11.10. | Fair Value of Financial Instruments |
ASC 820, Fair Value Measurement (ASC 820), defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.
The levels of the fair value hierarchy established by ASC 820 are:
Level 1: inputs are quoted prices, unadjusted, in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
Level 2: inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. A Level 2 input must be observable for substantially the full term of the asset or liability.
The Monte Carlo model was used to calculate the fair value of level 2 instrument liability award. The inputs used are current stock price, expected term, risk-free rate, number of trials, volatility and interest rates.
Level 3: inputs are unobservable and reflect the reporting entity'sentity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.
The contingent consideration was based on EBITDA.
At March 31, 2018,2019, and December 31, 2017,2018, the Company considers the recorded value of certain of its financial assets and liabilities, which consist primarily of cash equivalents, accounts receivable and accounts payable, to approximate fair value based upon their short-term nature.
As of March 31, 2019, the Company had four standby letters of credit totaling $1.9 million which represent performance bonds on three contracts.
For the three months ended March 31, 2018,2019, the Company did not have any transfers between fair value Level 1, Level 2 or Level 3. The Company did not hold any non-financial assets or non-financial liabilities subject to fair value measurements on a recurring basis at March 31, 2018.2019.
The following table presents assets and liabilities measured at fair value at March 31, 2018:2019:
(in thousands) | Quoted Prices in Active Markets for Identical Assets (Level 1) | | Significant Other Observable Inputs (Level 2) | | Significant Unobservable Inputs (Level 3) | | Total | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs (Level 2) | | | Significant Unobservable Inputs (Level 3) | | | Total | |
| | | | | | | | | | | | | | | | | | | | | | | |
Money market funds | $ | 2,780 | | $ | - | | $ | - | | $ | 2,780 | | $ | 825 | | | $ | - | | | $ | - | | | $ | 825 | |
Foreign exchange contracts | | - | | | 83 | | | - | | | 83 | | | - | | | | 145 | | | | - | | | | 145 | |
Total assets | $ | 2,780 | | $ | 83 | | $ | - | | $ | 2,863 | | $ | 825 | | | $ | 145 | | | $ | - | | | $ | 970 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Liability awards | | - | | | (272) | | | - | | | (272) | | $ | - | | | $ | (232 | ) | | $ | - | | | $ | (232 | ) |
Interest rate swap contract | | | | - | | | | (128 | ) | | | - | | | | (128 | ) |
Total liabilities | $ | - | | $ | (272) | | $ | - | | $ | (272) | | $ | - | | | $ | (360 | ) | | $ | - | | | $ | (360 | ) |
| | | | | | | | | | | | | | | | | |
Money market funds at both March 31, 20182019 and December 31, 20172018 are included in cash and cash equivalents in the respective consolidated balance sheets.
The following table presents assets and liabilities measured at fair value at December 31, 2017:2018:
(in thousands) | Quoted Prices in Active Markets for Identical Assets (Level 1) | | Significant Other Observable Inputs (Level 2) | | Significant Unobservable Inputs (Level 3) | | Total | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs (Level 2) | | | Significant Unobservable Inputs (Level 3) | | | Total | |
| | | | | | | | | | | | | | | | | | | |
Money market funds | $ | 3,240 | | $ | - | | $ | - | | $ | 3,240 | | $ | 824 | | | $ | - | | | $ | - | | | $ | 824 | |
Foreign exchange contracts | | - | | | 201 | | | - | | | 201 | | | - | | | | 43 | | | | - | | | | 43 | |
Total assets | $ | 3,240 | | $ | 201 | | $ | - | | $ | 3,441 | | $ | 824 | | | $ | 43 | | | $ | - | | | $ | 867 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Liability awards | | - | | | (242) | | | - | | | (242) | | $ | - | | | $ | (118 | ) | | $ | - | | | $ | (118 | ) |
Contingent consideration | | - | | | - | | | (1,701) | | | (1,701) | |
Interest rate swap contract | | | | - | | | | (103 | ) | | | 0 | | | | (103 | ) |
Total liabilities | $ | - | | $ | (242) | | $ | (1,701) | | $ | (1,943) | | $ | - | | | $ | (221 | ) | | $ | 0 | | | $ | (221 | ) |
| | | | | | | | | | | | | | | | | |
The following table provides a roll-forward of the fair value of the contingent consideration categorized as Level 3 for the three months ended March 31, 2018:2019:
(in thousands) | |
| | |
Balance, January 1, 2018 | $ | 1,701 |
Payments made on contingent liabilities | | (1,701) |
Change in fair value | | - |
Balance, March 31, 2018 | $ | - |
(in thousands) | | | |
Balance, January 1, 2019 | | $ | - | |
Issuance of contingent consideration in connection with acquisitions | | | 1,200 | |
Change in fair value | | | (1,200 | ) |
Balance, March 31, 2019 | | $ | - | |
12.11. | Derivative Instruments |
In the normal course of business, our operations are exposed to fluctuations in foreign currency values and interest rate changes. We may seek to control a portion of these risks through a risk management program that includes the use of derivative instruments.
Foreign Currency Risk Management
The Company utilizes forward foreign currency exchange contracts to manage market risks associated with the fluctuations in foreign currency exchange rates and minimize credit exposure by limiting counterparties to nationally recognized financial institutions.
As of March 31, 2018,2019, the Company had foreign exchange contracts outstanding of approximately 162.53.2 million Japanese Yen and 0.2 million Australian Dollars at fixed rates.Euro. The contracts expire on various dates through December 2018.2020. At December 31, 2017,2018, the Company had contracts outstanding of approximately 162.53.2 million Japanese Yen, 24,000 Euro and 0.2 million Australian Dollars at fixed rates.
