year 2000 and forward. We are subject to foreign tax examinations by tax authorities for years 2014 forward for Sweden, 2015 forward for China, 2015 forward for India and 2016 forward for the UK.

An uncertain tax position taken or expected to be taken in a tax return is recognized in the consolidated financial statements when it is more likely than not (i.e., a likelihood of more than 50%) that the position would be sustained upon examination by tax authorities that have full knowledge of all relevant information. A recognized tax position is then measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Interest and penalties related to income taxes are accounted for as income tax expense.

We recognize deferred tax assets to the extent that we believe these assets are more likely than not to be realized. We have evaluated all positive and negative evidence and determined that we will continue to assess a full valuation allowance on our U.S., Swedish, U.K., Chinese and Slovakian net deferred assets as of March 31, 2020. We have determined that it is not more likely than not that we will realize the benefits of our deferred taxes in the U.S. and foreign jurisdictions.

Critical Accounting Policies and Estimates

In preparing our consolidated financial statements, Management makes several estimates and assumptions that affect our reported amounts of assets, liabilities, revenues and expenses. Our most significant estimates relate to revenue recognition on contracts with customers, allowance for doubtful accounts, product warranties, valuation of goodwill and intangible assets acquired, valuation of long-lived assets to be disposed of, valuation of contingent consideration issued in business acquisitions, valuation of stock based compensation awards and the recoverability of deferred tax assets. These critical accounting policies and estimates are discussed in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section in our most recent Annual Report on Form 10-K. For all of our accounting policies, management cautions that future events rarely develop exactly as forecasted, and our best estimates may require adjustment as facts and circumstances change.

Liquidity and Capital Resources

As of March 31, 2020, our cash and cash equivalents totaled $11.4 million compared to $11.7 million at December 31, 2019.

For the three months ended March 31, 2020 and 2019, net cash provided by (used in) operating activities was $1.6 million and $(0.6) million, respectively. The increase of $2.2 million in cash flows provided by operating activities was primarily driven by collection of contract receivables during the period.

Net cash used in investing activities totaled $(0.1) million and $(13.6) million for the three months ended March 31, 2020 and 2019, respectively. The decrease in cash outflow used in investing activities in 2020 was primarily driven by the acquisition of DP Engineering in the three months ended March 31, 2019, for which the net cash consideration was $13.5 million.

For the three months ended March 31, 2020 and 2019, cash (used in) provided by financing activities totaled $(1.7) million and $13.5 million, respectively. The increase in the cash outflow from financing activities was driven by a reduction of draws on long-term debt of $14.3 million during the three months ended March 31, 2020; offset by an increase in repayments on term loans of $(4.5) million and a draw on the line of credit of $3.5 million.

We received funds under the Paycheck Protection Program after the period end in the amount of $10.0 million. We plan to use these funds for payroll and related costs, rent, utilities and other debt obligations incurred before February 15, 2020. The Company believes that the full amount of the $10.0 million Paycheck Protection Program loan will be forgiven based upon current projections.

We believe that our cash and cash equivalents at March 31, 2020, cash generated from our normal operations, and the PPP funds received will be sufficient to fund our operating requirements for at least the next twelve months. The PPP funds will not help us avoid violating our debt covenants or prevent substantial doubt from being raised about our ability to continue as a going concern, as discussed below.

Going Concern Consideration

As a result of the COVID-19 pandemic, we are experiencing a negative impact on our financial position and results of operations. We are likely to continue to experience delays in commencing outstanding orders or loss of orders altogether, disruption of our business as a result of worker illness or mandated shutdowns, and this could impact our ability to maintain compliance with our debt covenants, our ability to refinance existing indebtedness and our ability to access new capital. We received $10 million from the Paycheck Protection Program ("PPP") and indicated without these funds, the risk of employee terminations, layoffs and other drastic cost reductions exists. While the PPP funds will provide us liquidity, these funds will not prevent us from potentially not meeting the minimum EBITDA covenant or other of our debt covenants in the future. Including the proceeds from the PPP, we believe we have sufficient cash to meet our operating requirement needs for at least the next twelve months; however since some of our loan covenants are related to operating performance, and our operating performance is being significantly impacted by the COVID-19 pandemic, we believe it is probable we will not remain in compliance with our debt covenants throughout the remainder of fiscal 2020. As a result of the expected debt covenant violation, we have classified our debt as short-term in our consolidated balance sheets as of March 31, 2020 and December 31, 2019, which creates substantial doubt regarding our ability to continue as a going concern.

