TSS, Inc. - Annual Report: 2022 (Form 10-K)

“SAFE HARBOR” STATEMENT

UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

From time to time, we make oral and written statements that may constitute “forward looking statements” (rather than historical facts) as defined in the Private Securities Litigation Reform Act of 1995 or by the Securities and Exchange Commission (the “SEC”) in its rules, regulations and releases, including Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We desire to take advantage of the “safe harbor” provisions in the Private Securities Litigation Reform Act of 1995 for forward-looking statements made from time to time, including, but not limited to, the forward-looking statements made in this Annual Report on Form 10-K (this “Annual Report”), as well as those made in other filings with the SEC.

Forward-looking statements can be identified by the use of forward-looking terminology such as “believes,” “estimates,” “anticipates,” “expects,” “may,” “will,” “continue,” “forecast,” “foresee” or other similar words. Such forward-looking statements are based on our management’s current plans and expectations and are subject to risks, uncertainties and changes in plans that could cause actual results to differ materially from those described in the forward-looking statements. Important factors that could cause actual results to differ materially from those anticipated in our forward-looking statements include, but are not limited to, those described under “Risk Factors” set forth in Item 1A of this Annual Report.

We expressly disclaim any obligation to release publicly any updates or changes in our expectations or any changes in events, conditions, or circumstances on which any forward-looking statement is based.

As used herein, expect as otherwise indicated by the context, the terms “TSS,” “Company,” “we”, “us” and “our” are used to refer to TSS, Inc. and our wholly-owned subsidiaries.

PART I.

Item 1.     Business 

Company Overview

TSS, Inc. provides a range of comprehensive services to enable the planning, design, deployment, maintenance, and refurbishment of end-user and enterprise systems, including the mission-critical facilities they are housed in. We provide a single-source solution for enabling technologies in data centers, operation centers, network facilities, server rooms, security operations centers, communications facilities and the infrastructure systems that are critical to their function. Our services include technology consulting, design and engineering, project management, systems integration, system installations, facilities management and IT procurement and reseller services.

We were incorporated in Delaware in December 2004. Our headquarters and our systems integration facility are located in Round Rock, Texas.

Our business is concentrated on the data center infrastructure and services market. This market remains highly competitive as commerce continues to move to cloud-based solutions and as data storage and compute requirements continue to escalate for many industries. These underlying macroeconomic trends are driving demand for more information technology equipment, and more efficient data center design and operations, resulting in continued overall growth in this market. We compete in large growing market segments, often against larger competitors who have greater resources. We rely on several large customers to win contracts and to provide business to us under “Master Service Agreements”, and the loss of any such customers could have a material negative effect on our results.

In particular, we are focused on the cloud IT infrastructure market with emphasis on the modular data center area, and we have concentrated our activities around our systems integration and facilities maintenance businesses. We have also developed and expanded our rack integration, imaging and logistic services to increase the overall utilization of our systems integration facility and to insulate us from the variable timing of modular data center orders. This simplification of our business and the focus towards the modular data center market has increased our customer concentration and concentrated the markets in which we compete.

Almost all of the components used in our systems integration business are consigned to us by our original equipment manufacturer (OEM) or their end-user customers, thus our revenues reflect only the services we perform, and the consigned components are not reflected in our balance sheet. We also offer our customers the ability to procure third-party hardware, software and services on their behalf that are then used in our integration services as we integrate these components to deliver a completed system to our customer. In some cases, we also act as an agent and arrange for the purchase of third-party hardware, software or services that are to be provided to our customers by another party and we have no control of the goods or services before they are transferred to the customer. In these instances, we are acting as an agent in the transaction. These procurement and reseller activities allow us to develop relationships with new hardware, software and professional service providers and allow us to generate higher margins on integration projects by broadening our revenue and customer base.

Service Offerings

We have developed a unique set of solution offerings where we provide a range of services that enable our customers and partners to more efficiently plan, develop, deploy and maintain data centers and their related assets, along with end user systems. These solutions begin with strategies for the care of information technology assets that are being housed in the facility or modular data centers, including power, cooling and heat rejection, as well as disaster recovery backup systems. Our operating expenses are not exclusively aligned to each service offering, as shared resources such as sales, marketing and general and administrative expenses support all services. Our solutions involve all aspects of the life cycle of both traditional and modular data centers and their related assets and are described in more detail below.

Facilities Services:

Consulting:

During the initial phase of a data center project, we provide project development-related services that typically include establishing project goals and a preliminary budget and schedules, setting technical parameters and requirements, and determining project team members and the overall requirements of the team.

Design and engineering consulting services typically include critical power and mechanical load calculations, mechanical design and engineering, high and medium voltage electrical design and engineering, communications and security systems design and engineering, physical vulnerability assessments, force protection design and bomb blast analyses, fire protection system design and engineering, facility systems equipment selection and facility commissioning and testing. These offerings also include post commissioning support of on-going operations.

Our strategy is intended to increase the amount of recurring revenues we generate from our existing customers, IT equipment partners, and major systems integrators. Our mission critical facilities experience and our personnel skills position us as a trusted advisor to our customers and allow us to work on new opportunities as our customers grow or as their facilities mature and as partners introduce us to new client opportunities.

Deployment:

In connection with the deployment of a customer’s data center or related equipment requirements, our capabilities include project management, value engineering and design management, bid negotiation support, subcontractor pre-qualification and selection, long-lead equipment procurement, issuance of equipment and construction contracts, and refinement and management of project budgets and schedules. Our project managers mobilize the required expertise for the project, utilizing project superintendents, quality control and safety professionals, as well as qualified subcontractors and support personnel. Project managers supervise work by project team members, including subcontracted parties, including all aspects of the following: architecture and construction, electric power systems, heat rejection and cooling, energy management and controls, cooling tower systems, security systems, voice, data and network cabling, fire and life safety systems, and process piping and plumbing systems. The project manager remains responsible for managing all aspects of the project until project completion and customer delivery.

In addition, this installation portion of a project has the largest number of outside influences that can impact project goals and objectives, such as weather, non-performance of subcontractors, equipment deliveries, unexpected project changes from the owner, and influence from local authorities and utility providers. Therefore, management experience, skill and mission focus are critical during the project installation period.

Management:

We provide a comprehensive maintenance and service offering designed to ensure that the multiple systems critical to sustaining on-line applications in technologically intensive facilities and modular data centers remain operational and functional. Typical facilities management services include overall management of the post-construction facility maintenance program, and on-site staffing of technical engineering positions (e.g., electricians, HVAC mechanics, control technicians and voice/data technicians). Increasingly, data centers are being constructed in a modular format, whereby information technology, power and other related assets are deployed in pre-integrated solutions. Modular data centers may have lower overall cost of delivery, lower energy consumption and shorter deployment schedules compared to traditional data centers. Our on-site maintenance services provide additional project revenue for us and position us for involvement in any new facility planning, design and construction initiatives that the customer undertakes.

In addition, we provide 24X7 Network Operations support from our Round Rock, Texas facility that has the capability of remotely monitoring our data center service contract customers’ facilities for systems operations and emergency events that could lead to outages. Temperature levels, humidity, electrical connectivity, power usage and fire alarm conditions are among the items monitored. The system maintains all site documentation for repairs and maintenance performed on each critical piece of equipment covered under our services. The information is useful to our customers in assessing operational efficiency and causes of failure and enables them to make critical decisions on repair or replacement strategies based on the operating history of the monitored systems.

Our facilities maintenance service contracts are typically one to three years in duration with cancellation clauses for nonperformance and are typically billed annually in advance. Our service contracts take different forms including fixed-price equipment maintenance with optional comprehensive warranty to fix failures in key components such as uninterruptible power supplies or batteries, ticket-based service provided at contracted rates in a master service agreement, comprehensive facility services agreements that include on site staffing, scheduled equipment maintenance and nontechnical facility services, and direct job-specific contracts for additional moves, add, refresh, refurbishment and change work within a facility.

As computer density increased and data centers evolved into the use of modular form factors, we found that we could leverage our facilities maintenance experience and infrastructure by offering maintenance service of modules being deployed into new data centers. The number of modular units under our service contracts has continued to expand. Our design services continue to evolve to support changing data center requirements including installation and maintenance of systems deployed on the edge. Ultimately, we started working with IT vendors to help them in the design and integration of their IT equipment into modular data centers, which typically leads to ongoing maintenance contracts as these modular systems deploy.

Systems Integration Services:

To assist our customers with IT-equipment deployment in their data centers we provide what we call “systems integration” services. We provide integrated technology services and software tools designed to accelerate the delivery of complex information technology solutions. These services include custom configuration of a broad scope of information technology products including client products, enterprise products, clusters and modular containers. The integration of this equipment at both a rack-level or modular data center level is performed to our customer specifications and test criteria and may include imaging of software onto the hardware as well. We are generally not responsible for the performance of the related equipment in the field. In addition, we provide warehousing of high value equipment such as servers, switches and other information technology hardware that are generally provided on a consignment basis to us to by our OEM and end-user customers. We also provide second-touch services such as adding software, hardware or other features to end-user devices, bundling of such devices with peripherals, pre-loading of customer-determined application software, tagging, asset capture and other fulfilment services for our OEM and end-user customers.

Procurement and Reseller Services:

We generate revenues from fees we charge our customers to procure third-party hardware, software and professional services on their behalf that are then used in our integration services as we integrate these components to deliver a completed system to our customer. These procurement and reseller services enable highly customizable solutions for our OEM and end-user customers and enable us to generate larger revenues and profits while expanding our customer base. We recognize our reseller services revenue upon completion of the procurement activity. In some cases, we arrange for the purchase of third-party hardware, software or professional services that are to be provided directly to our customers by another party and we have no control of the goods before they are transferred to the customer. In these instances, we are acting as an agent in the transaction and recognize revenue as the amount of any fee or commissions that we expect to be entitled to after paying the other party for the goods or services provided to the customer.

Customers

Our customers include IT OEM equipment, technology and service companies, and private sector businesses that in some cases are the end users of the facility or in other cases are providing a facility to a government or commercial end user.

One customer comprised 96% and 95% of our revenues in the years ended December 31, 2022 and 2021, respectively.

Sales and Marketing

Our marketing approach emphasizes expertise in information technology hardware systems, energy consumption, real estate matters and facilities planning and operation. This marketing approach allows the customer to contract for comprehensive facilities services or to contract separately for each individual project phase. Our marketing program seeks to capitalize on our industry standing, including our existing relationships and our reputation based upon our performance on completed projects. We also seek to enhance our name recognition through the use of trade shows, technical seminars, direct mailings and the media. A key part of our selling strategy is entering into master service agreements with multiple partners and co-selling our range of services to the end-user customers of our partners, leveraging their customer relationships and broadening the scope of potential customers for us.

Our headcount in sales and marketing has fluctuated as we have worked to align the skill sets with our evolving service offerings, leverage partner relationships and increase the consultative capability of our sales organization.

Maintaining key alliances is also crucial to sales development and growth and often provides us with introductions to the customers of our alliance partners. These alliances reside with various information technology consulting firms, specialty mission-critical engineering firms, application service providers and internet service providers. Key alliance opportunities also reside in other firms within the market sector such as equipment manufacturers, product suppliers, property management firms, developers, information technology system integrators and firmware providers. We have key strategic alliances with large information technology corporations to provide engineering, design, construction management services, systems integration, modular solutions and facility management services. As we expand our reseller services, we are also establishing alliances with new hardware and software providers who operate in the IT infrastructure market.

Competition

The mission-critical information technology solutions market is large, fragmented and highly competitive. We compete for contracts based on the strength of our customer relationships, successful past performance record, significant technical expertise, specialized knowledge and broad service offerings. We often compete against divisions of large information technology service and equipment providers of various sizes. Some of these competitors are large, well-established companies that have broader geographic scope and greater financial and other resources than us. In some cases, because of diverse requirements, we frequently collaborate with these and other competitors for large projects. We expect competition in the information technology services sector to continue to increase in the future.

Because of the breadth of services that we provide, we face many different competitors some of which are our customers or vendors. We believe that, while we face large and small competitors across the spectrum of our service offerings, we are uniquely positioned to provide services to IT and facilities across both modular and traditional data center markets. We believe by providing a single source solution focused in the data center market allows us to meet our customer’s requirements cost effectively.

Employees

At December 31, 2022, we had 70 full-time employees. Our future success will depend significantly on our ability to attract, retain and motivate qualified personnel. We are not a party to any collective bargaining agreement, and we have not experienced any strikes or work stoppages. We consider our relationship with our employees to be satisfactory.  

Available Information

We file annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy statements relating to our annual stockholders’ meeting with the Securities and Exchange Commission (“SEC”). Copies of these filings, including amendments to such filings are available, free of charge, on our website, www.totalsitesolutions.com, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. Information contained on our website is not and should not be deemed to be a part of this Annual Report or a part of any other report or filing with the SEC. All reports that we file with the SEC are available to read and copy at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549, on official business days during the hours of 10:00 am to 3:00 pm. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site at www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC.

Item 1A.     RISK FACTORS

Our business involves a number of risks, some of which are beyond our control. The risks and uncertainties described below are not the only ones we face. Such factors could have a significant impact on our business, operating results and financial condition. We believe the most significant of these risks and uncertainties are as follows:

If our operating results do not improve, there may be concern about our ability to continue as a going concern.

Our consolidated financial statements included in this annual report have been prepared on the basis that we will continue to operate as a going concern. Accordingly, assets and liabilities are recorded on the basis that we will be able to realize our assets and discharge our liabilities in the normal course of business. As of December 31, 2022, we had an accumulated deficit of $66.4 million. In addition, although we generated operating income in 2022, we have a history of recurring operating and net losses and negative cash flow from operations which have been due in recent years, in part, to the effects of COVID-19 and related supply chain constraints. These factors may, by themselves, cause uncertainty about our ability to continue to operate our business as a going concern. Note 1 to our consolidated financial statements describes the actions we have taken and could take to improve our liquidity to alleviate the doubt about our ability to continue as a going concern.

Our business plans and our assumptions around the adequacy of our liquidity are based on estimates regarded expected revenues and future costs, and our ability to secure additional sources of funding if needed. However, our revenue may not meet our expectations, or our costs may exceed our estimates. Further, our estimates may change, and future events or developments may also affect our estimates. Any of these factors may change our expectation of cash usage in 2023 or significantly affect our level of liquidity, which may require us to take other measures to reduce our operating costs or obtain funding in order to continue operating. Any action to reduce operating costs may negatively affect our range of products and services that we offer or our ability to deliver such products and services, which could materially impact our financial results depending on the level of cost reductions taken.