Interest Rate Risk Management
As discussed in Note 13, the Company entered into a term loan to finance the acquisition of True North in May 2018. The loan bears interest at adjusted one-month LIBOR plus a margin ranging between 2% and 2.75% depending on the overall leverage ratio of the Company. As part of our overall risk management policies, in June 2018, the Company entered into a pay-fixed, receive-floating interest rate swap contract with a notional amount of $9.0 million to reduce the impact associated with interest rate fluctuations. The notional value amortizes monthly in equal amounts based on the five-year principal repayment terms. The terms of the swap require the Company to pay interest on the basis of a fixed rate of 3.02%, and the Company will receive interest on the basis of one-month USD-LIBOR-BBA-Bloomberg.
The Company reports all derivatives at fair value. These contracts are recognized as either assets or liabilities, depending upon the derivative’s fair value. The estimated net fair values of the derivative contracts on the consolidated balance sheets are as follows:
| | March 31, | | | December 31, | |
(in thousands) | | 2019 | | | 2018 | |
Prepaid expenses and other current assets | | | | | | |
Foreign exchange contracts | | $ | 145 | | | $ | 43 | |
Total asset derivatives | | | 145 | | | | 43 | |
| | | | | | | | |
Other liabilities | | | | | | | | |
Interest rate swaps | | | (128 | ) | | | (103 | ) |
Total liability derivatives | | | (128 | ) | | | (103 | ) |
| | | | | | | | |
Net fair value | | $ | 17 | | | $ | (60 | ) |
The Company has not designated the foreign exchangederivative contracts as hedges and recorded the estimated net fair values of the contracts on the consolidated balance sheets as follows:
| March 31, | | December 31, |
(in thousands) | 2018 | | 2017 |
| | | | | |
Asset derivatives | | | | | |
Prepaid expenses and other current assets | $ | 83 | | $ | 201 |
Net fair value | $ | 83 | | $ | 201 |
hedges. The changes in the fair value of the foreign exchangederivative contracts are included in lossgain (loss) on derivative instruments, net, in the consolidated statements of operations.
The foreign currency denominated contract receivables, billings in excess of revenue earned, and subcontractor accruals that are related to the outstanding foreign exchange contracts are remeasured at the end of each period into the functional currency using the current exchange rate at the end of the period. The gain or loss resulting from such remeasurement is also included in lossgain (loss) on derivative instruments, net, in the consolidated statements of operations.
For the three months ended March 31, 20182019 and 2017,2018, the Company recognized a net lossgain (loss) on its derivative instruments as outlined below:
| | Three months ended March 31, | | Three months ended March 31, | |
(in thousands) | | 2018 | | 2017 | | 2019 | | | 2018 | |
| | | | | | | |
Interest rate swap - change in fair value | | | $ | (26 | ) | | $ | - | |
Foreign exchange contracts - change in fair value | | $ | (118) | | $ | (86) | | | 102 | | | | (118 | ) |
Remeasurement of related contract receivables, and billings in excess of revenue earned | | | (38) | | | (74) | | | 17 | | | | (38 | ) |
Loss on derivative instruments, net | | $ | (156) | | $ | (160) | |
Gain (loss) on derivative instruments, net | | | $ | 93 | | | $ | (156 | ) |
13.12. | Stock-Based Compensation |
The Company recognizes stock-based compensation expense for all equity-based awards issued to employees, directors and non-employees that are expected to vest. Stock-based compensation expense is based on the fair value of awards as of the grant date. The Company recognized $595,000$570,000 and $614,000$595,000 of stock-based compensation expense related to equity awards for the three months ended March 31, 20182019 and 2017,2018, respectively, under the fair value method. In addition to the stock-based compensation expense recognized, the Company also recognized $32,000$27,000 and $(18,000)$32,000 of expense related to the change in the fair value of cash-settled restricted stock units (RSUs) during the three months ended March 31, 20182019 and 2017,2018, respectively.
During the three months ended March 31, 2019, the Company granted approximately three hundred thousand time-vesting RSUs to employees with an aggregate fair value of $0.8 million. During the three months ended March 31, 2018, the Company granted 210,092 time-basedapproximately two hundred thousand time-vesting RSUs to employees with an aggregate fair value of $682,799. During the three months ended March 31, 2017, the Company granted 223,802 time-based RSUs to employees with an aggregate fair value of $783,000.$0.7 million. A portion of the time-basedtime-vesting RSUs vest quarterly in equal amounts over the course of eight quarters and the remainder vest annually in equal amounts over the course of three years. The fair value of the time-basedtime-vesting RSUs is expensed ratably over the requisite service period, which ranges from one to three years.
The Company's 1995 long-term incentive program (LTIP) provides for the issuance of performance-vesting and time-vesting restricted stock units to certain executives and other Company employees. Vesting of the performance-vesting restricted stock units (PRSU's) is contingent upon the employee's continued employment and the Company's achievement of certain performance goals during designated performance period as established by the Compensation Committee of the Board of Directors. We recognize compensation expense, net of estimated forfeitures, for PRSU's on a straight-line basis over the performance period based on the probable outcome of achievement of the financial targets. At the end of each reporting period, we estimate the number of PRSUs that are expected to vest, based on the probability and extent to which the performance goals will be met, and take into account these estimates when calculating the expense for the period. If the number of shares expected to be earned changes during the performance period, we make a cumulative adjustment to compensation expense based on the revised number of shares expected to be earned.