We entered into a 3-year, $5.0 million revolving line of credit facility ("RLOC") with Citizens Bank National Association (the Bank) on December 29, 2016 to fund general working capital needs and provide funding for acquisitions. We are not required to maintain a restricted cash collateral account at Citizens Bank for outstanding letters of credit and working capital advances. The credit facility agreement is subject to certain financial covenants and reporting requirements.

On May 11, 2018, we entered into an Amended and Restated Credit and Security Agreement ("the Credit Agreement") with the Bank to include (a) a $5.0 million revolving credit facility, not subject to a borrowing base, with a letter of credit sub-facility, and (b) a $25.0 million delayed draw term loan facility available to be drawn upon for up to 18 months to finance certain permitted acquisitions. The credit facilities mature in five years and bear interest at one-month USD LIBOR plus a margin that varies depending on our overall leverage ratio. Revolving loans are interest-only with principal due at maturity, while term loans require monthly payments of principal and interest based on an amortization schedule.

Our obligations under the Credit Agreement are guaranteed by our wholly-owned subsidiaries Hyperspring, Absolute, True North, DP Engineering and by any future material domestic subsidiaries (collectively, the Guarantors). On June 28, 2019, we entered into the Fifth Amendment and Reaffirmation Agreement on June 28, 2019. This agreement changed the fixed charge coverage ratio from 1.25, to four different ratios ranging from 1.05 to 1.25 among different time periods and changed the leverage ratio to: (i) 2.75 to 1.00 for the period ending March 31, 2020; (ii) 2.50 to 1.00 for the periods ending June 30, 2020 and September 30, 2020; (iii) 2.25 to 1.00 for the periods ending December 31^st, March 31^st, June 30^th and September 30^th thereafter.

On January 8, 2020, we entered into the Sixth Amendment and Reaffirmation Agreement due to implications of the COVID-19, effective on December 31, 2020 pandemic and an expectation by management for a future violation of our debt covenants. The amendments contained therein relaxed the fixed charge coverage ratio and leverage ratio, as well as delayed testing of both financial covenants, but added a covenant requiring that the Company maintain a consolidated, Adjusted EBITDA target of $4.25 million to be tested as of December 31, 2019, March 31, 2020 and June 30, 2020. Further, we agreed to maintain a minimum USA liquidity of at least $5.0 million in the aggregate, to be tested bi-weekly as of the fifteenth and the last day of each month beginning on December 31, 2019 and thereafter until June 30, 2020. In addition to the revised covenants, we agreed to make additional principal payments as follows: $3.0 million on January 6, 2020; $1.0 million on March 31, 2020; and $1.0 million on June 30, 2020.

On April 17, 2020, we entered into a Seventh Amendment and Reaffirmation Agreement, effective on March 31, 2020. The Agreement requires us to maintain a minimum fixed charge coverage ratio of 1.25 to 1.00, to be tested quarterly as of the last day of each quarter beginning with the quarter ending June 30, 2021 and on a rolling four-quarter basis. We agreed not to exceed a maximum leverage ratio, to be tested quarterly as of the last day of each quarter, beginning with the quarter ending September 30, 2020, on a rolling four-quarter basis as follows:  (i)  3.00 to 1.00 for the period ending on September 30, 2020, (ii) 2.50 to 1.00 for the period ending on December 31, 2020, and (iii) 2.25 to 1.00 for the period ending on March 31, 2021 and for the periods ending on each December 31, March 31, June 30 and September 30 thereafter. In addition to the revised covenants, we agreed to make additional principal payment as follows: $0.75 million on April 17, 2020; and $0.5 million on June 30, 2020. We have the option to refinance the term loan facility if certain requirements are met, including certain covenant thresholds.

At March 31, 2020, the outstanding balance of our long-term debt was $13.3 million.

At March 31, 2020, there were $3.5 million outstanding borrowings on the RLOC and four letters of credit totaling $1.2 million. The amount available at March 31, 2020, after consideration of the letters of credit was approximately $0.3 million.

The credit facility agreement is subject to financial covenants, some of which were amended on April 17, 2020. At March 31, 2020, we were in compliance with our financial covenants, but we have projected non-compliance with the EBITDA covenant. We have a plan to address the expected non-compliance; however, due to our projections of failure to meet all of our covenants, we have classified our debt as current in our consolidated Balance Sheets as of March 31, 2020 and December 31, 2019.