Supply chain challenges have and will likely negatively affect our integration business by slowing the supply of parts needed to perform integration services, require us to hold greater quantities of inventory for longer periods and delaying completion of services for our customers.

Since the COVID 19 pandemic began in 2020, due to its impact on global production and distribution we have experienced ongoing impacts from shortages of components needed to complete integration and procurement services, delaying our ability to recognize revenue for these projects and negatively impacting our profitability. This has also resulted in us having to hold onto greater quantities of customer inventory for longer time periods while we wait for the missing components to be delivered. Due to our fixed storage capacity, holding customer-owned inventory for longer periods has negatively impacted our ability to perform other services, and added cost and risk, including custodial risk, into our integration business. The supply chain disruptions have also directly impacted vendors and other third parties from whom we procure goods and services for our reseller and procurement business, causing delays in completing procurement services for our customers. This has the potential to materially harm our operating results by delaying recognition of revenue. This can also harm our liquidity position if we are forced to pay vendors for products and services before we have the ability to invoice and receive payment from our customers, which could also prevent us from performing additional procurement services for our customers or cause other liquidity concerns for the Company.

Changes in labor market conditions are causing increases in our labor costs, and, if we are unable to adequately recover these costs from our customers, our business will be negatively impacted.

At times we experience higher levels of attrition, increasing compensation costs, and more intense competition for talent. We believe that our future success will be dependent upon retaining the services of our key personnel, developing their successors and certain internal processes to reduce our reliance on specific individuals, and on properly managing the transition of key roles when they occur. As a small company we are particularly susceptible to negative impacts if critical and experienced personnel leave. Hiring and retaining qualified executives and other employees is therefore critical to our business. During 2022 we had a number of changes to our executive leadership team, and we have experienced increased wage pressure and challenges in hiring people in the Austin, Texas market. We have had to pay higher wages to attract new employees and retain our existing employees. If our total compensation programs, employment benefits, and overall workplace culture are not viewed as competitive and inclusive, our ability to attract, retain and motivate employees could be compromised. To the extent we experience significant attrition or the loss of critical employees and are unable to timely replace employees, we could experience a loss of critical skills and reduced employee morale, potentially resulting in business disruptions or increased expenses to address any disruptions. We have recently increased the prices we charge for our integration services to recover these higher costs. To the extent that we are unable to promptly pass higher labor costs on to our customers, our business will be negatively impacted. Our inability to attract, retain and motivate employees or manage succession of key roles may inhibit or ability to maintain or expand our business operations.

We are partially through the implementation of a new enterprise resource IT system and have yet to fully deploy this new system across all of our business units. Any challenges, delays, difficulties or errors during the implementation of this new system may negatively impact our business operation and harm our operating results.

We rely on computerized inventory and management systems to coordinate and manage the activities in our integration business, as well as to communicate inventory and shipment information to our vendors and customers. Our ability to rapidly process incoming deliveries, track inventory through the integration process, and process shipments in a timely manner are essential to the operations of our integration business. As we introduce a new ERP system to perform these functions including our financial reporting and accounting functions, any challenges in the implementation of the system, changes to processes or errors in functionality where such systems fail to adequately perform as designed, could adversely affect our business and harm our operating results or affect our ability to timely and accurately complete our financial reporting. We began to use this new enterprise system as our system of record on October 1, 2022. We have not yet deployed the system across all of our business units.

We have a history of operating losses, and we may experience net losses in the future.

Although we recorded operating income in 2022, we had a net loss in 2022 and we recorded operating and net losses in both 2021 and 2020. We have a history of recurring net annual losses in prior years and at December 31, 2022 we had an accumulated deficit of approximately $66.4 million. Although we believe that changes we have made to the business in recent years, including the addition of procurement and reseller services and changes to our operating cost structure, have improved our operating results and allowed us to achieve multiple profitable quarters in each of the last several years, we do have a history of fluctuating operating results. Our efforts to align costs with sales and gross margin volume have reduced our level of overhead, but there can be no guarantee that we will be successful in sustaining or increasing profitability in 2023 or beyond. The negative impact of the COVID-19 pandemic including on global supply chains and government economic policy decisions has further exacerbated our operating results and there is no certainty regarding how long these factors will continue to negatively impact our operations and financial results. The uncertainty of a rapidly changing marketplace and the pandemic and subsequent economic slowdown has created a volatile and challenging business climate, which may continue to negatively impact our customers and their spending and investment decisions. We may not be able to generate the level of revenue necessary to achieve and maintain sustainable profitability. Any failure to maintain and grow our revenue volumes would adversely affect our business, financial condition and operating results.

We derive a significant portion of our revenues from one customer.

We currently derive and believe that we will continue to derive in the near term a significant portion of our revenues from one OEM customer. We provide a range of different services and generate revenue from multiple business units and divisions of this OEM customer. To the extent that any significant business unit or division of this OEM customer uses less of our services or terminates its relationship with us, or this OEM reorganizes its business units and divisions in such a way that directly impacts the level of business with us, our revenues would decline significantly, which would have a material adverse effect on our financial condition and the results of our operations.  Revenues from this OEM customer comprised 96% and 95% of our total revenues for the years ended December 31, 2022 and 2021, respectively.

We are attempting to diversify our customer base but there is no guarantee that we will be successful in doing so.

After the sale of certain components of our business in 2018 and 2017, our customer concentration increased and revenue from our three largest customers comprised 99% of our total revenues for each of the years ended December 31, 2022 and 2021. We are continuing our efforts to add new revenue streams such as our procurement and reseller services that we began offering in 2019, as well as targeting other vendors in the data center infrastructure market including Value Added Resellers and systems integrators who have the need for IT integration services. We are also targeting other vendors in the modular data center market to leverage our expertise and capabilities in this marketplace. We are also trying to stay ahead of emerging trends in the IT marketspace such as liquid-cooled product offerings, immersion technology and edge-based solutions so that we can develop service offerings to leverage growth opportunities for these new markets. Our efforts to successfully add new relationships has been impacted by the COVID-19 pandemic and taken us longer than anticipated. While we believe our efforts will allow us to broaden our customer base and reduce our customer concentration, there can be no guarantee that we will be successful at these endeavors, or of the time that it will take for these efforts to be successful.

Our procurement and reseller services business is still evolving and the level of this business may fluctuate significantly on a quarterly basis, requiring additional working capital in order to grow.

We began providing procurement and reseller services to our customers in 2019. We do not yet have a history of stable and ongoing contracts with customers for our procurement and reseller services and as a result we have experienced material fluctuations in our quarterly revenues from these services, which has had a material impact on our quarterly and annual revenues and profits. We have been able to structure our procurement and reseller activities in such a way as to minimize their overall impact on our liquidity by using trade creditors as the primary way to finance these activities. However, depending on the size of potential procurement and reseller contracts, we may be required to procure material amounts of hardware, software and professional services from other third parties and there can be no guarantee that our existing sources of liquidity or available trade finance will be sufficient to enable us to finance these transactions.

As the age of modular data centers increases and customers look to shut or replace such units, our recurring maintenance revenues could be negatively impacted, and this could adversely affect our operating results.

Modular Data Centers (MDC’s) typically have an expected useful life between 6-10 years unless refreshed with new IT equipment. As they approach the end of their expected life, we would expect customers to either perform “refresh” maintenance to extend the operating life of the MDC’s, or to terminate the annual maintenance contracts for those MDC’s which would cause our level of maintenance revenues and our profitability to be negatively impacted unless the units are immediately replaced. Our history suggests that customers will replace MDC’s with new MDC modules that will also be subject to an annual maintenance contract. However, the time-period between these two events could result in an overall decrease in our level of maintenance revenues and our overall level of revenue in our facilities business.

We have substantial amounts of goodwill and other intangibles, and changes in future business conditions could cause these assets to become impaired, requiring substantial write-downs that would adversely affect our operating results.

We have substantial amounts of goodwill and other intangibles resulting from prior acquisitions of businesses. Under generally accepted accounting principles, we do not amortize goodwill and intangible assets acquired in a purchase business combination that are determined to have indefinite useful lives, but instead review them annually (or more frequently if impairment indicators arise) for impairment. We are amortizing certain other intangibles over their useful lives. To the extent we determine that such assets have been impaired, we will write-down their carrying value on our consolidated balance sheet and book an impairment charge in our consolidated statement of operations. At December 31, 2022 and 2021, we conducted such analyses that resulted in no impairment. The net carrying value of goodwill totaled $0.8 million at December 31, 2022 and 2021, and the net carrying value of finite lived intangible assets totaled $0.01 million and $0.1 million at December 31, 2022 and 2021, respectively.

We operate in a highly competitive industry, which could reduce our growth opportunities, revenue and operating results.

The mission-critical information technology industry in which we operate is highly competitive and continues to become more competitive. We often compete against divisions of large information technology consulting and integration companies, including several that are large domestic companies that may have financial, technical and marketing resources that exceed our own. These larger competitors have an infrastructure and support greater than ours, and accordingly, we continue to experience some price pressure as some companies are willing to take on projects at lower margins. Our competitors may develop the expertise, experience and resources to provide services that are equal or superior in both price and quality to our services, and we may not be able to maintain or enhance our competitive position. Our size often prevents us from bidding on larger, more profitable projects, which significantly reduces our growth opportunities. Although our customers currently outsource a significant portion of these services to us and our competitors, we can offer no assurance that our existing or prospective customers will continue to outsource specialty contracting services to us in the future.

Most of our contracts may be canceled on short notice, so our revenue and potential profits are not guaranteed.

Most of our contracts are cancelable on short notice by the customer either at its convenience or upon our default. If one of our customers terminates a contract at its convenience, then we typically are able to recover only costs incurred or committed, settlement expenses and profit on work completed prior to termination, which could prevent us from recognizing all of our potential revenue and profit from that contract. If one of our customers terminates the contract due to our default, we could be liable for excess costs incurred by the customer in re-procuring services from another source, as well as other costs. Many of our contracts, including our service agreements, are periodically open to bid. We may not be the successful bidder on our existing contracts that are re-bid. We also provide a portion of our services on a non-recurring, project-by-project basis. We could experience a reduction in our revenue, profitability and liquidity if our customers cancel a significant number of contracts, we fail to win a significant number of our existing contracts upon re-bid or we complete the required work under a significant number of our non-recurring projects and cannot replace them with similar projects. In addition, we provide services under certain master service agreements. If these agreements are terminated, we would be unable to provide on-going services to those customers.

We submit change orders to our customers for work we perform beyond the scope of some of our contracts. If our customers do not approve these change orders, our results of operations could be adversely impacted.

We typically submit change orders under some of our contracts for payment of work performed beyond the initial contractual requirements. The applicable customers may not approve or may contest these change orders and we cannot assure you that these claims will be approved in whole, in part or at all. If these claims are not approved, our results of operations could be adversely impacted.

We may not accurately estimate the costs associated with services provided under fixed-price contracts, which could impair our financial performance.

Approximately 90% of our revenue is derived from fixed price contracts. Under these contracts, we set the price of our services and assume the risk that the costs associated with our performance may be greater than we anticipated. Our profitability is therefore dependent upon our ability to estimate accurately the costs associated with our services. These costs may be affected by a variety of factors, such as lower than anticipated productivity, conditions at the work sites differing materially from what was anticipated at the time we bid on the contract, and higher than expected costs of materials and labor. Certain agreements or projects could have lower margins than anticipated or losses if actual costs for contracts exceed our estimates, which could reduce our profitability and liquidity.

We warranty customer equipment against failure in some of our fixed price contracts, and a major equipment failure could have a material impact on our financial performance.

Under some of our maintenance contracts we provide limited warranties for the continued performance of equipment, including batteries and actuators used in modular data centers. We estimate the anticipated failure or replacement rate of this equipment, but if a customer location experienced a failure rate of equipment greater than we anticipated, we would incur higher equipment replacement costs and incur a loss on that maintenance contract, and potentially this could have a material negative impact on our profitability and liquidity.

We may choose, or be required, to pay our subcontractors even if our customers do not pay or delay paying us for the related services.

We use subcontractors to perform many portions of our services and to manage workflow. In some cases, we pay our subcontractors before our customers pay us for the related services. If we choose, or are required, to pay our subcontractors for work performed for customers who fail to pay, or delay paying us for the related work, we could experience a decrease in profitability and liquidity.

The industries we serve have experienced and may continue to experience rapid technological, structural and competitive changes that could reduce the need for our services and adversely affect our revenues.

The mission-critical information technology industry is characterized by rapid technological change, intense competition and changing consumer and data center needs. We generate a significant portion of our revenues from customers in the mission-critical information technology industry. New technologies, or upgrades to existing technologies by customers, could reduce the need for our services and adversely affect our revenues and profitability. Improvements in existing technology may allow companies to improve their networks without physically upgrading them. Reduced demand for our services or a loss of a significant customer or end-user could adversely affect our results of operations, cash flows and liquidity.

We may be unable to hire and retain sufficient qualified personnel and the loss of any of our key executive officers may adversely affect our business.

We believe that our future success will depend in large part on our continued ability to attract and retain highly skilled, knowledgeable, sophisticated and qualified managerial, professional and technical personnel. Our business involves the development of tailored solutions for customers, a process that relies heavily upon the expertise and services of employees. Accordingly, our employees are one of our most valuable resources. Competition for skilled personnel is intense in our industry. Recruiting and training these personnel require substantial resources particularly when seeking qualified staff in remote locations where a number of our customers operate their data centers. Our failure to attract and retain qualified personnel could increase our costs of performing our contractual obligations, reduce our ability to efficiently satisfy our customers’ needs, limit our ability to win new business and constrain our future growth.

If we are unable to engage appropriate subcontractors or if our subcontractors fail to perform their contractual obligations, our performance as a prime contractor and ability to obtain future business could be materially and adversely impacted.

Our contract performance may involve subcontracts with other companies upon which we rely to perform all or a portion of the work we are obligated to deliver to our customers. Our inability to find and engage appropriate subcontractors or a failure by one or more of our subcontractors to satisfactorily deliver on a timely basis the agreed-upon supplies and/or perform the agreed-upon services may materially and adversely affect our ability to perform our obligations as a prime contractor.

In extreme cases, a subcontractor’s performance deficiency could result in the customer terminating the contract for default with us. A default termination could expose us to liability for excess costs of procurement by the customer and have a material adverse effect on our ability to compete for future contracts and task orders.

Security breaches and attacks on our computer systems could lead to significant costs and disruptions that could harm our business, financial results and reputation.