During the three months ended March 31, 2019, the Company granted approximately three hundred fifty thousand performance-vesting RSUs to employees with an aggregate fair value of $0.9 million. During three months ended March 31, 2018, and 2017, the Company did not grant performance-based RSUs orany performance-vesting RSUs. The Company did not any grant stock options.options for the three months ended March 31, 2019 and 2018.
Line of Credit
Citizens Bank
The Company entered into a three-year, $5.0 million revolving line of credit facility (RLOC) with Citizens Bank, National Association (the Bank) on December 29, 2016, to fund general working capital needs. Working capital advances bear interest of one-month LIBOR plus 2.25% per annumneeds, including acquisitions. On May 11, 2018, GSE entered into an Amended and letter ofRestated Credit and Security Agreement (the Credit Agreement) with the Bank, amending and restating the Company's existing Credit and Security Agreement with the Bank, which included a $5.0 million asset-based revolving credit fees are 1.25% per annum. Thefacility between the Company isand the Bank, to now include (a) a $5.0 million revolving credit facility not required to maintain a restricted cash collateral account at Citizens Bank for outstanding letters of credit and working capital advances.
The maximum availability under the RLOC is subject to a borrowing base, equalincluding a letter of credit sub-facility, and (b) a $25.0 million delayed draw term loan facility available to 80%be drawn upon for up to 18 months and to finance certain permitted acquisitions by the Company. The credit facilities mature in five years and bear interest at one-month LIBOR plus a margin that varies depending on the overall leverage ratio of eligible accounts receivable,the Company and is reducedits subsidiaries. Revolving loans are interest-only with principal due at maturity, while term loans require monthly payments of principal and interest based on an amortization schedule. The Company's obligations under the Credit Agreement are guaranteed by the Company's wholly-owned subsidiaries. The credit facilities are secured by liens on all assets of the Company. Attendant to the Company's acquisition of DP Engineering, the Company and the Bank entered into a Third Amendment and Reaffirmation Agreement and a Fourth Amendment and Reaffirmation Agreement on February 15, 2019 and March 20, 2019, respectively.
RLOC
We intend to continue using the RLOC for any issuedshort-term working capital needs and outstandingthe issuance of letters of credit in connection with business operations. Letter of credit issuance fees range between 1.25% and working capital advances. 2% depending on the Company’s overall leverage ratio, and the Company pays an unused RLOC fee quarterly based on the average daily unused balance.
At March 31, 2018,2019, there were no outstanding borrowings onunder the RLOC and twofour letters of credit totaling $0.7$1.9 million. The amount available at March 31, 2018,2019, after consideration of the borrowing base, letters of credit and working capital advances was approximately $4.3$3.1 million.
Term Loan
As discussed in Note 4, we acquired DP Engineering on February 15, 2019 for approximately $13.5 million in cash. The credit facility agreement ispurchase price was subject to standardcustomary pre- and post-closing working capital adjustments plus an additional earn-out amount not to exceed $5.0 million potentially payable in 2020 and 2021. We drew down $14.3 million to finance the acquisition of DP Engineering. The loan bears interest at the adjusted one-month LIBOR plus a margin ranging between 2% and 2.75% depending on the overall leverage ratio of the Company and matures in five years.
As discussed in Note 4, we also acquired True North on May 11, 2018 for approximately $9.75 million in cash. The purchase price was subject to customary pre and post-closing working capital adjustments. We drew down $10.3 million to finance the acquisition of True North, $0.5 million of which was repaid to the Bank on the same day. The loan bears interest at the adjusted one-month LIBOR plus a margin ranging between 2% and 2.75% depending on the overall leverage ratio of the Company and matures in five years. We also incurred $70,000 debt issuance costs and $75,000 loan origination fees related to the Credit Agreement. Debt issuance costs and loan origination fees are reported as a direct deduction from the carrying amount of the loan and are amortized over the term of the loan using the effective interest method.
The outstanding long-term debt under the delayed draw term loan facility was as follows:
(in thousands) | | March 31, 2019 | | | December 31, 2018 | |
Long-term debt, net of discount | | $ | 22,104 | | | $ | 8,512 | |
Less: current portion of long-term debt | | | (4,763 | ) | | | 1,902 | |
Long-term debt, less current portion | | $ | 17,341 | | | $ | 6,610 | |
The Credit Agreement contains customary covenants and restrictions typical for a financing of this type that, among other things, require the Company to satisfy certain financial covenants and reporting requirements.restrict the Company's ability to incur additional debt, pay dividends and make distributions, make certain investments and acquisitions, repurchase its stock and prepay certain indebtedness, create liens, enter into agreements with affiliates, modify the nature of its business, enter into sale-leaseback transactions, transfer and sell material assets and merge or consolidate. Non-compliance with one or more of the covenants and restrictions after any applicable grace period could result in the obligations under the Credit Agreement becoming immediately due and payable and termination of the credit facilities. In addition to non-compliance with covenants and restrictions, the Credit Agreement also contains other customary events of default. If an event of default under the Credit Agreement occurs and is continuing, then the Bank may declare the obligations under the Credit Agreement to be immediately due and payable and may terminate the credit facilities. At March 31, 2018,2019, the Company was in compliance with its financial covenants.
BB&T Bank
At March 31, 2018, the Company had two letters of credit with BB&T totaling $0.6 million, which have expired and are pending release by the bank and customer. At March 31, 2018 and December 31, 2017, the cash collateral account with BB&T totaled $0.6 million and $1.0 million, respectively. The balances were classified as restricted cash on the consolidated balance sheets.