Non-GAAP Financial Measures

References to “EBITDA” mean net (loss) income, before taking into account interest expense (income), provision for income taxes, depreciation and amortization. References to Adjusted EBITDA exclude loss on impairment, impact of the change in fair value of contingent consideration, restructuring charges, stock-based compensation expense, impact of the change in fair value of derivative instruments, and acquisition-related expense. EBITDA and Adjusted EBITDA are not measures of financial performance under generally accepted accounting principles (GAAP). Management believes EBITDA and Adjusted EBITDA, in addition to operating profit, net income and other GAAP measures, are useful to investors to evaluate the Company’s results because it excludes certain items that are not directly related to the Company’s core operating performance that may, or could, have a disproportionate positive or negative impact on our results for any particular period. Investors should recognize that EBITDA and Adjusted EBITDA might not be comparable to similarly-titled measures of other companies. This measure should be considered in addition to, and not as a substitute for or superior to, any measure of performance prepared in accordance with GAAP. A reconciliation of non-GAAP EBITDA and Adjusted EBITDA to the most directly comparable GAAP measure in accordance with SEC Regulation G follows:

(in thousands)

References to Adjusted net income exclude the impact of gain from loss on impairment, impact of the change in fair value of contingent consideration, restructuring charges, stock-based compensation expense, impact of the change in fair value of derivative instruments, acquisition-related expense, and amortization of intangible assets related to acquisitions, net of income tax expense impact of adjustments. Adjusted Net Income and adjusted earnings per share (adjusted EPS) are not measures of financial performance under generally accepted accounting principles (GAAP). Management believes adjusted net income and adjusted EPS, in addition to other GAAP measures, are useful to investors to evaluate the Company’s results because they exclude certain items that are not directly related to the Company’s core operating performance and non-cash items that may, or could, have a disproportionate positive or negative impact on our results for any particular period, such as stock-based compensation expense.  These measures should be considered in addition to, and not as a substitute for or superior to, any measure of performance prepared in accordance with GAAP. A reconciliation of non-GAAP adjusted net income and adjusted EPS to GAAP net income, the most directly comparable GAAP financial measure, is as follows:

⁽¹⁾ During the three months ended March 31, 2020 and 2019, the Company reported both a GAAP net loss and adjusted net loss and an adjusted net loss and adjusted net income during the three months ended March 31, 2020 and 2019, respectively. Accordingly, there were 59,421 and 237,834 dilutive shares from options and RSUs included in the adjusted earnings per common share calculation that were considered anti-dilutive in determining the GAAP diluted (loss)/income per common share.

Not required of a smaller reporting company.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of the end of the period covered by this Quarterly Report on Form 10-Q. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their control objectives. Based on the evaluation of our disclosure controls and procedures as of the end of the period covered by this quarterly report and our annual report, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were not effective; we are currently in remediation of our internal controls to address the following material weaknesses identified in our Form 10-K for the year ended December 31, 2019:

Material Weaknesses Identified

Management realizes that two material weaknesses in our internal controls surrounding the evaluation of significant or unusual transactions and financial reporting close process are serious matters and require thoughtful responses. To address the control environment surrounding the evaluation of significant or unusual transactions and application of guidance, management has focused on: (i) hiring dedicated staffing and (ii) revision of controls in application of guidance. Management has hired key management level staffing, including a permanent Controller with a background in remediating control environments and a permanent SEC reporting manager. We are performing a review of our controls surrounding the application of guidance with experts in control environments in order to remediate our controls and prevent the misapplication of guidance in the future.

To address the control environment surrounding the financial reporting process, management has implemented measures focusing on four key areas: (i) hiring of dedicated staffing, (ii) shortening the close process, (iii) new revenue process tools and controls, (iv) and expanding our mitigating controls. Management has redesigned the tools used in its monthly flux reviews to evaluate differences at a more precise level in order to identify and prevent errors in the financial close process. In addition to addressing accounting resource turnover, management added additional staffing at the level which will provide the necessary support required to observe all accounting controls and workflow processes to perform the financial reporting controls. Furthermore, management has realigned its accounting resources to optimize workflows and has set in motion a plan to shorten the close cycle. A plan management believes, with the additional staffing resources, will allow for increased time spent on performing analytics and using newly implemented tools to observe control activities necessary to identify errors in our financial statements. Additionally, management has redesigned revenue process controls and the tools used in its monthly reviews to evaluate differences at a more precise level to identify and prevent errors in the financial close process.