We are reliant upon a number of third party and internally developed software programs to operate our business. We store and transmit our own as well as customer information and data, including individual data of and about their end-user customers. Maintaining the security and availability of our services, network and internal IT systems and the security of information we hold is a critical issue for us and our customers. Any software failure or corruption, including cyber-based attacks or network security breaches, could lead to the dissemination of proprietary information or sensitive, personal or confidential data about us, our employees, customers and end-user customers, could threaten our ability to provide services to our customers, generate negative publicity about us, result in litigation and increased legal liability or costs or lead to government inquiry or oversight. The occurrence of any of these events could harm our business or damage our brand and reputation, lead to loss of customers, higher expenses and possibly impede our present and future success in retaining and attracting new customers.

A successful assault on our infrastructure would be damaging to our reputation and could adversely affect our financial condition. Similar security risks exist with respect to our business partners and the third-party vendors we rely on for aspects of our information technology infrastructure, support services and administrative functions. As a result, we are subject to the risk that the activities of our business partners and third-party vendors may adversely affect our business even if an attack or breach does not directly impact our systems.

Because we do not currently intend to pay dividends on our common stock, stockholders will benefit from an investment in our common stock only if it appreciates in value.

We have never declared or paid any cash dividends on our common stock. We currently intend to retain all future earnings, if any, for use in the operations and expansion of our business. As a result, we do not anticipate paying cash dividends in the foreseeable future. Any future determination as to the declaration and payment of cash dividends will be at the discretion of our board of directors and will depend on factors our board of directors deems relevant, including, among others, our results of operations, financial condition and cash requirements, business prospects, and the terms of our credit facility and other financing arrangements. Accordingly, realization of a gain on stockholders’ investments will depend on the appreciation of the price of our common stock. There is no guarantee that our common stock will appreciate in value or even maintain the price at which stockholders purchased their shares.

Our insiders beneficially own a significant portion of our outstanding common stock.  Future sales of common stock by these insiders may have an adverse effect on the market price of our common stock.

Our officers, directors or their affiliates beneficially own approximately 6.3 million shares of common stock or approximately 28% of our outstanding common shares as of March 31, 2023. Stock sales by our directors and officers are subject to compliance with our Code of Conduct and preapproval process from the Chief Financial Officer. Sales of a substantial number of these shares in the public market could decrease the market price of our common stock. In addition, the perception that such sales might occur may cause the market price of our common stock to decline. Future issuances or sales of our common stock could have an adverse effect on the market price of our common stock.

Our shares are thinly traded and may not be readily marketable.

Our shares are not widely traded, and daily trading volume is generally very low compared with most publicly traded companies. As a result, you may not be able to readily resell your shares in the company.

Our common stock may be characterized as a “penny stock” under applicable SEC regulations.

Our common stock may be characterized as “penny stock” under SEC regulations. As such, broker-dealers dealing in our common stock may be subject to the disclosure rules for transactions involving penny stocks, which generally require that, prior to a purchase, the broker-dealer determine if purchasing the common stock is suitable for the applicable purchaser. The broker-dealer must also obtain the written consent of the applicable purchasers to purchase the common stock and disclose the best bid and offer prices available for the common stock and the price at which the broker-dealer last purchased or sold the common stock. These additional burdens imposed upon broker-dealers may discourage them from effecting transactions in our common stock, which could make it difficult for an investor to sell his, her or its shares at any given time

Item 1B.       Unresolved Staff Comments.

Not applicable.

Item 2.         Properties.

We lease a production facility, warehouse and office space in Round Rock, Texas and in 2021 renewed a 7 year lease for this space. We believe that our current facilities are adequate for our operations and additional or replacement facilities would be available if necessary.

Item 3.        Legal Proceedings 

We are not a party to any material litigation in any court, and we are not aware of any contemplated proceeding by any governmental authority against us. From time to time, we are involved in various legal matters and proceedings concerning matters arising in the ordinary course of business such as employment-related matters. We believe that any potential liability arising out of these matters and proceedings will not have a material adverse effect on our financial position, results of operations or cash flows.

Item 4.        Mine Safety Disclosures

Not applicable.

PART II

Item 5.        Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 

The market for our common stock is limited due to the relatively low trading volume of our common stock and lack of analyst coverage. Our common stock is currently quoted on the OTCQB tier of OTC Markets Group, Inc. under the symbol “TSSI.” The OTCQB is a centralized quotation service that collects and publishes market maker quotes for over-the-counter securities in real time. Over-the-counter market quotations, like those on the OTCQB, reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

The following table sets forth the high and low bid prices for our common stock for each of the quarters of 2022 and 2021 as reported by the OTC Markets Group:

As of March 31, 2022, there were 86 stockholders of record of our common stock, although we believe there is a larger number of beneficial owners of our common stock. 

We did not pay dividends on our outstanding stock during the years ended December 31, 2022 and 2021. We currently intend to retain all future earnings, if any, for use in the operations and expansion of our business. As a result, we do not anticipate paying cash dividends in the foreseeable future. Any future determination as to the declaration and payment of cash dividends will be at the discretion of our board of directors and will depend on factors our board of directors deems relevant, including, among others, our results of operations, financial condition and cash requirements, business prospects and the terms of our credit facilities and other financing arrangements.

The following table provides information as of December 31, 2022 with respect to shares of our common stock that may be issued under equity compensation plans:

The following table provides information with respect to shares of our common stock that were acquired by the Company during the fourth quarter of 2022:

Item 6.          Selected Financial Data and Supplementary Financial Information

The information called for by this item is not required as we are a smaller reporting company.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains statements that are forward-looking. These statements are based on expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of, among other reasons, factors discussed in Item 1A – Risk Factors and elsewhere in this Annual Report. The commentary should be read in conjunction with the consolidated financial statements and related notes and other statistical information included in this Annual Report.

Overview

TSS, Inc. (“TSS”, the “Company”, “we”, “us” or “our”) provides a range of comprehensive services to enable the planning, design, deployment, maintenance, and refurbishment of end-user and enterprise systems, including the mission-critical facilities they are housed in. We provide a single source solution for enabling technologies in data centers, operation centers, network facilities, server rooms, security operations centers, communications facilities and the infrastructure systems that are critical to their function. Our services include technology consulting, design and engineering, project management, systems integration, system installations, facilities management, and IT procurement services. Our headquarters and our integration facility are located in Round Rock, Texas

Our business is concentrated on the U.S. data center infrastructure and services market. This market continues to be highly competitive as commerce moves to cloud-based solutions and as data storage requirements continue to escalate for many industries. These underlying macroeconomic trends are driving demand for more information technology equipment and more efficient data center design and operation, resulting in continued overall growth in this market. We compete against many larger competitors who have greater resources than we do, which may affect our competitiveness in the market. We rely on several large customers to win contracts and to provide business to us under “Master Service Agreements”, and the loss of such customers would have a material negative effect on our results.

Almost all of the components used in our systems integration business are consigned to us by our original equipment manufacturer (OEM) or their end-user customers, thus our revenues reflect only the services we perform, and the consigned components are not reflected in our balance sheet. We also offer our customers the ability to procure third-party hardware, software and services on their behalf that are then used in our integration services as we integrate these components to deliver a completed system to our customer. In some cases, we also act as an agent and arrange for the purchase of third-party hardware, software or services that are to be provided to our customers by another party and we have no control of the goods or services before they are transferred to the customer. In these instances, we are acting as an agent in the transaction. These procurement and reseller activities allow us to develop relationships with new hardware, software and professional service providers and allow us to generate higher margins on integration projects by broadening our revenue and customer base.

In March 2020, the coronavirus disease 2019 (“COVID-19”) was declared a pandemic by the World Health Organization and a national emergency by the U.S. Government. The pandemic has negatively affected the U.S. and global economy, disrupted global supply chains and financial markets, and resulted in governments around the world implementing increasingly stringent measures to help control the spread of the virus, including quarantines, “shelter in place” and “stay at home” orders, travel restrictions, business curtailments, school closures and other measures. In addition, governments and central banks in several parts of the world have subsequently enacted fiscal and monetary stimulus measures to counteract the impacts of COVID-19.

The COVID-19 pandemic had an immediate and ongoing impact on our operations in both our facilities segment and our systems integration segment since it began. Travel restrictions and other customer actions that restricted physical access to customer sites negatively impacted our facilities segment because we were unable to access customer locations to provide our services. We also experienced supply-chain disruptions beginning in the second half of 2021 until early 2022 that delayed the delivery of equipment needed for both integration and for deployments, further delaying customer projects. Overall, these travel restrictions and supply chain challenges directly impacted our operating results through the first quarter of 2022 for our facilities segment and up to the third quarter of 2022 for our systems integration business. Additionally, as our customers deferred or cancelled the deployment of new modular data centers (MDCs) in 2021, they instead maintained and updated their existing MDCs. As supply chain issues continued to improve during 2022, we were able to source the needed equipment and complete MDC deployments, including for those projects deferred from 2021. Revenue from MDC deployments have increased during 2022 by $3.9 million or 262% compared to 2021, driving the overall increase in our facilities revenues in 2022.

Our systems integration business has also been negatively impacted due to logistical and supply-chain issues that have continued to affect component supply to us and negatively impact our revenue through the pandemic. Safety and other measures that we had to implement in our systems integration facility so that we could continue to operate safely despite the pandemic materially increased the cost of operating and providing our integration services, particularly at the onset of the pandemic. As time has passed and with knowledge gained, we have been able to significantly reduce those incremental operating costs. The supply-chain disruptions have prevented our customers from providing product to us for use in our integration business, preventing us from providing our services, and negatively impacting our revenue. The disruptions began to dissipate in the second half of 2022 but still persist. The improvement in supply chain has helped our integration revenues grow by 27% in 2022 compared to 2021.

At this point we do not know how long this pandemic and its associated impact on our business will continue, or if it will worsen or improve. To the extent these customer delays continue, the pandemic worsens, or we have continued supply chain challenges, our business will continue to be negatively impacted.

Our total revenue in 2022 was $30.6 million, a $3.2 million or 12% increase from our 2021 revenues of $27.4 million. Our facilities revenues increased by $3.1 million or 44% to $10.2 million, driven by an increase in deployments of MDCs as customer projects delayed by the COVID-19 pandemic during 2021 were now able to be completed. Our systems integration revenues grew by $1.5 million or 27% compared to 2021 as supply-chain issues attributable to the COVID-19 pandemic dissipated, and because of stronger demand from our OEM partner. Our procurement and reseller revenues decreased by $1.3 million or 11% compared to 2021 because we completed more agent-type transactions in 2022 than we did in 2021, resulting in lower recorded revenue but higher profits from this line of business.

Our gross profits increased by $2.6 million or 41% compared to 2021, mainly due to the higher volumes of activity across all our business units, and our gross profit margin as a percentage of sales increased to 29% in 2022 from 23% in 2021. The primary cause of the increase in gross profit margin percentage was the decrease in volume of our procurement and reseller business as a proportion of our total revenue where we generally earn much lower margins on product purchase/resell services than we do with our traditional maintenance and integration services. Absent this business, the margins on our core integration and maintenance operations decreased to 37% in 2022 from 44% in 2021 as we experienced higher operating costs in our integration business attributable to the deployment of new lines of services and increased wage costs and from inefficiencies in running this business because of fluctuating monthly production volumes and higher turnover of employees during 2022.

Our selling, general and administrative expenses of $7.7 million were 15% higher than the $6.7 million we recorded in selling, general and administrative expenses in 2021. The increase was primarily due to higher labor costs, including approximately $0.6 million attributable to a change in our chief executive officer in the fourth quarter of 2022, and the impact of wage inflation which was more pronounced during 2022 than the previous year.

Because of the higher overall gross profits, even with higher selling, general and administrative expenses, we were able to improve our operating profit by $1.7 million or 210% from 2021, recording operating income of $914,000 in 2022 compared to an operating loss of $831,000 that we recorded in 2021.

Our interest expense increased substantially compared to 2021. This was due to higher activity in our procurement and reseller business. During 2022 we transacted approximately $73 million of transactions in this business activity, although $60 million of this was for agent-type transactions. With our receivable-financing program that we have with a third-party banking partner, all of these procurement and reseller transactions are financed via this program, and we incur interest cost on the gross value of these transactions. As volume increases in these procurement and reselling activities, our interest cost will increase. This was exacerbated by the increase in interest rates during the second half of 2022. By way of comparison, we transacted approximately $28.3 million of such transactions in 2021.

We ended 2022 with $20.4 million of cash on hand, an increase of $12.4 million from the balance at the end of 2021. This increase was primarily due to the timing of cash flows connected with our procurement and reseller activities. These activities also resulted in a large increase in our accounts payable at the end of 2022 and drive large quarterly fluctuations in our accounts receivables, inventory and deferred revenues, depending on the timing of particular transactions. We were able to generate $14.7 million of cash flows from operations during 2022, and we were able to repay all the Company’s long-term notes payable during 2022 from our operating cash flows. We have been able to structure our procurement and reseller activities in such a way as to minimize their overall impact on our liquidity by using trade creditors as the primary way to finance these activities.

Critical Accounting Policies and Estimates

We consider an accounting policy to be critical if:

Management has reviewed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors, and the Audit Committee has reviewed these disclosures. In addition, there are other items within our financial statements that require estimation but are not deemed critical as defined above. Changes in these and other items could still have a material impact upon our financial statements.

Revenue Recognition

We recognize revenues when control of the promised goods or services is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services.

Some of our contracts with customers contain multiple performance obligations. For these contracts, we account for individual performance obligations separately if they are distinct. The transaction price is allocated to the separate performance obligations based on relative standalone selling prices.

Maintenance services

We generate maintenance services revenues from fees that provide our customers with as-needed maintenance and repair services on modular data centers during the contract term. Our contracts are typically one year in duration, are billed annually in advance, and are non-cancellable. As a result, we record deferred revenue (a contract liability) and recognize revenue from these services on a ratable basis over the contract term. We can mitigate our exposure to credit losses by discontinuing services in the event of non-payment, however our history of non-payments and bad debt expense has been insignificant.

Integration services

We generate integration services revenues from fees that provide our customers with customized system and rack-level integration services. We typically recognize revenue upon shipment to the customer of the completed systems as this is when we have completed our services and when the customer obtains control of the promised goods. We typically extend credit terms to our integration customers based on their creditworthiness and generally do not receive advance payments. As such, we record accounts receivable at the time of shipment, when our right to the consideration becomes unconditional. Accounts receivable from our integration customers are typically due within 30-105 days of invoicing. An allowance for doubtful accounts is provided based on a periodic analysis of individual account balances, including an evaluation of days outstanding, payment history, recent payment trends, and our assessment of our customers’ creditworthiness. As of December 31, 2022 and 2021, our allowance for doubtful accounts was $7,000.