The Company accrues for estimated warranty costs at the time the related revenue is recognized based on historical experience and projected claims. The Company's SDB contracts generally provide a one to two-yearone-year base warranty on the systems. The portion of the warranty provision expected to be incurred within 12 months is classified as current within accrued warranty and totals $1.2$1.1 million, while the remaining $0.7$0.6 million is classified as long-term within other liabilities. The activity in the accrued warranty accounts is as follows:
(in thousands) | | | | |
| | | | |
Balance, January 1, 2018 | $ | 1,953 | |
Balance, January 1, 2019 | | | $ | 1,621 | |
Current period provision | | 28 | | | 89 | |
Current period claims | | (103) | | | (27 | ) |
Currency adjustment | | 5 | | | 2 | |
Balance at March 31, 2018 | $ | 1,883 | |
Balance at March 31, 2019 | | | $ | 1,685 | |
We generate revenue primarily through three broad revenue streams: 1) SDB, 2) Software, and 3) Training and Consulting Services. We recognize revenue from SDB and software contracts mainly through the Performance Improvement Solutions segment and the training and consulting service contracts through both the Performance Improvement Solutions segment and Nuclear Industry Training and Consulting segment.
The following table represents a disaggregation of revenue by type of goods or services for the three months ended March 31, 20182019 and 2017,2018, along with the reportable segment for each category:
(in thousands) | | Three Months Ended March 31, |
| | 2018 | | 2017(1) |
Performance Improvement Solutions | | | | | | |
System Design and Build | | $ | 7,495 | | $ | 7,319 |
Software | | | 869 | | | 456 |
Training and Consulting Services | | | 1,537 | | | 1,895 |
| | | | | | |
Nuclear Industry Training and Consulting | | | | | | |
Training and Consulting Services | | | 12,994 | | | 6,672 |
| | | | | | |
Total revenue | | $ | 22,895 | | $ | 16,342 |
(in thousands)
| | Three months ended March 31, | |
| | 2019 | | | 2018 | |
Performance Improvement Solutions segment | | | | | | |
System Design and Build | | $ | 6,442 | | | $ | 7,495 | |
Software | | | 749 | | | | 869 | |
Training and Consulting Services | | | 4,999 | | | | 1,537 | |
| | | | | | | | |
Nuclear Industry Training and Consulting segment | | | | | | | | |
Training and Consulting Services | | | 10,004 | | | | 12,994 | |
Total revenue | | $ | 22,194 | | | $ | 22,895 | |
(1) Prior period amounts have not been adjusted under the modified retrospective transition method for the adoption of ASC 606.
SDB contracts are typically fixed-priced, and we receive payments based on a billing schedule as established in our contracts. The transaction price for software contracts is generally fixed. Fees for software are normally due in advance of or shortly after delivery of the software. Fees for PCS are normally paid in advance of the service period. For Training and Consulting Services, the customers are generally billed on a regular basis, such as weekly, biweekly or monthly, for services provided. Contract liability, which we classify as billing in excess of revenue earned, relates to payments received in advance of performance under the contract. Contract liabilities are recognized as revenue as performance obligations are satisfied.
The following table reflects the balance of contract liabilities and the revenue recognized in the reporting period that was included in the contract liabilities from contracts with customers:
(in thousands)
| | March 31, 2018 | | December 31, 2017 | | March 31, 2019 | | | December 31, 2018 | |
Billings in excess of revenue earned (BIE) | | $ | 12,592 | | $ | 14,543 | | $ | 7,511 | | | $ | 10,609 | |
Revenue recognized in the period from amounts included in BIE at the beginning of the period | | $ | 5,115 | | | N/A | | $ | 5,040 | | | | 11,275 | |
For an SDB contract, we generally have two main performance obligations: the training simulator build and PCS. The training simulator build generally includes hardware, software, and labor. We recognize the training simulator build revenue over the construction and installation period using the cost-to-cost input method. In applying the cost-to-cost input method, we use the actual costs incurred to date relative to the total estimated costs to measure the work progress toward the completion of the performance obligation and recognize revenue accordingly. Estimated contract costs are reviewed and revised periodically as the work progresses, and the cumulative effect of any change in estimates is recognized in the period in which the change is identified. Estimated losses are recognized in the period such losses are identified. Uncertainties inherent in the performance of contracts include labor availability and productivity, material costs, change order scope and pricing, software modification and customer acceptance issues. The reliability of these cost estimates is critical to the Company's revenue recognition as a significant change in the estimates can cause the Company's revenue and related margins to change significantly from the amounts estimated in the early stages of the project.
For the three months ended March 31, 2018,2019, the Company did not recognize significantrecognized revenue of $0.8 million related to performance obligations satisfied in previous periods.
As of March 31, 2018,2019, the aggregate amount of transaction price allocated to the remaining performance obligations of SDB, software and Softwarefixed-price training and consulting services contracts is $35.6$33.7 million. The Company will recognize the revenue as the performance obligations are satisfied, which is expected to occur over the next 12 months.
Training and consulting services contracts are primarily T&M based. Under a typical T&M contract, the Company is compensated based on the number of hours of approved time provided by temporary workers and the bill rates, which are fixed per type of work, as well as approved expenses incurred. As part of our adoption of ASU 2014-09, we have elected to use the optional exemption under ASC 606-10-50-14(b), pursuant to which we have excluded disclosures of transaction prices allocated to remaining performance obligations under such contracts and when we expect to recognize the revenue.18
The following table presents the (benefit) provision for income taxes and the effective tax rates:
| | Three months ended March 31, |
($ in thousands) | | 2018 | | 2017 |
| | | | | | |
Provision for income taxes | | $ | 259 | | $ | 73 |
Effective tax rate | | | (20.9%) | | | (37.8%) |
(in thousands) | | Three months ended March 31, | |
| | 2019 | | 2018 | |
(Benefit) provision for income taxes | | $ | (1,848 | ) | | $ | 259 | |
Effective tax rate | | | 30.4 | % | | | (20.9 | )% |
The Company's income tax (benefit) provision for interim periods is determined using an estimate of its annual effective tax rate, adjusted for discrete items arising in that quarter. Tax expense in 2019 is comprised mainly of the tax impact of the loss for impairment, federal income tax expense, foreign income tax expense, and state tax expense. Tax expense in 2018 is comprised mainly of federal income tax expense, foreign income tax expense, and state taxes. Tax expense in 2017 is comprised mainly of foreign income tax expense, Alternative Minimum Tax, state taxes, and deferred tax expense relating to the tax amortization of goodwill.expense.