Changes in Internal Control over Financial Reporting

There were no changes in our internal controls over financial reporting that occurred during the most recent fiscal quarter that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

Limitation of Effectiveness of Controls

Internal control over financial reporting has inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements will not be prevented or detected on a timely basis by internal control over financial reporting.  However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.

PART II - OTHER INFORMATION

GSE and its subsidiaries are from time to time involved in litigation incidental to the conduct of its business. GSE and its subsidiaries are not a party to, and its property is not the subject of, any material pending legal proceedings that, in the opinion of management, are likely to have a material adverse effect on the Company’s business, financial condition or results of operations.

On March 29, 2019, a former employee of Absolute Consulting, Inc., filed a putative class action against Absolute and the Company, Joyce v. Absolute Consulting Inc., case number 1:19 cv 00868 RDB, in the United States District Court for the District of Maryland. The plaintiff alleges he was not properly compensated for overtime hours worked. On July 14, 2020, a mediation session occurred between our legal counsel, Absolute Consulting's management and the plaintiffs in the Joyce v. Absolute Consulting Inc. matter. As a result, the parties have entered into non-binding memorandum of understanding (‘MOU’), which if memorialized in a final settlement agreement that receives court approval, would result in an estimated gross settlement between $861 thousand and $1.5 million. If the case is not settled, then the parties would remain in their pre-MOU positions.

The following additional risk factors should be read in conjunction with the risk factors set forth under "Item 1A. Risk Factors" in our 2019 Form 10-K. Except as described herein, there have been no material changes with respect to the risk factors disclosed in our 2019 Form 10-K.

A novel strain of coronavirus, the COVID-19 virus, may adversely affect our business operations and financial condition.

In December 2019, an outbreak of the COVID-19 virus was reported in Wuhan, China. On March 11, 2020, the World Health Organization declared the COVID-19 virus a global pandemic and on March 13, 2020, President Donald J. Trump declared the virus a national emergency in the United States. This highly contagious disease has spread to most of the countries in the world and throughout the United States, creating a serious impact on customers, workforces and suppliers, disrupting economies and financial markets, and potentially leading to a world-wide economic downturn. It has caused a disruption of the normal operations of many businesses, including the temporary closure or scale-back of business operations and/or the imposition of either quarantine or remote work or meeting requirements for employees, either by government order or on a voluntary basis. The pandemic may adversely affect our customers’ operations, our employees and our employee productivity. It may also impact the ability of our subcontractors, partners, and suppliers to operate and fulfill their contractual obligations, and result in an increase in costs, delays or disruptions in performance. These supply chain effects, and the direct effect of the virus and the disruption on our employees and operations, may negatively impact both our ability to meet customer demand and our revenue and profit margins. Our employees, in many cases, are working remotely and using various technologies to perform their functions. We might experience delays or changes in customer demand, particularly if customer funding priorities change. Further, in reaction to the spread of COVID-19 in the United States, many businesses have instituted social distancing policies, including the closure of offices and worksites and deferring planned business activity. Our Performance Improvement Solutions business segment, as they are classified essential, for the most part continue without pause. With regard to our NITC business segment, because of the embedded presence of our on-site workforce, if COVID-19 or a similar outbreak of infectious disease were to prevent our workers from being deployed to the applicable customer site, it may disrupt our NITC service offerings, interrupt performance on our Nuclear Industry Training and Consulting contracts with clients and negatively impact our business, financial condition and results of operations. Additionally, the disruption and volatility in the global and domestic capital markets may increase the cost of capital and limit our ability to access capital. Both the health and economic aspects of the COVID-19 virus are highly fluid and the future course of each is uncertain. For these reasons and other reasons that may come to light if the coronavirus pandemic and associated protective or preventative measures expand, we may experience a material adverse effect on our business operations, revenues and financial condition; however, its ultimate impact is highly uncertain and subject to change.

If we cannot comply with the financial or other restrictive covenants in our credit agreement, or obtain waivers or other relief from our lender, we may cause an event of default to occur, which could result in loss of our sources of liquidity and acceleration of our debt.