Equipment sales

We generate revenues under fixed price contracts from the sale of data center and related ancillary equipment to customers in the United States. We typically recognize revenue when the product is shipped to the customer as that is when the customer obtains control of the promised goods. Typically, we do not receive advance payments for equipment sales, however if we do, we record the advance payment as deferred revenue. Normally we record accounts receivable at the time of shipment when our right to the consideration has become unconditional. Accounts receivable from our equipment sales are typically due within 30-45 days of invoicing.

Deployment and Other services

We generate revenues from fees we charge our customers for other services, including repairs or other services not covered under maintenance contracts, installation and servicing of equipment including modular data centers that we sold, and other fixed-price services including repair, design and project management services. In some cases, we arrange for a third party to perform warranty and servicing of equipment, and in these instances, we recognize revenue as the amount of any fees or commissions that we expect to be entitled to. Other services are typically invoiced upon completion of services or completion of milestones. We record accounts receivable at the time of completion when our right to consideration becomes unconditional.

Procurement and Reseller services

We generate revenues from fees we charge our customers to procure third-party hardware, software and professional services on their behalf that are then used in our integration services as we integrate these components to deliver a completed system to our customer. We recognize our procurement and reseller services revenue upon completion of the procurement activity. In some cases, we arrange for the purchase of third-party hardware, software or professional services that are to be provided to our customers by another party and we have no control of the goods before they are transferred to the customer. In these instances, we are acting as an agent in the transaction and recognize revenue as the amount of any fee or commissions that we expect to be entitled to after paying the other party for the goods or services provided to the customer. Accounts receivable from our reseller activities are typically due within 30-60 days of invoicing.         

Judgments

We consider several factors in determining that control transfers to the customer upon shipment of equipment or upon completion of our services. These factors include that legal title transfers to the customer, we have a present right to payment, and the customer has assumed the risks and rewards of ownership at the time of shipment or completion of the services.

Sales taxes

Sales (and similar) taxes that are imposed on our sales and collected from customers are excluded from revenues.

Shipping and handling costs

Costs for shipping and handling activities, including those activities that occur subsequent to transfer of control to the customer, are recorded as cost of sales and are expensed as incurred. We accrue costs for shipping and handling activities that occur after control of the promised good or service has transferred to the customer.

The following table shows our revenues disaggregated by reportable segment and by product or service type (in $’000):

Remaining Performance Obligations

Remaining performance obligations include deferred revenues and amounts we expect to receive for goods and services that have not yet been delivered or provided under existing, non-cancellable contracts. For contracts that have an original duration of one year or less, we have elected the practical expedient applicable to such contracts and we do not disclose the transaction price for remaining performance obligations at the end of each reporting period and when we expect to recognize this revenue. As of December 31, 2022, current deferred revenue of $2,080,000 consists of $1,787,000 representing our remaining performance obligations for our maintenance contracts, all of which are expected to be recognized within one year, and $293,000 relating to procurement and integration services where we have yet to complete our services for our customers, all of which are expected to be recognized within one year.

Intangible Assets

We recorded goodwill and intangibles with definite lives, including customer relationships and acquired software, in conjunction with the acquisition of various businesses. Intangible assets with finite lives are amortized based on their estimated economic lives. Goodwill represents the excess of the purchase price over the fair value of net identified tangible and intangible assets acquired and liabilities assumed, and it is not amortized.

We perform an impairment test of goodwill on an annual basis with a measurement date of December 31, or whenever events or circumstances make it more likely than not that impairment of goodwill may have occurred. Our goodwill impairment test involves comparing the fair value of a reporting unit with its carrying amount. If that fair value exceeds the carrying amount, no impairment charge is required to be recorded. If the carrying value exceeds the reporting unit’s fair value, an entity should recognize a goodwill impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. However, the impairment losses recognized cannot exceed the total amount of goodwill allocated to that reporting unit. If necessary, the fair value of a reporting unit will be determined using a discounted cash flow, which requires the use of estimates and assumptions. Significant assumptions that may be required include forecasted operating results, and the determination of an appropriate discount rate. Actual results may differ from forecasted results, which may have a material impact on the conclusions reached.

We also review intangible assets with definite lives for impairment whenever events or circumstances indicate that the carrying amount may not be recoverable.  If the sum of the expected undiscounted cash flows is less than the carrying value of the related asset, a loss is recognized for the difference between the fair value and carrying value of the intangible asset. 

Allowance for Doubtful Accounts

We estimate an allowance for doubtful accounts based on factors related to the specific credit risk of each customer. Historically our credit losses have been minimal. We perform credit evaluations of new customers and may require prepayments or use of bank instruments such as trade letters of credit to mitigate credit risk. We monitor outstanding amounts to limit our credit exposure to individual accounts. We continue to pursue collection even if we have fully provided for an account balance.

Stock Based Compensation

We account for stock-based compensation using a fair-value based recognition method. Stock-based compensation cost is estimated at the grant date based on the fair value of the award and is recognized ratably over the requisite service period of the award. Determining the appropriate fair-value model and calculating the fair value of stock-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life and forfeiture rates. We develop our estimates based on historical data and market information that can change significantly over time. A small change in estimates used can have a relatively large change in the estimated valuation.

We use the Black-Scholes option valuation model to value employee stock option awards that are not performance- based awards. We estimate stock price volatility based upon our historical volatility. Estimated option life and forfeiture rate assumptions are derived from historical data. For restricted stock awards, we use the quoted price of our common stock on the grant date as the fair value of the award. For stock-based compensation awards with graded vesting, we recognize compensation expense using the straight-line amortization method. For performance-based stock awards, if applicable, we may use third-party valuation specialists and a Monte-Carlo simulation model to ascertain the fair value of the award at grant date.

Results of Operations

Comparison of 2022 to 2021

Revenue

Revenue consists of fees earned from the planning, design and project-management of mission-critical facilities and information infrastructures, as well as fees earned from providing maintenance services on these facilities. We also earn revenue from providing system configuration and integration services, including reseller services, to IT equipment vendors. Currently we derive all our revenue from the U.S. market.

We contract with our customers under five primary contract types: fixed-price service and maintenance contracts, time and material contracts, cost-plus-fee, guaranteed maximum price and fixed-price contracts. Cost-plus-fee and guaranteed maximum price contracts are typically lower risk arrangements and thus yield lower profit margins than time-and-materials and fixed-price arrangements which generate higher profit margins generally, relative to their higher risk. Certain of our service and maintenance contracts provide comprehensive coverage of all of the customer’s equipment (generally excluding IT equipment) at a facility during the contract period. Where customer requirements are clear, we prefer to enter comprehensive fixed-price arrangements or time-and-materials arrangements rather than cost-plus-fee and guaranteed maximum price contracts.

Most of our revenue is generated based on services provided either by our employees or subcontractors. To a lesser degree, the revenue we earn includes reimbursable travel and other costs to support the project. Since we earn higher profits from the labor services that our employees provide compared with use of subcontracted labor and other reimbursable costs, we seek to optimize our labor content on the contracts we are awarded to maximize our profitability.

We have been concentrating our sales efforts towards maintenance and integration services where we have traditionally earned higher margins. Historically we performed design, construction and project-management services in a concentrated number of high-value contracts for the construction of new data centers, but we have transitioned our business away from this market. We have also focused on providing maintenance services for modular data center applications as this market matures. We continue to focus on increasing our systems integration revenues through more consistent revenue streams that will better utilize the assets in that business, and through adding additional services such as procurement and reseller services, to help drive volume through the facility. This includes adapting our integration services to stay abreast of emerging technologies such as immersion computing, liquid-cooled computing, and edge-based technology, so that we can help our customers succeed in these new markets.

Our total revenue in 2022 was $30.6 million, a $3.2 million or 12% increase from our 2021 revenues of $27.4 million. Our facilities revenues increased by $3.1 million or 44% to $10.2 million, driven by an increase in deployments of MDCs as customer projects delayed by the COVID-19 pandemic during 2021 were now able to be completed. Our systems integration revenues grew by $1.5 million or 27% compared to 2021 as supply-chain issues attributable to the COVID-19 pandemic dissipated, and because of stronger demand from our OEM partner. Our procurement and reseller revenues decreased by $1.3 million or 11% compared to 2021 because we completed more agent-type transactions in 2022 than we did in 2021, resulting in lower recorded revenue but higher profits from this line of business.

The volume and timing of revenues from our procurement and reseller services is unpredictable and dependent on customer requirements. Our experience to date with this business is that we have seen material fluctuations in our quarterly and annual level of revenue and profits from these activities and we have not yet established a consistent flow of transactions. We anticipate that this business will continue to fluctuate quarterly, and that as we reduce our customer concentration and increase revenues from our core integration and maintenance businesses, we will have more opportunities to grow and predict our procurement and reseller business.

Cost of Revenue

Cost of revenue includes the cost of component parts for our products, labor costs expended in the production and delivery of our services, subcontractor and third-party expense, equipment and other costs associated with our test and integration facilities, excluding depreciation of our manufacturing property and equipment, shipping costs, and the costs of support functions such as purchasing, logistics and quality assurance. The cost of revenue as a percentage of revenue was 71% for the year ended December 31, 2022, compared to 77% for 2021. This decrease in margin percentage from 2021 reflects the lower proportion of our total revenues that come from our procurement and reseller activities. Our reseller and procurement revenues were 43% of total revenue in 2022 compared to 54% of total revenues in 2021. We earn much lower margins on product purchase/resell services, unless we are acting as an agent in the transaction, than we do with our traditional maintenance and integration services. As the percentage of revenues derived from procurement and reseller services decreases, we would anticipate that cost of revenue as a percentage of sale will decrease.

As our procurement and reseller service business is relatively new, the level of expected revenues from this business has and will continue to fluctuate significantly on a quarterly basis. As a result, our cost of revenue as a percentage of total revenue will also fluctuate significantly. Cost of revenue for procurement and reseller services is higher than cost of revenue for our integration and maintenance services. Thus, as procurement and reseller revenues as a percentage of total revenue increases, our cost of sales will increase and our gross profit margin will decrease.

Since we earn higher profits when using our own labor services, we expect gross margins to improve when our labor service mix increases relative to the use of subcontracted or third-party labor. Our direct labor costs are relatively fixed in the short-term, and the utilization of direct labor is critical to maximizing our profitability. As we continue to bid and win contracts that require specialized skills that we do not possess, we would expect to have more third-party subcontracted labor to help us fulfill those contracts. In addition, we can face hiring challenges in internally staffing larger contracts. While these factors could lead to a higher ratio of cost of services to revenue, the ability to outsource these activities without carrying a higher level of fixed overhead allows us to increase income, broaden our revenue base and have a favorable return on invested capital. As we increase the level of procurement and reseller services in the future, we anticipate that our overall gross margin will decrease as the normal margins on reseller activities are lower than the margins from our traditional facilities and systems integration services.

A large portion of our revenue is derived from fixed price contracts. Under these contracts, we set the price of our services and assume the risk that the costs associated with our performance may be greater than we anticipated. Our profitability is therefore dependent upon our ability to estimate accurately the costs associated with our services. These costs may be affected by a variety of factors, such as lower than anticipated productivity, conditions at the work sites differing materially from what was anticipated at the time we bid on the contract, and higher than expected costs of materials and labor. Certain agreements or projects could have lower margins than anticipated or losses if actual costs for contracts exceed our estimates, which could reduce our profitability and liquidity.

Gross Profit

Our gross profits increased by $2.6 million or 41% compared to 2021, mainly due to the higher volume of activity across all our business units, and our gross profit margin as a percentage of sales increased to 29% in 2022 from 23% in 2021. The increase in gross profit was greater than the increase in total revenues due in part to the impact of growth in the number of agent-type transactions in our procurement and reseller business in 2022. Under these transactions we recognize as revenue the net margin we receive after paying the other party for goods or services that they deliver to the customer. Profits from our procurement and reseller services increased by $1.7 million in 2022 compared to 2021. Absent this business, the margins on our core integration and maintenance operations decreased from 44% in 2021 to 37% in 2022 despite higher revenues. This was primarily due to an increase in costs, particularly labor costs, in our integration business that reflected higher wage inflation, higher levels of employee turnover that impacted efficiency, and development and other costs incurred in developing and introducing new types of integration service during 2022.

Our ability to maintain and to further improve gross profits will depend, in part, upon our ability to continue increasing sales of our higher-margin services including maintenance and integration services, improve our service margins by passing our higher operating costs on to our customers through increasing pricing, improving the operating efficiency of the integration business including utilization of our direct labor, and increasing the total revenues to a level that will allow us to increase the utilization of our integration and service operations. Our gross profit margin is likely to fluctuate based on the proportion of our total revenues that comes from our reseller activities.

Selling, General and Administrative Expenses

Selling, general and administrative expenses primarily consist of compensation and related expenses, including variable sales compensation, for our executive, administrative and sales and marketing personnel, as well as related travel, selling and marketing expenses, professional fees, facility costs, insurances and other corporate costs. For the year ended December 31, 2022, our selling, general and administrative expenses of $7.7 million increased by $1 million, or 15% compared to 2021. The increase was primarily due to higher labor costs, including approximately $0.6 million attributable to a change in our chief executive officer in the fourth quarter of 2022, and the impact of wage inflation on our workforce which was more pronounced during 2022 than in previous years.

Operating income (loss)

Because of the higher absolute gross profits, even with the higher level of selling, general and administrative expenses, we were able to improve our operating profit by $1.7 million or 210% from 2021, and recorded operating income of $914,000 in 2022 compared to an operating loss of $831,000 that we recorded in 2021.

Interest expense

For the year ended December 31, 2022 we recorded interest expense, net of interest income, of $931,000. This compares to interest expense, net of interest income, of $401,000 for the year ended December 31, 2021. The increase in interest expense was due to the higher number of agent-type transactions that were factored in our procurement and reseller business compared to 2021. Interest expense in our procurement and reseller activities increased by $480,000 in 2022 due to the higher number of transactions and the impact of higher interest rates during 2022.

Income tax expense

Due to a history of consolidated net operating losses, we have not recorded any income tax expenses, other than minimum or statutory costs. As of December 31, 2022, our accumulated net operating loss carry forward was $41 million. We anticipate that these loss carry-forwards may offset future taxable income that we may achieve and future tax liabilities. However, because of uncertainty regarding our ability to use these carry forwards and the potential limitations due to ownership changes, we have established a valuation allowance for the full amount of our net deferred tax assets.