Our effective tax rate was (20.9%)30.4% for the three months ended March 31, 2018. The2019. For the three months ended March 31, 2019, the difference inbetween our effective tax rate of 30.4% and the U.S. statutory federal income tax rate of 21% was primarily due to permanent differences, accruals related to uncertain tax positions for certain U.S. and foreign tax contingencies, a change in valuation allowance in our China subsidiary, discrete item adjustments for the U.S. and foreign taxes, including the tax impact of the loss for impairment, and the excess book deduction related to stock options and restricted stock units that were exercised or vested during the quarter. For the three months ended March 31, 2018, the difference between the effective tax rate of (20.9)% and the U.S. statutory federal income tax rate of 21% was primarily due to our China subsidiary which had a taxable income for the three months ended March 31, 2018 and the accruals related to uncertain tax positions for certain foreign tax contingencies.
Because of its net operating loss carryforwards, the Company is subject to U.S. federal and state income tax examinations from the year 19972000 and forward. The Company is subject to foreign tax examinations by tax authorities for years 2011 forward for Sweden, 20142015 forward for China, and 2015 forward for both India, and 2016 forward for the UK.
An uncertain tax position taken or expected to be taken in a tax return is recognized in the consolidated financial statements when it is more likely than not (i.e., a likelihood of more than 50%) that the position would be sustained upon examination by tax authorities that have full knowledge of all relevant information. A recognized tax position is then measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Interest and penalties related to income taxes are accounted for as income tax expense.
The Company recognizes deferred tax assets to the extent that it is believed that these assets are more likely than not to be realized. The Company has evaluated all positive and negative evidence and determined that it will continue to assess a full valuation allowance on its India, Swedish and U.K. net deferred assets as of March 31, 2018.2019. The Company has determined that it will continue to assess a valuation allowance on its China deferred tax asset related to transfer pricing. The Company has determined that it is more likely than not that it will realize the benefits of its deferred taxes in the U.S, China, and India.U.S.
The Company maintains leases of office facilities and equipment. Leases generally have remaining terms of one year to six years, whereas leases with an initial term of twelve months or less are not recorded on the Consolidated Balance Sheets. The Company recognizes lease expense for minimum lease payments on a straight-line basis over the taxterm of the lease. Certain leases include options to renew or terminate. Renewal options are exercisable per the discretion of the Company and vary based on GILTIthe nature of each lease, with renewal periods generally ranging from one year to five years. The term of the lease includes renewal periods only if the Company is reasonably certain that it will exercise the renewal option. When determining if a renewal option is reasonably certain of being exercised, the Company considers several factors, including but not limited to, the cost of moving to another location, the cost of disruption to operations, whether the purpose or location of the leased asset is unique and the contractual terms associated with extending the lease.
Upon the adoption of the new lease standard ASU 2016-02, on January 1, 2019, the Company elected the package of practical expedients permitted under the transition guidance within the amended guidance, which among other things, allowed registrants to carry forward historical lease classification. Accordingly, all existing leases that were classified as operating leases by the Company historically, were classified as operating leases.
Operating lease ROU assets and operating lease liabilities are recognized based on the present value of the future minimum lease payments over the lease term at commencement date. The operating lease ROU assets represent the lease liability, plus any lease payments made at or before the commencement date, less any lease incentives received. The Company's real estate leases, which are comprised primarily of office spaces, represent a period costmajority of the lease liability. The majority of our lease payments are fixed, although an immaterial portion of payments are variable in the period the tax is incurred. Under this policy, we have not provided deferred taxesnature. Variable lease payments vary based on changes in facts and circumstances related to temporary differences that upon their reversal will affect the amountuse of income subject to GILTIthe ROU and are recorded as incurred. The Company uses an incremental borrowing rate based on rates available at commencement in determining the period.
present value of future payments.
The Company has made an entity classification (CTB) election to treat GSE UKlease agreements with lease and non-lease components, which are accounted for as a disregarded entity effective Januarysingle lease component. The Company applies a portfolio approach to effectively account for the operating lease ROU assets and liabilities.
Lease contracts are evaluated at inception to determine whether they contain a lease, where the Company obtains the right to control an identified asset. The following table summarizes the classification of operating ROU assets and lease liabilities on the consolidated balance sheets (in thousands):
Operating Leases | Classification | | March 31, 2019 | |
Leased Assets | | | | |
Operating lease - right of use assets | Long term assets | | $ | 4,331 | |
| | | | | |
Lease Liabilities | | | | | |
Operating lease liabilities - Current | Other current liabilities | | | 1,088 | |
Operating lease liabilities | Long term liabilities | | | 3,703 | |
| | | $ | 4,791 | |
The Company has entered into a sublease with a tenant to rent out 3,822 of square feet from the lease at its Sykesville office on April 1, 2018. Therefore,2017, with the exact same consideration as on the head lease. The sublease does not relieve the Company of January 1, 2018, GSE UK is treatedits primary lease obligation. The lessor agreement was an operating lease historically. The Company does not recognize underlying assets for the sublease as a branchlessor of the US for tax purposes. Accordingly, GSE UK's 2018 first quarter activity has been includedoperating lease. The net amount received from the sublease is recorded within selling, general and administrative expenses.