In order to fund our recent acquisitions, we borrowed under a delayed-draw term loan facility. Our ability to generate sufficient cash flow from operations to make scheduled payments on our term loan will depend on a range of economic, competitive and business factors, some of which are outside our control. If we are unable to meet our debt service obligations, we may need to refinance or restructure all or a portion of our debt on or before its stated maturity date, sell assets, pay down our outstanding debt and/or raise equity. We may not be able to refinance or restructure any of our debt, sell assets or raise equity, in each case on commercially reasonable terms or at all, which could cause us to default on our obligations and impair our liquidity. Our inability to generate sufficient cash flow to satisfy our debt obligations or to refinance or restructure our obligations on commercially reasonable terms could have a material adverse effect on our business, financial condition, results of operations and cash flows. Our credit agreement also contains financial and other restrictive covenants. Our ability to comply with the covenants in our credit agreement will depend upon our future performance and various other factors, some of which are beyond our control. We may not be able to maintain compliance with all of these covenants. In that event, we would need to seek an amendment to our credit agreement, a waiver from our lender, utilize cash to pay down outstanding debt and/or refinance or restructure our debt. There can be no assurance that we could obtain future amendments or waivers of our credit agreement, or refinance or restructure our debt, in each case on commercially reasonably terms or at all. Our failure to maintain compliance with the covenants under our credit agreement could result in an event of default, subject to applicable notice and cure provisions. Upon the occurrence of an event of default under our credit agreement, our lender could elect to declare all amounts outstanding thereunder to be immediately due and payable, terminate all commitments to extend further credit and cease making further loans. If we were unable to repay all outstanding amounts in full, our lender could exercise various remedies including instituting foreclosure proceedings against our assets pledged to them as collateral to secure that debt.

We have incurred indebtedness under the CARES Act, which will be subject to review, may not be forgivable in whole or in part and may eventually have to be repaid.

We received funds under the Paycheck Protection Program, after the period end, in the amount of $10.0 million, serviced by Citizen's Bank. The application for these funds requires us to, in good faith, certify that the current economic uncertainty made the loan request necessary to support our ongoing operations. This certification further requires the Company to take into account our current business activity and our ability to access other sources of liquidity sufficient to support ongoing operations in a manner that is not significantly detrimental to the business. The receipt of these funds, and the forgiveness of the loan attendant to these funds, is dependent on the Company having initially qualified for the loan and qualifying for the forgiveness of such loan based on our future adherence to the forgiveness criteria.

On April 24, 2020, after the period end, the Company received the loan. Under the terms of the CARES Act and the corresponding promissory note, the use of the proceeds of the loan is restricted to payroll costs (as defined in the CARES Act), covered rent, covered utility payments and certain other expenditures that, while permitted, would not result in forgiveness of a corresponding portion of the loan. Following recent amendments to the Paycheck Protection Program, after an eight- or twenty-four-week period starting with the disbursement of the loan proceeds, the Company may apply for forgiveness of some or all of the loan, with the amount which may be forgiven equal to the sum of eligible payroll costs, mortgage interest (not applicable to the Company), covered rent, and covered utility payments, in each case incurred by the Company during the eight- or twenty-four-week period following the date of first disbursement. Certain reductions in the Company’s payroll costs or full-time equivalent employees (when compared against the applicable measurement period) may reduce the amount of the Loan eligible for forgiveness.

The U.S. Department of the Treasury ("Treasury") and the U.S. Small Business Administration ("SBA") have announced that they will review all Payroll Protection Program loans that equal or exceed $2.0 million. Guidance from Treasury and SBA has been slow to develop and occasionally unclear. At the same time, the Payroll Protection Program has been amended twice with the latest series of amendments significantly altering the timeline associated with the Payroll Protection Program spending and loan forgiveness. While the Company believes that it acted in good faith and has complied with all requirements of the Payroll Protection Program, if Treasury or SBA determined that the Company’s loan application was not made in good faith or that the we did not otherwise meet the eligibility requirements of the Payroll Protection Program, we may not receive forgiveness of the loan (in whole or in part) and we could be required to return the loan or a portion thereof. Further, there is no guarantee that we will receive forgiveness for any amount and forgiveness will be subject to review by our Bank of information and documentation that we submit, as required by SBA and the lender.