Net income (loss)

After interest, other income and income taxes, we recorded a net loss of $73,000, or $(0.00) per share for the year ended December 31, 2022. This compares to a net loss of $1.3 million, or $(0.07) per share we recorded for the year ended December 31, 2021.

Comparison of 2021 to 2020

Revenue

Our total revenue in 2021 was $27.4 million, a $17.7 million or 39% decrease from our 2020 revenues of $45.1 million. This decrease was driven by a $14.1 million decrease in revenues from our procurement and reseller services that decreased by 49% from 2020 levels. Our remaining core businesses were both impacted by the COVID-19 pandemic that resulted in customer delays and cancellations of modular data center deployments which caused our facilities revenues to decrease by 21% to $7.1 million. Our integration services decreased 22% or $1.6 million compared to 2020 on lower volumes from our OEM partner primarily attributable to the impact of supply-chain interruptions and other factors related to the COVID-19 pandemic.

Cost of revenue

Cost of revenue includes the cost of component parts for our products, labor costs expended in the production and delivery of our services, subcontractor and third-party expense, equipment and other costs associated with our test and integration facilities, excluding depreciation of our manufacturing property and equipment, shipping costs, and the costs of support functions such as purchasing, logistics and quality assurance. The cost of revenue as a percentage of revenue was 77% for the year ended December 31, 2021 compared to 85% for 2020. This decrease in costs from 2020 reflects the lower proportion of our total revenues that come from our procurement and reseller business where we earn much lower margins on product purchase/resell services than we do with our traditional maintenance and integration services. As the percentage of revenues derived from procurement and reseller services decreases, we would anticipate that cost of revenue as a percentage of sale will decrease. The profit margin from our maintenance and integration services increased by 14% from 2020 despite lower revenue levels, primarily due to lower operating costs on our integration facility in 2021 as we adjusted to operating our business in a pandemic environment.

Gross Profit

Our gross profits decreased by $0.4 million or 6% compared to 2020, mainly due to the lower volume of procurement service, while our gross profit margin as a percentage of sales increased to 23% in 2021 from 15% in 2020. The primary cause of the increase in gross profit margin was the change in volume of our procurement and reseller business where we earn much lower margins on product purchase/resell services than we do with our traditional maintenance and integration services. Absent this business, the margins on our core integration and maintenance operations increased from 30% in 2020 to 44% in 2021 as we eliminated costs from operating our integration facility that had increased in 2020 as we adapted to operating in a pandemic and had to introduce safety and other measures to keep the facility operating. With experience we have been able to lower our labor requirements and reduce many of these costs during 2021, helping to increase the gross margins in our integration services by 23% compared to 2020. We continued to experience fluctuating volumes in our systems integration facility throughout the year that prevented us from optimizing the utilization of this facility on a consistent basis, further dampening the overall profitability of this operation.

Selling, General and Administrative Expenses

Selling, general and administrative expenses primarily consist of compensation and related expenses, including variable sales compensation, for our executive, administrative and sales and marketing personnel, as well as related travel, selling and marketing expenses, professional fees, facility costs, insurances and other corporate costs. For the year ended December 31, 2021, our selling, general and administrative expenses of $6.7 million decreased by $18,000, compared to 2020.

Operating Income

Because of the lower overall gross profits, with consistent selling, general and administrative expenses, we incurred a higher operating loss of $831,000 in 2021. This was $431,000 higher than the operating loss of $400,000 that we recorded in 2020.

Other Income

During the second quarter of 2020 we were able to participate in the Payroll Protection Program of the Coronavirus Aid, Relief and Economic Security Act of 2020 (the “CARES Act”) and qualified for a loan of approximately $890,000. The proceeds were received in April 2020 and were used for covered payroll costs, rent and utilities in accordance with the relevant terms and conditions of the CARES Act. We applied for forgiveness of this loan amount during the third quarter of 2020 and in November 2020 were notified by the Small Business Administration that this loan had been forgiven in full. The gain on forgiveness of debt is shown as other income in our 2020 financial statements.

Income tax expense

Due to a history of consolidated net operating losses, we have not recorded any income tax expenses, other than minimum or statutory costs. As of December 31, 2021, our accumulated net operating loss carry forward was $42.1 million. We anticipate that these loss carry-forwards may offset future taxable income that we may achieve and future tax liabilities. However, because of uncertainty regarding our ability to use these carry forwards and the potential limitations due to ownership changes, we have established a valuation allowance for the full amount of our net deferred tax assets.

Net income (loss)

After interest, other income and income taxes, we recorded a net loss of $(1.3 million), or $(0.07) per share for the year ended December 31, 2021. This compares to net income of $0.1 million, or $0.001 per share we recorded for the year ended December 31, 2020.

LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity at December 31, 2022 are our cash and cash equivalents on hand, funds available under our bank credit facility and projected cash flows from operating activities.

As of December 31, 2022, the Company had an accumulated deficit of $66,385,000. In addition, the Company has a history of annual operating and net losses which have been due, in part, to the effects of COVID-19 and related supply chain constraints. These factors may be indicative of doubt about the Company’s ability to continue as a going concern.  Management has evaluated the significance of these conditions in relation to its ability to meet its obligations. Our primary sources of funds to meet our liquidity and capital requirements include cash on hand, funds generated from operations including the funds from our customer financing programs, trade credit extended to us by our vendors, and borrowings under our bank credit facility. If our future results do not meet expectations, management believes that we can implement reductions in selling, general and administrative expenses to better achieve profitability and therefore improve cash flows, or that we could take further steps such as the issuance of new equity or debt. We may also require additional capital if we seek to acquire additional businesses as a way to increase the scale of our operations, or if there is a sudden increase in the level of reseller services. There can be no assurance as to the Company’s ability to scale its business operations on terms upon which additional financing might be available. 

Management believes that we will be able to generate sufficient cash flows and liquidity as described above, as we still have a significant backlog of projects which have been impacted due to COVID-19 and the related supply chain constraints. We have invested in supporting new IT technologies and received new orders that should drive an increase in our integration business going forward and have also seen new MDC customers emerge during 2022 These factors among others allow us to believe that we will be profitable in 2023. We anticipate generating further cash flows from operations and, having repaid all of the Company’s long-term debt during 2022 from existing sources, we now have no long-term debt outstanding apart from lease obligations.  As a result, management has concluded that there is not substantial doubt about the Company’s ability to continue as a going concern

If we continue to meet the cash flow projections in our current business plan, we expect that we will have adequate capital resources necessary to continue operating our business for at least the next twelve months. Our business plan and our assumptions around the adequacy of our liquidity are based on estimates regarding expected revenues and future costs. However, there are potential risks, including that our revenues may not meet our projections, our costs may exceed our estimates, or our working capital needs may be greater than anticipated. Further, our estimates may change, and future events or developments may also affect our estimates. Any of these factors may change our expectation of cash usage in 2023 and beyond or significantly affect our level of liquidity, which may limit our opportunities to grow our business.

As of December 31, 2022 and 2021, we had cash and cash equivalents of $20.4 million and $8.0 million, respectively.

Significant uses of cash

Operating activities:

Cash provided by operating activities was $14.7 million for the year ended December 31, 2022, compared to cash used in operating activities of $10.5 million for the year ended December 31, 2021. The primary reason for the increase in cash is due to the timing and financial impact of our procurement and reseller services on our financial statements. At the end of 2022 we were able to be paid for multiple large procurement projects but had yet to pay vendors for these same projects. This resulted in an increase of approximately $14 million in our outstanding accounts payable at the end of 2022. During the first quarter of 2023 we paid those vendors and both our cash and accounts payable decreased by over $12 million. We had a similar situation at the end of 2020 and during the first quarter of 2021, where we paid over $10 million to vendors from transactions that we had collected funds from during 2020 causing us to use cash in operations during 2021. We have been able to structure our procurement and reseller activities in such a way as to minimize their overall impact on our liquidity by using trade creditors as the primary way to finance these activities. We have been able to leverage the increase in trade payables tied to procurement and reseller services to finance the growth in inventory and receivables and believe that we will have adequate trade credit to continue to grow this service line in 2023.

We expect that our balance sheet will continue to be materially impacted by the timing of cash flows tied to particular reseller and procurement projects. This will cause cash, receivables, inventory, payables and deferred revenue balances to fluctuate, sometimes materially, on a quarterly basis. 

Investing activities:

Cash used in investing activities was $0.5 million in 2022, primarily for the expansion and upgrading of our integration business and improvements to our facility. This compares to cash used in investing activities was $0.1 million in 2021 for the purchases of computer equipment as we added new infrastructure and equipment to support our business.

Finance activities:

Cash used in financing activities was $1.8 million in 2022 compared to cash used in financing activities of $0.5 million during 2021. During the third quarter of 2022 we repaid outstanding interest and principal on our notes payable of $2,045,000, and we received $367,000 in proceeds from the exercise of warrants that had been issued in connection with our notes payable. We also received $41,000 in proceeds during 2022 from the exercise of employee stock options and used $134,000 during 2022 for the purchase of stock related to tax obligations around option exercises and the vesting of restricted shares. In 2021 we used $352,000 to retire a portion of our long-term notes payable after the lenders offered us an incentive to repay this debt prior to maturity. We also received $45,000 in proceeds in 2021 from the exercise of employee stock options, and we used $197,000 in 2021 for the purchase of stock related to tax obligations from option exercises and the vesting of restricted shares by our employees.

Future uses of cash

Our business plans and our assumptions around the adequacy of our liquidity are based on estimates regarding estimated revenues and future costs and our ability to secure sources of funding when needed. Further, our estimates may change, and future events or developments may also affect our estimates. Any of these factors may change our expectation of cash usage during 2023 and beyond or significantly affect our level of liquidity, which may require us to take other measures to reduce our operating costs in order to continue operating. Any action to reduce operating costs may negatively affect our range of products and services that we offer or our ability to deliver such products and services, which could materially impact our financial results depending on the level of cost reductions taken.

Our primary liquidity and capital requirements are to fund working capital from current operations. Our primary sources of funds to meet our liquidity and capital requirements include cash on hand, funds generated from operations including the funds from our customer financing programs, and, if needed, borrowings under our bank credit facility. We believe that if future results do not meet expectations, we can implement reductions in selling, general and administrative expenses to better achieve profitability and therefore improve cash flows, or that we could take further steps such as the issuance of new equity or debt. However, the timing and effect of these steps may not completely alleviate a material effect on liquidity. We may also require additional capital if we seek to introduce new lines of business or if we seek to acquire additional businesses as a way to increase the scale of our operations.

New Accounting Pronouncements

Recently Adopted Accounting Guidance

In December 2019, FASB issued Accounting Standards Update 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (“ASU 2019-12). ASU 2019-12 simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740. The guidance also clarifies and amends existing guidance to improve consistent application. The standard was adopted by us in our first quarter of fiscal 2021 and did not have any material impact on our consolidated results of operations, cash flows, financial position or disclosure.

In March 2020, FASB issued Accounting Standards Update ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, (“ASU 2020-04”). ASU 2020-04 provides optional expedients and exceptions for applying GAAP principles to contracts, hedging relationships, and other transactions that reference London Interbank Offered Rate (LIBOR) or another reference rate expected to be discontinued due to reference rate reform. This guidance was effective beginning on March 12, 2020 and was adopted by us in the fourth quarter of 2022 and did not have any material impact on our consolidated results of operations, cash flows, financial position or disclosure.

Recently Issued Accounting Pronouncements

In June 2016, FASB issued Accounting Standards Update ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). The standard’s main goal is to improve financial reporting by requiring earlier recognition of credit losses on financing receivables and other financial assets. Among the provisions of ASU 2016-13 is a requirement that assets measured at amortized cost, which includes trade accounts receivable, be presented at the net amount expected to be collected. This pronouncement requires that an entity reflect all of its expected credit losses based on current estimates which will replace the current standard requiring that an entity need only consider past events and current conditions in measuring an incurred loss. We are subject to this guidance effective with the consolidated financial statements we issue for the annual and interim periods during the year ending December 31, 2023. We are currently evaluating the adoption date and the impact of the adoption of this guidance on our consolidated financial statements and disclosures and do not expect it to have a material impact on our consolidated results of operation, cash flows, financial position or disclosure.

In May 2019, FASB issued Accounting Standards Update ASU No. 2019-15, Financial Instruments – Credit Losses (Topic 326), (“ASU 2019-15”). ASU 2019-15 provides final guidance that allows entities to make an irrevocable one-time election upon adoption of the new credit losses standard to measure financial assets at amortized cost (except held-to-maturity securities) using the fair value option. The effective date and transition methodology are same as in ASU 2016-13.

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk.

The information called for by this item is not required as we are a smaller reporting company.

TSS, Inc.

Consolidated Balance Sheets

(in ’000 except per-share amounts)

See accompanying notes to consolidated financial statements.

TSS, Inc.

Consolidated Statements of Operations

(in ’000 except per-share amounts)

See accompanying notes to consolidated financial statements.

TSS, Inc.

Consolidated Statements of Changes in Stockholders’ Equity 

(in ‘000)

See accompanying notes to consolidated financial statements.

TSS, Inc.

Consolidated Statements of Cash Flows

(in ’000)

See accompanying notes to consolidated financial statements.

Note 1 -          Significant Accounting Policies

Description of Business

TSS, Inc. (“TSS”, the “Company”, “we”, “us” or “our”) provides comprehensive services for the planning, design, deployment, maintenance, refresh and take-back of end-user and enterprise systems, including the mission-critical facilities they are housed in. We provide a single source solution for enabling technologies in data centers, operations centers, network facilities, server rooms, security operations centers, communications facilities and the infrastructure systems that are critical to their function. Our services consist of technology consulting, design and engineering, project management, systems integration, system installation, facilities management and IT procurement services. Our corporate offices and integration facility are located in Round Rock, Texas.

The preparation of the consolidated financial statements in accordance with the accounting principles generally accepted in the United States of America (“GAAP”) requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates which are based on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form a basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions; however, we believe that our estimates are reasonable and that the actual results will not vary significantly from the estimated amounts.