The table below summarizes the lease income and expenses recorded in the US Company's income tax provision.consolidated statement of operations incurred during the three months ended March 31, 2019, (in thousands):
Lease Cost | Classification | | Three Months Ended March 31, 2019 | |
Operating lease cost (1) | Selling, general and administrative expenses | | $ | 228 | |
Short-term leases costs (2) | Selling, general and administrative expenses | | | 38 | |
Sublease income (3) | Selling, general and administrative expenses | | | (16 | ) |
Net lease cost | | | $ | 250 | |
(1) Includes variable lease costs which are immaterial.
(2) Include leases maturity less than twelve months from the report date.
(3)Sublease portfolio consists of the sublease part of our principal executive office located at 1332 Londontown Blvd, Suite 200, Sykesville, MD.
The future minimum lease payments under non-cancellable operating leases are reflected below. This table also reflects the reconciliation of the undiscounted cash flows to the discounted operating lease liabilities as recognized at March 31, 2019 consolidated balance sheets (in thousands):
| | Operating Leases | |
2019 | | $ | 986 | |
2020 | | | 1,246 | |
2021 | | | 1,216 | |
2022 | | | 1,157 | |
2023 | | | 622 | |
After 2023 | | | 107 | |
Total lease payments | | $ | 5,334 | |
Less: Interest | | | 543 | |
Present value of lease payments | | $ | 4,791 | |
The Company has calculated the weighted-average remaining lease term, presented in years below, and the weighted-average discount rate for our operating leases. As noted in our lease accounting policy, the Company uses the incremental borrowing rate as the lease discount rate.
Lease Term and Discount Rate | | Three Months Ended March 31, 2019 |
Weighted-average remaining lease term (years) | | |
Operating leases | | 4.44 |
Weighted-average discount rate | | |
Operating leases | | 5% |
The table below sets out the classification of lease payments in the consolidated statement of cash flows. The right-of-use assets obtained in exchange for operating lease liabilities represent new operating leases obtained through business combination during the three months ended March 31, 2019.
(in thousands)
Other Information | | Three Months Ended March 31, 2019 | |
- Operating cash flows used in operating leases | | $ | 235 | |
Cash paid for amounts included in measurement of liabilities | | | 235 | |
| | | | |
Right-of-use assets obtained in exchange for new operating liabilities | | $ | 1,777 | |
The Company has two reportable business segments. The Performance Improvement Solutions segment provides simulation, training and engineering products and services delivered across the breadth of industries we serve. Solutions include simulation for both training and engineering applications. Example engineering services include, but not limited to, plant design verification and validation, thermal performance evaluation and optimization programs, and engineering programs for plants for ASME code and ASME Section XI. The Company provides these services through GSE, True North and DP Engineering across all market segments. Example training applications include turnkey and custom training services, while engineering services include plant design verification and validation. The Company provides these services across all market segments.services. Contract terms are typically less than two years.
The Nuclear Industry Training and ConsultingNITC segment provides specialized workforce solutions primarily to the nuclear industry, working at clients' facilities. This business is managed through our Hyperspring and Absolute subsidiaries. The business model, management focus, margins and other factors clearly separate this business line from the rest of the GSE product and service portfolio.
On February 15, 2019, through our wholly-owned subsidiary GSE Performance Solutions, Inc., the Company entered into the DP Engineering Purchase Agreement, to purchase 100% of the membership interests in DP Engineering. DP Engineering is a provider of value-added technical engineering solutions and consulting services to nuclear power plants with an emphasis on preparation and implementation of design modifications during plant outages. Located in Fort Worth, Texas, DP Engineering is well-regarded as a leading service provider to the nuclear power industry, having been designated an “engineer of choice” by two large power generation companies. For reporting purposes, DP Engineering is included in our Performance segment due to similarities in services provided including engineering solutions and implementation of design modifications to nuclear power sector.
On May 11, 2018, GSE, through our wholly-owned subsidiary GSE Performance Solutions, Inc., entered into the True North Purchase Agreement to purchase 100% of the membership interests in True North. True North is a provider of technical engineering solutions to nuclear and fossil fuel power plants with an emphasis on regulatory-driven ASME code programs. The acquisition of True North is expected to broaden our engineering services offering, expand our relationships with several of the largest nuclear energy providers in the United States, and add a highly specialized, complimentary talent pool to our employee base. For reporting purposes, True North is included in our Performance segment due to similarities in services provided including technical engineering solutions to the nuclear and fossil fuel power sector.
Due to the impairment described in Note 9 related to DP Engineering, we recognized charges totaling $5.5 million related to the impairment of certain definite-lived intangible assets and goodwill in our Performance segment.
Our primary measure of segment performance as shown in the table below excluded loss on impairment of intangible and goodwill, and the change in fair value of contingent consideration, net, which we do not believe are representative of the ongoing operations of the Performance segment. Excluding this discrete item from our segment measure of performance allows for better period over period comparison.