A failure to obtain forgiveness of the Payroll Protection Program loan may adversely impact loan covenants under our senior credit facility. In the event that our Payroll Protection Program loan was not forgiven in whole or in part, we may need to seek an amendment to our credit agreement, a waiver from our lender, utilize cash to repay the Payroll Protection Program debt and/or refinance or restructure our outstanding debt. There can be no assurance that we could obtain future amendments or waivers of our credit agreement, or refinance or restructure our debt, in each case on commercially reasonably terms or at all. Our failure to maintain compliance with the covenants under our credit agreement could result in an event of default, subject to applicable notice and cure provisions. Upon the occurrence of an event of default under our credit agreement, our lender could elect to declare all amounts outstanding thereunder to be immediately due and payable, terminate all commitments to extend further credit and cease making further loans. If we were unable to repay all outstanding amounts in full, our lender could exercise various remedies including instituting foreclosure proceedings against our assets pledged to them as collateral to secure that debt.

Substantial doubt has been raised in our ability to continue as going concern as a result of the economic slowdown caused the global COVID 19 pandemic and continued deterioration of business could have an adverse effect.

The global COVID-19 pandemic could continue to have a negative impact on our financial position and results of operations. Negative impacts could include but are not limited to: loss or delayed orders, canceled or paused projects, possible disruption of business as a result of worker illness or mandated shutdowns, our ability to maintain compliance with loan covenants and/or refinance existing indebtedness, and access to new capital. Any additional deterioration in the business would result in missing minimum EBITDA covenants and possibly leverage ratios associated with covenants contained in our senior credit facility.

Although as of March 31, 2020, we are in compliance with the amended financial covenants contained in our debt agreement, and have entered into an additional amendment in April 2020, we cannot rely on forecasted future earnings and could continue to see further deterioration in business causing non-compliance. Management believes the entity will be able to continue to develop new opportunities and will be able to obtain additional debt amendments; however, there is no assurance.

If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results, and current and potential stockholders may lose confidence in our financial reporting.

We are required by the Securities and Exchange Commission ("SEC") to establish and maintain adequate internal control over financial reporting that provides reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles. We are likewise required, on a quarterly basis, to evaluate the effectiveness of our internal controls and to disclose any changes and material weaknesses in those internal controls.

Based on management’s assessment, management has concluded that the Company’s internal control over financial reporting was not effective as of December 31, 2019 or at March 31, 2020 due to the existence of two material weaknesses in internal control over financial reporting surrounding the evaluation of significant or unusual transactions and certain controls within the  financial reporting close process. Management realizes that two material weaknesses in our internal controls are serious matters and require thoughtful responses. We developed and implemented a remediation plan to address the identified material weakness as follows: (i) hiring of dedicated staffing, (ii) revision of controls to improve review of complex transactions and application of guidance, (iii) shortening the close process, (iv) new revenue process tools and controls and (v) and expanding our mitigating controls.

Although we believe that these efforts have strengthened our internal control over financial reporting and address the concern that gave rise to the material weakness as of December 31, 2019, we cannot be certain that our expanded knowledge and revised internal control procedures will ensure that we maintain adequate internal control over our financial reporting in future periods. Any failure to maintain such internal controls could adversely impact our ability to report our financial results on a timely and accurate basis. If our financial statements are not accurate, investors may not have a complete understanding of our operations. Likewise, if our financial statements are not filed on a timely basis as required by the SEC and The NASDAQ Capital Market (Nasdaq), we could confront an enforcement action from the SEC and/or delisting from Nasdaq. In either case, such an event could have a material adverse effect on our business. Finally, inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock.

A disruption, failure or breach of our networks or systems, including as a result of cyber-attacks, could harm our business.

Global cyber security threats can range from uncoordinated individual attempts to gain unauthorized access to our information technology (IT) systems to sophisticated and targeted measures known as advanced persistent threats. While we employ comprehensive measures to prevent, detect, address and mitigate these threats (including access controls, data encryption, vulnerability assessments, continuous monitoring of our IT networks and systems, and maintenance of backup and protective systems), cyber security incidents, depending on their nature and scope, could potentially result in the misappropriation, destruction, corruption or unavailability of critical data and confidential or proprietary information (our own or that of third parties) and the disruption of business operations. The potential consequences of a material cyber security incident include reputational damage, litigation with third parties, civil or regulatory liability for loss of sensitive or protected information such as personal data, incident response costs, diminution in the value of our investment in research, development and engineering, loss of intellectual property, and increased cyber security protection and remediation costs, which in turn could adversely affect our competitiveness and results of operations.

None

None

Not applicable.

None.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date:  July 23, 2020

GSE SYSTEMS, INC.