Liquidity

As of December 31, 2022, the Company had an accumulated deficit of $66,385,000. Although we reported operating income in 2022, we have a history of annual operating and net losses over recent years which have been due, in part, to the effects of COVID-19 and related supply chain constraints. These factors may be indicative of doubt regarding the Company’s ability to continue as a going concern. Management has evaluated the significance of these conditions in relation to its ability to meet its obligations. Our primary sources of funds to meet our liquidity and capital requirements include cash on hand, funds generated from operations including the funds from our customer financing programs, trade credit extended to us by our vendors or under our revolving credit facilities with our bank. If future results do not meet expectations, management believes that we can implement reductions in selling, general and administrative expenses to better achieve profitability and therefore improve cash flows, or that we could take further steps such as the issuance of new equity or debt. We may also require additional capital if we seek to acquire additional businesses to increase the scale of our operations, or if there is a sudden increase in the level of reseller services. There can be no assurance as to the Company’s ability to continue to operate profitably or to scale its business operations on terms upon which additional financing might be available.

Management believes that we will be able to generate sufficient cash flows and liquidity as described above, as we have a significant backlog of projects which have been delayed due to COVID-19 and the related supply chain constraints. During 2022 we were able to achieve operating income as we saw improvements in delivery of products and components that allowed us to fulfil a large portion of our existing backlog. We were able to repay all of our long-term debt during 2022 using cash from operations, and we saw strong growth across all of our operating units for the year, and we believe that this will continue and that we will be profitable in 2023 As a result, management has concluded that there is not substantial doubt about the Company’s ability to continue as a going concern. These financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern for a reasonable period of time.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

Financial Instruments

The Company’s financial instruments primarily consist of cash and cash equivalents, accounts receivable, accounts payable and debt. The carrying amounts of the other financial instruments approximate their fair value at December 31, 2022 and 2021, due to the short-term nature of these items. See Note 9 – Fair Value Measurements.

Accounting for Business Combinations

We allocate the purchase price of an acquired business to its identifiable assets and liabilities based on estimated fair values. The excess of the purchase price over the fair value of the assets acquired and liabilities assumed, if any, is recorded as goodwill.

We use all available information to estimate fair values. We typically engage outside appraisal firms to assist in the fair value determination of identifiable intangible assets such as customer contracts, leases and any other significant assets or liabilities and contingent consideration. Preliminary purchase price allocation is adjusted, as necessary, up to one year after the acquisition closing date if management obtains more information regarding asset valuations and liabilities assumed.

Revenue Recognition

We recognize revenues when control of the promised goods or services is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services.

Some of our contracts with customers contain multiple performance obligations. For these contracts, we account for individual performance obligations separately if they are distinct. The transaction price is allocated to the separate performance obligations based on relative standalone selling prices.

Maintenance services

We generate maintenance services revenues from fees that provide our customers with as-needed maintenance and repair services on modular data centers during the contract term. Our contract terms are typically one year in duration, are billed annually in advance, and are non-cancellable. As a result, we record deferred revenue (a contract liability) and recognize revenue from these services on a ratable basis over the contract term. We can mitigate our exposure to credit losses by discontinuing services in the event of non-payment, however our history of non-payments and bad debt expense has been insignificant.

Integration services

We generate integration services revenues from fees that provide our customers with customized system and rack-level integration services. We typically recognize revenue upon shipment to the customer of the completed systems as this is when we have completed our services and when the customer obtains control of the promised goods. We typically extend credit terms to our integration customers based on their creditworthiness and generally do not receive advance payments. As such, we record accounts receivable at the time of shipment, when our right to the consideration becomes unconditional. Accounts receivable from our integration customers are typically due within 30-105 days of invoicing. An allowance for doubtful accounts is provided based on a periodic analysis of individual account balances, including an evaluation of days outstanding, payment history, recent payment trends, and our assessment of our customers’ creditworthiness. As of December 31, 2022, and 2021, our allowance for doubtful accounts was $7,000 and $7,000, respectively.

Equipment sales

We generate revenues under fixed price contracts from the sale of data center and related ancillary equipment to customers in the United States. We typically recognize revenue when the product is shipped to the customer as that is when the customer obtains control of the promised goods. Typically, we do not receive advance payments for equipment sales, however if we do, we record the advance payment as deferred revenue. Normally we record accounts receivable at the time of shipment when our right to the consideration has become unconditional. Accounts receivable from our equipment sales are typically due within 30-45 days of invoicing.

Deployment and Other services

We generate revenues from fees we charge our customers for other services, including repairs or other services not covered under maintenance contracts, installation and servicing of equipment including modular data centers that we sold, and other fixed-price services including repair, design and project management services. In some cases, we arrange for a third party to perform warranty and servicing of equipment, and in these instances, we recognize revenue as the amount of any fees or commissions that we expect to be entitled to. Other services are typically invoiced upon completion of services or completion of milestones. We record accounts receivable at the time of completion when our right to consideration becomes unconditional.

Procurement services

We generate revenues from fees we charge our customers to procure third-party hardware, software and professional services on their behalf that are then used in our integration services as we integrate these components to deliver a completed system to our customer. We recognize our procurement services revenue upon completion of the procurement activity. In some cases, we arrange for the purchase of third-party hardware, software or professional services that are to be provided directly to our customers by another party and we have no control of the goods before they are transferred to the customer. In these instances, we act as an agent in the transaction and recognize revenue on a net basis as the amount of any fee or commissions that we expect to be entitled to after paying the other party for the goods or services provided to the customer. Accounts receivable from our reseller activities are typically due within 30-60 days of invoicing.

Judgments

We consider several factors in determining that control transfers to the customer upon shipment of equipment or upon completion of our services. These factors include that legal title transfers to the customer, we have a present right to payment, and the customer has assumed the risks and rewards of ownership at the time of shipment or completion of the services.

Sales taxes

Sales (and similar) taxes that are imposed on our sales and collected from customers are excluded from revenues.

Shipping and handling costs

Costs for shipping and handling activities, including those activities that occur subsequent to transfer of control to the customer, are recorded as cost of sales and are expensed as incurred. We accrue costs for shipping and handling activities that occur after control of the promised good or service has transferred to the customer.

The following table shows our revenues disaggregated by reportable segment and by product or service type (in ’000’s):

Remaining Performance Obligations

Remaining performance obligations include deferred revenue and amounts we expect to receive for goods and services that have not yet been delivered or provided under existing, non-cancellable contracts. For contracts that have an original duration of one year or less, we have elected the practical expedient applicable to such contracts and we do not disclose the transaction price for remaining performance obligations at the end of each reporting period and when we expect to recognize this revenue. As of December 31, 2022, current deferred revenue of approximately $1,787,000 represents our remaining performance obligations for our maintenance contracts, all of which are expected to be recognized within one year, and $293,000 relates to procurement and integration services where we have yet to complete our services for our customers, all of which are expected to be recognized within one year. Contract liabilities, consisting of deferred revenues were $2,457,000 at December 31, 2021 and $4,061,000 at December 31, 2020.

Stock-Based Compensation

Stock-based compensation is measured at the grant date based on the fair value of the award and is recognized as expense ratably over the requisite service period, net of estimated forfeitures. We award shares of restricted stock and stock options to employees, managers, executive officers and directors.

During each of the years ended December 31, 2022 and 2021, we incurred approximately $0.5 million in non-cash compensation expense which was included in selling, general and administrative expenses in the accompanying Consolidated Statements of Operations.

Concentration of Credit Risk

We are currently economically dependent upon our relationship with a large US-based IT Original Equipment Manufacturer (OEM). If this relationship is unsuccessful or discontinues, our business and revenue will suffer. The loss of or a significant reduction in orders from this customer or the failure to provide adequate products or services to them would significantly reduce our revenue.

The following customers accounted for a significant percentage of our revenues for the periods shown:

No other customers represented more than 10% of our revenues for any periods presented. Our U.S. based IT OEM customer represented 93% and 51% of our trade accounts receivable at December 31, 2022 and 2021, respectively. A US-based data center equipment customer represented 29% of our trade accounts receivable at December 31, 2021. No other customer represented more than 10% of our accounts receivable at December 31, 2022 or 2021.

Cash and cash equivalents

Cash and cash equivalents are comprised of cash in banks and highly liquid instruments with original maturities of three months or less, primarily consisting of bank time deposits. We had unrestricted cash of $20.1 million and $7.7 million in excess of FDIC insured limits at December 31, 2022 and 2021, respectively.

Contract and Other Receivables

Accounts receivable are recorded at the invoiced amount and may bear interest in the event of late payment under certain contracts.

Allowance for Doubtful Accounts

We estimate an allowance for doubtful accounts based on factors related to the specific credit risk of each customer. Historically our credit losses have been minimal. We perform credit evaluations of new customers and may require prepayments or use of bank instruments such as trade letters of credit to mitigate credit risk. We monitor outstanding amounts to limit our credit exposure to individual accounts. We continue to pursue collection even if we have fully provided for an account balance.

The following table summarizes the changes in our allowance for doubtful accounts (in ’000):

Inventories

Inventories are stated at the lower of cost or net realizable value. Cost is determined using the first-in, first-out method for all purchased inventories. We write down obsolete inventory or inventory in excess of our estimated usage to its estimated market value less cost to sell, if less than its cost. Inherent in our estimates of net realizable value in determining inventory valuation are estimates related to future demand and technological obsolescence of our products. Any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventories and our results of operations and financial position could be materially affected.

Property and Equipment

Property and equipment are recorded at cost. We provide for depreciation using the straight-line method over the estimated useful lives of the assets. Additions and major replacements or improvements are capitalized, while minor replacements and maintenance costs are charged to expense as incurred. Depreciation expense is included in operating expenses in the consolidated statements of operations. The cost and accumulated depreciation of assets sold or retired are removed from the accounts and any gain or loss is included in the results of operations for the period of the transaction.

Goodwill and Intangible Assets

We have recorded goodwill and intangibles with definite lives, including customer relationships and acquired software, in conjunction with the acquisition of various businesses. These intangible assets are amortized based on their estimated economic lives. Goodwill represents the excess of the purchase price over the fair value of net identified tangible and intangible assets acquired and liabilities assumed, and it is not amortized. The recorded goodwill is allocated to the reporting unit to which the underlying transaction relates.

GAAP requires us to perform an impairment test of goodwill on an annual basis or whenever events or circumstances make it more likely than not that impairment of goodwill may have occurred. As part of the annual impairment test, we compare the fair value of the reporting unit with its carrying amount. If that fair value exceeds the carrying amount no impairment charge is required to be recorded. If the carrying value exceeds the reporting unit’s fair value, an entity should recognize a goodwill impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. However, the impairment loss recognized cannot exceed the total amount of goodwill allocated to that reporting unit. If necessary, the fair value of a reporting unit will be determined using a discounted cash flow, which requires the use of estimates and assumptions. Significant assumptions that may be required include forecasted operating results, and the determination of an appropriate discount rate. Actual results may differ from forecasted results, which may have a material impact on the conclusions reached.

We also review intangible assets with definite lives for impairment whenever events or circumstances indicate that the carrying amount may not be recoverable. If the sum of the expected undiscounted cash flows is less than the carrying value of the related asset, a loss is recognized for the difference between the fair value and carrying value of the intangible asset.

We have elected to use December 31 as our annual assessment date. As circumstances change that could affect the recoverability of the carrying amount of the assets during an interim period, we will evaluate our indefinite lived intangible assets for impairment. The Company performed a quantitative analysis of our indefinite lived intangible assets at December 31, 2022 and 2021 and concluded there was no impairment. The valuation results indicated that the fair value of our reporting units was greater than the carrying value, including goodwill, for each of our reporting units. Thus, we concluded that there was no impairment at December 31, 2022 or 2021 for our goodwill and other long-lived intangible assets. At December 31, 2022 and 2021, the carrying value of goodwill was $0.8 million.

Income Taxes

Deferred income taxes are provided for the temporary differences between the financial reporting and tax basis of the Company’s assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The U.S. net operating losses generated prior to 2018 and not utilized can be carried forward for 20 years to offset future taxable income. A full valuation allowance has been recorded against our net deferred tax assets, because we have concluded that under relevant accounting standards it is more likely than not that deferred tax assets will not be realizable. We recognize interest and penalty expense associated with uncertain tax positions as a component of income tax expense in the consolidated statements of operations.

Non-recourse factoring

We have entered into a factoring agreement with a financial institution to sell certain of our accounts receivables from a US-based OEM customer under a non-recourse agreement. Under the arrangement, we sell certain trade receivables on a non-recourse basis and account for the transaction as sales of the receivable. The financial institution assumes the full risk of collection, without recourse to the Company in the event of a loss. Debtors are directed to send payments directly to the financial institution. The applicable receivables are removed from our consolidated balance sheet when the cash proceeds are received by us. We do not service any factored accounts after the factoring has occurred. We utilize this factoring arrangement as part of our financing for working capital. The aggregate gross amount factored under this arrangement was approximately $87.8 million and $37.3 million for the years ended December 31, 2022 and 2021, respectively. We paid financing fees under this arrangement of approximately $810,000 and $177,000 for the years ended December 31, 2022 and 2021, respectively, which was recorded as interest expense in our consolidated statement of operations.

Earnings Per-Common Share

Basic and diluted earnings per share are based on the weighted average number of shares of common stock and potential common stock outstanding during the period. Potential common stock, for the purposes of determining diluted earnings per share, includes the effects of dilutive unvested restricted stock, options to purchase common stock and convertible securities. The effect of such potential common stock is computed using the treasury stock method or the if-converted method, as applicable.

Treasury Stock

We account for treasury shares using the cost method. Purchases of shares of common stock are recorded at cost and results in a reduction of stockholders’ equity. We hold repurchased shares in treasury for general corporate purposes, including issuances under various employee compensation plans. When treasury shares are issued, we use a weighted average cost method. Purchase costs in excess of reissue price are treated as a reduction of retained earnings. Reissue price in excess of purchase costs is treated as additional paid-in-capital.

Recent Accounting Guidance

Recently Adopted Accounting Guidance

In August 2018, FASB issued Accounting Standards Update 2018-15, Intangibles-Goodwill and Other Internal Use Software (Topic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement that is a Service Contract (“ASU 2015-18”). ASU 2018-15 aligns a company’s accounting for implementation costs incurred in a cloud computing arrangement that is a service contract with the guidance on capitalizing costs associated with developing or obtaining internal-use software. ASU 2015-18 clarifies that a company should apply ASC 350-40 to determine which implementation costs should be capitalized in a cloud computing arrangement that is a service contract. ASU 2018-15 does not change the accounting for the service component of a cloud computing arrangement. ASU 2018-15 is effective for our fiscal 2020 year and interim periods beginning in 2020. We applied the prospective transition approach when we adopted this guidance in 2020 as we began to implement cloud computing arrangements in 2020 and the adoption of this guidance did not have a material impact on our consolidated financial statements.