The following table sets forth the revenue and operating results attributable to each reportable segment and includes a reconciliation of segment revenue to consolidated revenue and operating results to consolidated loss before income taxes:taxes. Inter-segment revenue is eliminated in consolidation and is not significant:
(in thousands) | Three months ended | | Three months ended | |
| March 31, | | March 31, | |
| 2018 | | 2017 | | 2019 | | | 2018 | |
Revenue: | | | | | | | | | | | |
Performance Improvement Solutions | $ | 9,901 | | $ | 9,670 | | $ | 12,190 | | | $ | 9,901 | |
Nuclear Industry Training and Consulting | | 12,994 | | | 6,672 | | | | | | | 12,994 | |
| $ | 22,895 | | $ | 16,342 | | $ | 22,194 | | | $ | 22,895 | |
| | | | | | | | | | | | | |
Operating income: | | | | | | |
Operating loss: | | | | | | | | | |
Performance Improvement Solutions | $ | (790) | | $ | (110) | | $ | (802 | ) | | $ | (790 | ) |
Nuclear Industry Training and Consulting | | (338) | | | 307 | | | (925 | ) | | | (338 | ) |
Loss on impairment | | | | (5,464 | ) | | | - | |
Change in fair value of contingent consideration, net | | - | | | (254) | | | 1,200 | | | | - | |
Operating loss | | (1,128) | | | (57) | | | (5,991 | ) | | | (1,128 | ) |
| | | | | | | | | | | | | |
Interest income, net | | 22 | | | 27 | |
Loss on derivative instruments, net | | (156) | | | (160) | |
Other income (expense), net | | 25 | | | (3) | |
Interest (expense) income, net | | | | (208 | ) | | | 22 | |
Gain (loss) on derivative instruments, net | | | | 93 | | | | (156 | ) |
Other income, net | | | | 22 | | | | 25 | |
Loss before income taxes | $ | (1,237) | | $ | (193) | | $ | (6,084 | ) | | $ | (1,237 | ) |
| | | | | | | | | |
Effective January 2018, and due to21
19.Non-consolidated Variable Interest Entity
The Company, through its wholly owned subsidiary DP Engineering, effectively holds 48% membership interest in DP-NXA Consultants LLC (DP-NXA) upon the acquisition of Absolute,DP Engineering on February 15, 2019.
DP-NXA was established to provide in industrial services that include civil, structural, architectural, electrical, fire protection, plumbing, mechanical consulting engineering services to customers. DP-NXA sub-contracts their work to its two owners, NXA Consultants LLC (NXA), which owns 52% of the Performance Improvement Solutions allocated corporate overheadentity, and DP Engineering. DP Engineering and NXA contributed $48 and $52, respectively, for 48% and 52% interest in DP-NXA. DP Engineering recorded the contributed cash as an equity investment.
Upon the acquisition of DP Engineering, the Company evaluated the nature of DP Engineering's investment in DP-NXA and determined that DP-NXA is a variable interest entity (“VIE”). The Company does not have the power to direct activities that most significantly impact DP-NXA, and therefore, cannot be DP-NXA’s primary beneficiary. Furthermore, the Company concluded that it did not hold a controlling financial interest in DP-NXA since NXA, the VIE's majority owner, makes all operation and business decisions. As a result, the Company did not consolidate the assets and liabilities of the VIE in our financial statements.
The Company's maximum exposure to loss is limited to the Nuclear Industry Training and Consulting segment. Forinvestment in the three months endedVIE. As of March 31, 20182019, the Company has not made any additional contributions to DP-NXA and 2017,its maximum exposure to loss relating to this unconsolidated VIE was immaterial. As of March 31, 2019, the Company does not have existing guarantee in relation to DP-NXA and any third-party it contracted with.
The Company will reevaluate if DP-NXA meets the definition of a totalVIE upon specific reconsideration of $1.2 millionevents.
The following table presents the carrying amount and $0.6 millionclassification of corporate overhead, respectively, was allocatedthe assets related to Nuclear Industry Trainingthe Company’s variable interests in non-consolidated VIE and Consulting segment. Prior period amounts were reclassifiedthe maximum exposure to reflect the change.loss at March 31, 2019.
(In thousands) | | March 31, 2019 | |
Assets | | | |
Cash: | | | |
Checking account | | $ | 155 | |
Total assets | | | 155 | |
Liabilities | | | | |
Credit card and other payables | | | 1 | |
Total liabilities | | | 1 | |
Total net assets | | | 154 | |
Maximum exposure to loss | | $ | 154 | |
On May 14, 2018, we announced that the Company acquired True North Consulting, LLC (True North) on May 11, 2018, a leading provider of specialty engineering solutions to the nuclear power industry. Founded in 1999 in Montrose, Colorado, True North generated revenue of approximately $11 million for the year ended December 31, 2017, of which over 85% came from the nuclear power industry. True North employs roughly 60 full-time and part-time professionals with expertise in areas such as in-service testing for engineering programs focused on ASME OM code including Appendix J, balance of plant programs, thermal performance, in-service inspection for specialty engineering including ASME Section XI and software solutions.
The Company acquired True North for approximately $9.8 million in cash, consisting of approximately $8.3 million paid at close and approximately $1.5 million held in escrow for indemnity and leadership retention purposes. The transaction closed on May 11, 2018. Due to the timing and complexity of the acquisition, the Company had not completed the purchase accounting for the acquisition on the report issuance date.
On May 11, 2018, the Company entered into an amended and restated credit agreement with Citizen's Bank, consisting of a five-year $5 million revolving line of credit and a five-year $25 million delayed draw term loan facility to fund acquisitions approved by the Lender. We drew down approximately $10.3 million to fund the acquisition of True North. Interest is based on a LIBOR spread of 200 to 275 basis points, depending on pre-defined leverage thresholds defined in the agreement.