In December 2019, FASB issued Accounting Standards Update 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (“ASU 2019-12). ASU 2019-12 simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740. The guidance also clarifies and amends existing guidance to improve consistent application. The standard was adopted by us in our first quarter of fiscal 2021 and did not have any material impact on our consolidated results of operations, cash flows, financial position or disclosure.

In March 2020, FASB issued Accounting Standards Update ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, (“ASU 2020-04”). ASU 2020-04 provides optional expedients and exceptions for applying GAAP principles to contracts, hedging relationships, and other transactions that reference London Interbank Offered Rate (LIBOR) or another reference rate expected to be discontinued due to reference rate reform. This guidance was effective beginning on March 12, 2020 and was adopted by us in the fourth quarter of 2022 and did not have any material impact on our consolidated results of operations, cash flows, financial position or disclosure.

Recently Issued Accounting Pronouncements

In June 2016, FASB issued Accounting Standards Update ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). The standard’s main goal is to improve financial reporting by requiring earlier recognition of credit losses on financing receivables and other financial assets. Among the provisions of ASU 2016-13 is a requirement that assets measured at amortized cost, which includes trade accounts receivable, be presented at the net amount expected to be collected. This pronouncement requires that an entity reflect all of its expected credit losses based on current estimates which will replace the current standard requiring that an entity need only consider past events and current conditions in measuring an incurred loss. We are subject to this guidance effective with the consolidated financial statements we issue for the year ending December 31, 2023, and the quarterly periods during that year. We are currently evaluating the adoption date and the impact of the adoption of this guidance on our consolidated financial statements and disclosures.

In May 2019, FASB issued Accounting Standards Update ASU No. 2019-15, Financial Instruments – Credit Losses (Topic 326), (“ASU 2019-15”). ASU 2019-15 provides final guidance that allows entities to make an irrevocable one-time election upon adoption of the new credit losses standard to measure financial assets at amortized cost (except held-to-maturity securities) using the fair value option. The effective date and transition methodology are same as in ASU 2016-13.

Note 2 -         Supplemental Balance-sheet Information

Receivables

Contract and other receivables consisted of the following (in ‘000’s):

Contract assets, consisting of accounts receivable, were $ 915,000 at December 31, 2020.

Inventories

We state inventories at the lower of cost or net realizable value, using the first-in-first-out-method (in ‘000’s) as follows:

Goodwill and Intangible Assets

Goodwill and Intangible Assets consisted of the following (in ‘000’s):

Goodwill attributable to reporting units (in ‘000’s):

At December 31, 2022, the date of our last annual test, both the facilities unit and the systems integration unit had negative carrying amounts on our records.

We recognized amortization expense related to intangibles of approximately $91,000 for the years ended December 31, 2022 and 2021. Annual amortization expense for the customer relationships is expected to be approximately $36,000 in 2023.

Property and equipment

Property and equipment consisted of the following (in ’000’s):

Depreciation of property and equipment and amortization of leasehold improvements and software totaled $0.2 million and $0.4 million for the years ended December 31, 2022 and 2021, respectively.

Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses consisted of the following (in ’000’s):

Note 3 -Long-term Borrowings

Long-term borrowings consisted of the following (in ’000’s):

In February 2015 we entered into a multiple advance term loan agreement and related agreements with MHW SPV II, LLC (‘‘MHW’’), an entity affiliated with the Chairman of our Board of Directors, for a loan in the maximum amount of $2 million. We borrowed $945,000 under the terms of this loan agreement on February 3, 2015 and executed a promissory note to evidence this loan and the terms of repayment which required interest only payments until maturity.

In July 2017, we amended and restated the terms of this multiple advance term loan agreement whereby we increased the maximum principal amount of loans to $2.5 million for up to sixty days, and $2 million thereafter. The term of the loan was modified to be five years from the date of modification, thereby extending the term of the $945,000 loan to July 19, 2022. As part of this modification, the interest rate on the $945,000 loan remained at a fixed annual rate of 12%, however it was changed so that 6% was paid in cash monthly in arrears, and 6% was payable in kind, to be evidenced by additional promissory notes having an aggregate principal amount equal to the accrued but unpaid interest.

In conjunction with entering into the loan agreement with MHW, the Company and MHW also entered into a warrant agreement granting MHW the right to purchase up to 1,115,827 shares of the Company’s common stock. As part of the July 2017 modification, we also modified the warrant to change the exercise price of the shares and to extend the term of the warrant to July 19, 2022. The warrant is now exercisable for a period of five years from July 19, 2017 at an exercise price of $0.10 for the first 390,539 shares, $0.20 for the next 390,539 shares and $0.30 for the final 334,749 shares. The exercise price and number of shares of common stock issuable on exercise of the warrant was subject to adjustment in the event of any stock split, reverse stock split, recapitalization, reorganization or similar transaction. The fair value of the modified warrant was determined to be approximately $167,000 and the incremental value of the warrant compared to the original warrant was approximately $6,000. This amount was added to the remaining unamortized value of the original warrant such that approximately $93,000 was amortized to interest expense using the straight-line method (which approximated the effective interest rate method) over the term of the loan. Amortization expense of approximately $9,000 and $19,000 was recorded during the years ended December 31, 2022 and 2021, respectively, for this warrant.

On July 19, 2017, we also borrowed an additional $650,000 from MHW Partners, an entity affiliated with MHW. This loan ranked parri-passu with the $945,000 promissory notes held by MHW and was subject to the same loan agreement. Similar to the notes held by MHW, this note issued to MHW Partners bore interest at 12% per annum payable in cash monthly in arrears at a rate of 6% per annum and payable in kind at a fixed rate of 6% per annum and had a maturity date of July 19, 2022.

In conjunction with entering into the loan with MHW Partners, we entered into a warrant granting MHW Partners the right to purchase up to 767,500 shares of our common stock. The warrant was exercisable for a period of 5 years from July 19, 2017, at an exercise price of $0.10 for the first 268,625 shares, $0.20 for the next 268,625 shares and $0.30 for the final 230,250 shares. The exercise price and number of shares of common stock issuable upon exercise of this warrant were subject to adjustment in the event of any stock split, reverse stock split, recapitalization, reorganization or similar transactions. The fair value of the warrant granted was approximately $115,000. Using the relative-fair value allocation method, the debt proceeds were allocated between the debt value and the fair value of the warrants, resulting in a recognition of a discount on the loan of approximately $98,000 and a corresponding increase to additional paid-in capital. This discount was amortized using the straight-line method (which approximated the effective interest rate method) over the term of the loan. Approximately $10,000 and $20,000 was amortized during the years ended December 31, 2022 and 2021, respectively.

Peter H. Woodward, the Chairman of our Board of Directors, is a principal of MHW Capital Management LLC, which is the investment manager of MHW and MHW Partners. MHW Capital Management LLC was entitled to a performance-related fee tied to any appreciation in the valuation of the common stock in excess of the applicable strike price under the warrants.

On October 6, 2017, we entered into an amendment to our multiple advance term loan agreement and the related security agreement with MHW and MHW Partners, to add new lenders to the loan and security agreements. Upon execution, Mr. Glen Ikeda and Mr. Andrew Berg became new lenders to the Company. In accordance with the terms of the Amendment, Mr. Ikeda then provided a loan in the amount of $300,000 and Mr. Berg provided a loan in the amount of $100,000 (collectively the “New Loans”).

The New Loans had a maturity date of July 19, 2022. The New Loans did not bear interest and we were permitted to make optional prepayments at any time without premium or penalty, provided that if we prepay the outstanding principal amount of a New Loan prior to the second anniversary of the date of the applicable note, then the total amount of such prepayment will not exceed 95% of the total principal amount of the applicable note and any remaining principal amount under the note shall be fully and finally cancelled, extinguished, forgiven and terminated without further action of any party.

Concurrent with the New Loans, we entered into a warrant with Mr. Ikeda granting Mr. Ikeda the right to purchase up to 954,231 shares of our common stock. This warrant is exercisable until July 19, 2022, at an exercise price of $0.10 for the first 498,981 shares, $0.20 for the next 273,981 shares and $0.30 for the final 181,269 shares. The exercise price and number of shares of common stock issuable on exercise of this warrant will be subject to adjustment in the event of any stock split, reverse stock split, recapitalization, reorganization or similar transaction. Mr. Ikeda exercised the warrant in December 2018.

Concurrent with the New Loans, we entered into a warrant with Mr. Berg granting Mr. Berg the right to purchase up to 318,077 shares of our common stock. This warrant is exercisable until July 19, 2022, at an exercise price of $0.10 for the first 166,327 shares, $0.20 for the next 91,327 shares and $0.30 for the final 60,423 shares. The exercise price and number of shares of common stock issuable on exercise of this warrant will be subject to adjustment in the event of any stock split, reverse stock split, recapitalization, reorganization or similar transaction. Mr. Berg exercised the warrant in December 2018.

The fair value of the two warrants granted in connection with the New Loans was approximately $367,000. Using the relative fair-value allocation method, the debt proceeds were allocated between the debt value and the fair value of the warrants, resulting in a recognition of a discount on the new loans of approximately $191,000, with a corresponding increase to additional paid-in capital. This discount was amortized to interest expense over the term of the loan using the straight-line method (which approximates the effective interest rate method). Approximately $40,000 was amortized during the year ended December 31, 2021.

In June 2021 both Mr. Berg and Mr. Ikeda agreed to give the Company a 12% discount if the Company satisfied its indebtedness obligations under the New Loans on or prior to June 23, 2021. On June 23, 2021, the Company paid $88,000 to Mr. Berg and $264,000 to Mr. Ikeda in full satisfaction of all outstanding indebtedness under the New Loans. The remaining unamortized discount of $46,000 and remaining unamortized loan issuance costs of approximately $2,000 were expensed at this time, resulting in a loss of extinguishment of debt of $470 which was included in Interest expense, net, in the Company’s consolidated statement of operations during the three-month period ended June 30, 2021.

On July 1, 2022, we repaid in full the remaining amounts outstanding under multiple advance term loan agreements with MHW SPV II, LLC and MHW Partners L.P, including the accrued interest-in-kind outstanding on the loans. The outstanding amounts due under such loans were payable on or before July 19, 2022. Under their terms, the Company was permitted to prepay such loans without penalty.

On July 19, 2022, MHW and MHW Partners exercised their outstanding warrants and purchased 1,883,326 shares of common stock of the Company. The warrants were granted in connection with the multiple advance term loan agreements with MHW SPV II, LLC and MHW Partners, LP. The Company received approximately $367,000 from the aggregate exercise price of the warrants.

Note 4 -         Revolving Line of Credit

In May 2022, we entered into a revolving line of credit (the “credit facility”) with Susser Bank (“Lender”) pursuant to a Business Loan Agreement (Asset Based) (the “Loan Agreement”), dated effective May 5, 2022. The obligations under the credit facility are secured by substantially all of our assets. Our wholly-owned subsidiaries, Vortech L.L.C., and VTC, L.L.C. jointly and severally guarantee our obligations under the credit facility.

The maximum amount of the credit facility is $1,500,000. The credit facility is subject to a borrowing base of the lesser of $1,500,000 and 80% of eligible accounts receivables, subject to customary exclusions and limitations. Certain accounts receivables subject to a vendor payment program with a customer are excluded from the definition of eligible accounts receivables under the credit facility. Borrowings under the credit facility will bear interest based on the U.S. Prime Rate as published in the Money Rates section of The Wall Street Journal (effective rate of 7.50% at December 31, 2022) and such interest rate shall not be less than 3.50% per annum. In addition to interest payable on the principal amount of indebtedness outstanding from time to time under the credit facility, we paid a loan origination fee of 0.5%, payable in advance upon entering into the credit facility. The credit facility matures on May 5, 2023.

The credit facility requires that we maintain a minimum liquidity of $1,500,000 at all times.

The Loan Agreement and ancillary documents include customary affirmative covenants for secured transactions of this type, including maintaining adequate books and records, periodic financial reporting, compliance with laws, maintenance of insurance, maintenance of assets, timely payment of taxes, and notices of adverse events. The Loan Agreement and ancillary documents include customary negative covenants, including incurrence of other indebtedness, mergers, consolidations and transfers of assets and liens on our assets. The Loan Agreement and ancillary documents also include customary events of default, including payment defaults, failure to perform or observe terms, covenants or agreements included in the Loan Agreement and ancillary documents, insolvency and bankruptcy defaults, judgment defaults, material adverse chance defaults, and change of ownership defaults.

The maximum amount we would have been eligible to borrow at December 31, 2022 was approximately $131,000. There were no amounts outstanding under this credit facility at December 31, 2022.

Note 5 - Leasing Arrangements

We have operating leases for our office and integration facilities as well as for certain equipment and vehicles. Our leases have remaining lease terms of 3 to 75 months. As of December 31, 2022, we have not entered into any lease arrangement classified as a finance lease.

We determine if an arrangement is a lease at inception. Operating leases are included in lease right-of-use assets, current lease liabilities and lease liabilities, non-current, on our consolidated balance sheets. We have elected an accounting policy to not recognize short-term leases (one year or less) on the balance sheet. We also elected the package of practical expedients which applies to leases that commenced before the adoption date. By electing the package of practical expedients, we did not need to reassess whether any existing contracts are or contain leases, the lease classification for any existing leases and initial direct costs for any existing leases.

Right-of-use assets and operating lease liabilities are recognized based on the present value of future minimum lease payments over the lease term at commencement date. When the implicit rate of the lease is not provided or cannot be determined, we use our incremental borrowing rate based on the information available at the commencement date to determine the present value of future payments. Lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise those options. Lease expense for minimum lease payments is recognized on a straight- line basis over the lease term. Components of lease expense and other information is as follows (in ‘000’s):

The following presents information regarding the Company's operating leases as of December 31:

Future minimum lease payments under non-cancellable leases as of December 31, 2022 were as follows (in ‘000’s):

Note 6 – Income Taxes

Income taxes are recognized for the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets are established for the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. The effects of income taxes are measured based on enacted tax laws and rates.

The provision for income taxes from continuing operations consists of the following (in $’000):

The significant components of our deferred tax assets and liabilities are as follows (in $’000):

At December 31, 2022 and 2021, we had net operating losses (“NOL”) of approximately $41 million and $42.1 million, respectively, to offset future taxable income. A portion of the Company’s NOL will begin to expire in 2028.

Utilization of the net operating loss and credit carryforwards may be subject to a substantial annual limitation due to the “change in ownership” provisions of the Internal Revenue Code of 1986. The annual limitation may result in the expiration of net operating losses and credit carryforwards before utilization.

Our provision for income taxes reflects the establishment of a full valuation allowance against deferred tax assets as of December 31, 2022, and 2021. Accounting Standards Codification Topic 740 Income Taxes requires management to evaluate its deferred tax assets on a regular basis to reduce them to an amount that is realizable on a more likely than not basis. During 2022, the valuation allowance increased by approximately $32 thousand due to continuing operations. In determining our provision/(benefit) for income taxes, net deferred tax assets, liabilities and valuation allowances, we are required to make judgments and estimates related to projections of profitability, the timing and extent of the utilization of net operating loss carryforwards and applicable tax rates. Judgments and estimates related to our projections and assumptions are inherently uncertain; therefore, actual results could differ materially from the projections.

We have adopted the provisions of the guidance related to accounting for uncertainties in income taxes. We have analyzed our current tax reporting compliance positions for all open years and have determined that it does not have any material unrecognized tax benefits. Accordingly, we have omitted the tabular reconciliation schedule of unrecognized tax benefits. We do not expect a material change in unrecognized tax benefits over the next 12 months. All of our prior federal and state tax filings from the 2018 tax year forward remain open under statutes of limitation. Operating losses generated in years prior to 2018 remain open to adjustment until the statute closes for the tax year in which the net operating losses are utilized.

The Company’s provision for income taxes attributable to continuing operations differs from the expected tax benefit amount computed by applying the statutory federal income tax rate of 21% to income before taxes for the years ended December 31, 2022 and 2021 primarily as a result of the following:

Note 7– Commitments and Contingencies

For the years ended December 31, 2022 and 2021, rent expense included in selling, general and administrative expenses on the accompanying Consolidated Statement of Operations for operating leases was approximately $0.2 million for both years. Rent expense included in cost of revenue for operating leases was $0.7 million and $0.8 million for the years ended December 31, 2022 and 2021, respectively.

In the normal course of business, we issue binding purchase orders to subcontractors and equipment suppliers. At December 31, 2022, these open purchase order commitments amount to approximately $29 million. The majority of services to be delivered and inventory or equipment to be received is expected to be satisfied during the first six months of 2023 at which time these commitments will be fulfilled.

In January 2022 we reached a settlement agreement with a third party relating to litigation that commenced in 2016 emanating from our construction business which we discontinued at the end of 2016. The lawsuit related to the quality of equipment purchased from third parties on behalf of our customers and installed in a data center expansion project. In 2016, the Company accrued $50,000 which represented our deductible under our insurance policy as the potential exposure over the deductible was unknown. Under the settlement agreement, we agreed to pay the third party $500,000 in full settlement of all claims. $450,000 of this amount was covered under the Company’s insurance policies. The settlement was a recognized subsequent event to fiscal 2021 in accordance with FASB ASC 855, Subsequent Events. Accordingly, as of December 31, 2021, we recorded an additional settlement liability of $450,000 reported in accounts payable and accrued expenses, and a corresponding insurance recovery receivable in Prepaid expenses and other current assets. The loss accrual and insurance recovery are offset within Selling, general and administrative expenses in the accompanying Consolidated Statements of Operations for the year ended December 31, 2021, resulting in a net $0 impact. The settlement amount was paid by our insurance company in February 2022.

We are not a party to any material litigation in any court, and we are not aware of any contemplated proceeding by any governmental authority against us. From time to time, we are involved in various legal matters and proceedings concerning matters arising in the ordinary course of business such as employment-related matters. We believe that any potential liability arising out of these matters and proceedings will not have a material adverse effect on our financial position, results of operations or cash flows.

Note 8 – Fair Value Measurements

GAAP 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. GAAP also established 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. As of December 31, 2022, we did not have any assets measured at fair value on a recurring basis that would require disclosure based on the fair value hierarchy of valuation techniques. In addition, certain non-financial assets and liabilities are to be initially measured at fair value on a non-recurring basis. This includes items such as non-financial assets and liabilities initially measured at fair value in a business combination (but not measured at fair value in subsequent periods) and non-financial, long-lived assets measured at fair value for an impairment assessment. In general, non-financial assets and liabilities including goodwill and property and equipment are measured at fair value using Level 3 inputs, which result in management’s best estimate of fair value from the perspective of a market participant, when there is an indication of impairment and are recorded at fair value only when impairment is recognized.

Note 9 – Share Based Payments

In January 2007, our stockholders approved the Company’s 2006 Omnibus Incentive Compensation Plan, which was designed to attract, retain and motivate key employees. Under this plan, we reserved 5.1 million shares of our common stock for issuance to employees and directors through incentive stock options, non-qualified stock options or restricted stock. In June 2015 our stockholders approved a new 2015 Omnibus Incentive Compensation Plan (the “Plan”) and reserved a further 2.5 million shares of our common stock for issuance to employees and directors through incentive stock options, non-qualified stock options or restricted shares. At our 2021 Annual Meeting of Stockholders our stockholders approved an increase further 3.0 million shares of our common stock reserved for our 2015 plan. At December 31, 2022, 3,251,708 shares remain available for issuance.

The Plan is administered by the compensation committee of our Board of Directors. Subject to the express provisions of the Plan, the compensation committee has the Board of Directors' authority to administer and interpret the Plan, including the discretion to determine the form of grant, exercise price, vesting schedule, contractual life and the number of shares to be issued. We have historically issued restricted stock under the Plan; however, as further incentive to key employees, the Company also issued options to purchase shares of our common stock during the year ended December 31, 2022.

Stock-based Compensation Expense

For the years ended December 31, 2022 and 2021, we recognized stock-based compensation of approximately $530,000 and $469,000, respectively, which was included in selling, general and administrative expenses on the accompanying Consolidated Statements of Operations.

As of December 31, 2022, the total unrecognized compensation cost related to unvested restricted stock and options to purchase common stock was approximately $0.9 million with a weighted average remaining vest life of 1.74 years.

Stock Options

Although we have historically issued restricted stock under the Plan, we also issued options to purchase shares of our common stock during the years ended December 31, 2022 and 2021. Option grants can have various vesting features but typically involve time-based vesting.

Fair Value Determination –We utilize a Black-Scholes-Merton model to value stock options vesting over time. We will reconsider the use of the Black-Scholes-Merton model if additional information becomes available in the future that indicates another model would be more appropriate or if grants issued in future periods have characteristics that cannot be reasonably estimated under these models.

Volatility -The expected volatility of the options granted was estimated based upon historical volatility of our share price through weekly observations of our trading history corresponding to the expected term for Black-Scholes-Merton model.

Expected Term -Given the lack of historical experience, the expected term of options granted to employees was determined utilizing a plain vanilla approach whereby minimum or median time to vest and the contractual term of 10 years are averaged.

Risk-free Interest Rate -The yield was determined based on U.S. Treasury rates corresponding to the expected term of the underlying grants.

Dividend Yield -The Black-Scholes-Merton valuation model requires an expected dividend yield as an input. We currently do not anticipate paying dividends; therefore, the yield was estimated at zero.

The following table summarizes weighted-average assumptions used in our calculations of fair value for stock-option grants for the years ended December 31, 2022 and 2021:

During the year ended December 31, 2022 we granted stock options to purchase 1,450,000 shares of common stock at a weighted-average exercise price of $0.62 per share, which reflected the 30-day weighted fair market value of the shares on date of grant. In accordance with the terms of the Plan, the Board of Directors determined that the average of the high and low bid prices for the Common Stock reported daily on the OTCQB marketplace on the grant date was the fair market value of the shares. The weighted-average fair value of options granted during the year ended December 31, 2022, as determined under the Black-Scholes-Merton valuation model was $0.41.

The following table includes information with respect to stock option activity and stock options outstanding for the years ended December 31, 2022 and 2021:

*Aggregate intrinsic value includes only those options with intrinsic value (options where the exercise price is below the market price).

The following table summarizes non-vested stock options for the years ended December 31, 2022 and 2021:

The following table includes information concerning stock options exercisable and stock options expected to vest at December 31, 2022:

Restricted Stock

We have granted shares of restricted stock under the Plan. A restricted stock award is an issuance of shares that cannot be sold or transferred by the recipient until the vesting period lapses. Restricted shares issued to employees typically vest over two or three years in equal installments on the anniversaries of the grant date, contingent upon employment with the Company on the vesting dates. The related compensation expense is recognized over the service period and is based on the grant date fair value of the stock and the number of shares expected to vest.

The fair value of restricted stock awarded for the years ended December 31, 2022 and 2021 was $239,000 and $9,000, respectively, and was calculated using the value of TSS’ common stock on the grant date. The value of awards are amortized over the vesting periods of the awards taking into account the effect of an estimated forfeiture rate of zero associated with termination behavior for the years ended December 31, 2022 and 2021, respectively.

The following table summarizes the restricted stock activity during the years ended December 31, 2022 and 2021:

Note 10 – Common Stock Repurchases

During the years ended December 31, 2022 and 2021, we repurchased 232,526 and 327,563 treasury shares, respectively, with an aggregate value of approximately $134,000 and $197,000 respectively, associated with the vesting of restricted stock held by employees or upon the exercise of stock options held by employees. Per terms of the restricted stock agreements, for certain employees we paid the employee’s related taxes associated with the employee’s vested stock and decreased the freely tradable shares issued to the employee by a corresponding value, resulting in a share issuance net of taxes to the employee. The value of the shares netted for employee taxes represents treasury stock repurchased. Per terms of the stock option agreements, for certain employees we paid the exercise price of the stock option and decreased the freely tradable shares issued to the employee by a corresponding value, resulting in a share issuance, net of exercise price to the employee.

Note 11 – Related Party Transactions

We had the following related party balances that are included in long-term borrowings (in ’000’s):

Peter H. Woodward, the Chairman of our Board of Directors, is a principal of MHW Capital Management, LLC, which is the investment manager of MHW and MHW Partners. MHW Capital Management LLC is entitled to a performance-related fee tied to appreciation in the valuation of the common stock in excess of the applicable strike price under the warrant issued to MHW

Note 12 – Net Income (Loss) Per-Share

Basic and diluted income (loss) per share are based on the weighted average number of shares of common stock and potential common stock outstanding during the period. Potential common stock, for the purpose of determining diluted income per share, includes the effects of dilutive unvested restricted stock, options to purchase common stock and convertible securities. The effect of such potential common stock is computed using the treasury stock method or the if-converted method, as applicable.

The following table presents a reconciliation of the numerators and denominators of the basic and diluted income (loss) per share computations for income from continuing operations. In the table below, income (loss) represents the numerator and shares represent the denominator (in thousands except per share amounts):

For the years ended December 31, 2022 and 2021, 2,969,000 and 4,410,000 potentially dilutive shares, respectively, were excluded from the calculation of dilutive shares because their effect would have been anti-dilutive.

Note 13 - Segment Reporting

Segment information reported in the tables below represents the operating segments of the Company organized in a manner consistent with which separate information is available and for which segment results are evaluated regularly by our chief operating decision-maker in assessing performance and allocating resources. Our activities are organized into two major segments: facilities, and systems integration. Our facilities unit is involved in the design, project management and maintenance of data center and mission-critical business operations. Our systems integration unit integrates IT equipment for OEM vendors and customers to be used inside data center environments, including modular data centers. All of our revenues are derived from the U.S. market. Segment operating results reflect earnings before stock-based compensation, acquisition related expenses, other expenses, net, and provision for income taxes.

Revenue and operating result by reportable segment reconciled to reportable net loss for the years ended December 31, 2022 and 2021 and other segment-related information is as follows (in thousands):

Other consolidated activities includes assets not specifically attributable to each business segment including cash, prepaid and other assets that are managed at a corporate level.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

None.

Item 9A. Controls and Procedures.

(a) Disclosure Controls and Procedures

The Company carried out an evaluation, under the supervision of and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934, as amended) as of the date of this Annual Report. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this Annual Report, the Company’s disclosure controls and procedures were effective such that information relating to the Company (including its combined subsidiaries) required to be disclosed in the Company’s SEC reports (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and  (2) is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

(b) Management’s Report on Internal Control Over Financial Reporting

The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act. There are inherent limitations on the effectiveness of any system of internal controls, including the possibility of human error and circumvention or overriding of the controls and procedures. Accordingly, even effective internal controls and procedures provide only reasonable assurance of achieving their objectives.

Management, including the Chief Executive Officer and the Chief Financial Officer, assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2022. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission’s 2013 Internal Control-Integrated Framework. Management has determined that the Company’s internal controls over financial reporting were effective as of December 31, 2021.

(c) Changes in Internal Control Over Financial Reporting

There have been no changes in the Company’s internal control over financial reporting during the three months ended December 31, 2022 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting as such term is defined in Rule 13a-15 and 15d-15 of the Exchange Act of 1934, as amended except for the introduction of a new enterprise resource planning IT system as the Company’s system of record with effect from October 1, 2022.

Item 9B. Other Information

None.

PART III

Item 10. Directors, Executive Officers and Corporate Governance.

Information required by this item regarding our directors, executive officers and corporate governance matters may be found under the caption “Management and Corporate Governance” in our Proxy Statement relating to our 2023 Annual Meeting of Stockholders (the “2023 Proxy Statement”) to be filed with the SEC within 120 days of December 31, 2022 and is incorporated herein by reference. Information relating to compliance with Section 16(a) of the Securities and Exchange Act of 1934, as amended, may be found under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the 2023 Proxy Statement and is incorporated herein by reference.

Item 11. Executive Compensation.

The information required by this item is included under the captions “Management and Corporate Governance,” and “Executive Officer and Director Compensation” in the 2023 Proxy Statement and incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

The information required by this item is included under the caption “Security Ownership of Certain Beneficial Owners and Management” in the 2023 Proxy Statement and is incorporated herein by reference.

Item 13. Certain Relationships and Related Transactions, and Director Independence.

The information required by this item is included under the captions “Related Person Transactions” and “Management and Corporate Governance” in the 2023 Proxy Statement and is incorporated herein by reference.

Item 14. Principal Accounting Fees and Services.

The information required by this item is included under the caption “Independent Registered Public Accounting Firms” in the 2023 Proxy Statement and is incorporated herein by reference.

PART IV

Item 15. Exhibits, Financial Statement Schedules.

(a) The following documents are filed as part of this Annual Report: 

The following consolidated financial statements of TSS, Inc. for each of the years ended December 31, 2022 and 2021 are submitted in Part II, Item 8. Financial Statements and Supplementary Data of this report:

None.