Item 2. | Management'sManagement’s Discussion and Analysis of Financial Condition and Results of Operations |
GSE is a world leaderleading provider of professional and technical engineering, staffing services, and simulation software to clients in real-time high-fidelity simulation, and provides a wide range of simulation, consulting, training, and engineering solutions to the global power and process industries. We provide customers with simulation, engineering and plant services that help clients reduce risks associated with operating their plants, increase revenue through improved plant and employee performance, and lower costs through improved operational efficiency. In addition, we provide professional services that systematically help clients fill key vacancies in the organization on a short-term basis, primarily in procedures, engineering, technical support, and training focused on regulatory compliance and certification in the nuclear power industry. Our operations also include interactive computer-based tutorials and simulation software for the refining, chemical, and petrochemical industries.
On February 15, 2019, GSE acquired DP Engineering for $13.5 million (subject to pre- and post-closing working capital adjustments). DP Engineering is a provider of value-added technical engineering solutions and consulting services to nuclear power plants with an emphasis on preparation and implementation of design modifications during plant outages. Located in Fort Worth, Texas, DP Engineering is well-regarded as a leading service provider to the nuclear power industry, having been designated an “engineer of choice” by two large power generation companies. The Company's allocation of the purchase price remains incomplete and the net assets are subject to adjustments within the measurement period, which is not to exceed one year from the acquisition date. For reporting purposes, DP Engineering is included in our Performance segment due to similarities in services provided including engineering solutions and implementation of design modifications to the nuclear power sector.
Approximately one week following our acquisition of DP Engineering, an adverse event occurred at one of DP Engineering’s major customer's location that affected plant operations. In its initial analysis of the causes of that event, the customer identified a prior plant modification by DP Engineering as meriting further analysis. As is customary in the industry, pursuant to an Engineer of Choice agreement, the customer issued DP Engineering a Notice of Suspension while a root cause analysis was completed. We completed our root cause analysis and presented it to the customer on April 25, 2019. Following the initial analysis, the customer had DP Engineering restarted all existing work with the Company, however, the customer also informed DP Engineering that it was suspended from bidding new contracts for new work for up to six months. We believe this incident adversely impacted our relationship with the customer and the Company. As a result, DP Engineering has experienced a significant decline in new orders from this customer and are not able or permitted to bid on new work. The Company determined this represented a triggering event requiring an interim assessment for impairment. As the result of impairment, we recognized the impairment charges of $2.1 million on goodwill and $3.4 million on definite-lived intangible assets related to the acquisition of DP Engineering. Due to the recentness of this acquisition, we have not finalized the allocation of our purchase price to the tangible and intangible assets of DP Engineering we purchased. As such, we may need to record additional expense once the purchase price allocation is final. As a result, on May 10, 2019, the Company determined that a material impairment had occurred, requiring an interim assessment for impairment to be completed.
On May 11, 2018, GSE acquired True North Consulting, LLC, now a wholly-owned subsidiary of GSE Performance Solutions, Inc., for $9.75 million (subject to customary pre- and post-closing working capital adjustments). True North is a provider of technical engineering solutions to nuclear and fossil fuel power plants with an emphasis on regulatory-driven ASME code programs. Located in Montrose, Colorado, True North is a well-regarded service provider to leading companies in the power industry. The acquisition of True North is expected to broaden our engineering services offering, expand our relationships with several of the largest nuclear energy providers in the United States, and add a highly specialized, complimentary talent pool to our employee base.
Cautionary Statement Regarding Forward-Looking Statements
This report and the documents incorporated by reference herein contain "forward-looking" statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act") that are based on management's assumptions, expectations and projections about us, and the industry within which we operate, and that have been made pursuant to the Private Securities Litigation Reform Act of 1995 reflecting our expectations regarding our future growth, results of operations, performance and business prospects and opportunities. Wherever possible, words such as "anticipate", "believe", "continue", "estimate", "intend", "may", "plan", "potential", "predict", "expect", "should", "will" and similar expressions, or the negative of these terms or other comparable terminology, have been used to identify these forward-looking statements. These forward-looking statements may also use different phrases. These statements regarding our expectations reflect our current beliefs and are based on information currently available to us. Accordingly, these statements by their nature are subject to risks and uncertainties, including those listed under Item 1A - Risk Factors in our most recent annual report on Form 10-K, which could cause our actual growth, results, performance and business prospects and opportunities to differ from those expressed in, or implied by, these forward-looking statements. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements we make. Except as otherwise required by federal securities law, we are not obligated to update or revise these forward lookingforward-looking statements to reflect new events or circumstances. We caution you that a variety of factors, including but not limited to the factors described under Item 1A - Risk Factors in our most recent annual report on Form 10-K, could cause our business conditions and results to differ materially from what is contained in forward-looking statements.
Other factors and assumptions not identified above were also involved in the formation of these forward-looking statements and the failure of such other assumptions to be realized, as well as other factors, may also cause actual results to differ materially from those projected. Most of these factors are difficult to predict accurately and are generally beyond our control. You should consider the areas of risk described in Item 1A - Risk Factors in our most recent annual report on Form 10-K in connection with any forward-looking statements that may be made by us. You should not place undue reliance on any forward-looking statements. New factors emerge from time to time, and it is not possible for us to predict which factors will arise.
We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any additional disclosures we make in proxy statements, quarterly reports on Form 10-Q and current reports on Form 8-K filed with the SEC.
General Business Environment
We operate through two reportable business segments: Performance Improvement Solutions and Nuclear Industry Training and Consulting. Each segment focuses on delivering solutions to customers within our targeted markets - primarily the power and process industries. Marketing and communications, accounting, finance, legal, human resources, corporate development, information systems and other administrative services are organized at the corporate level. Business development and sales resources are generally aligned with each segment to support existing customer accounts and new customer development. The business units collaborate to facilitate cross-selling and the development of new solutions. The following is a description of our business segments:
Performance Improvement Solutions (approximately 43%55% of revenue)
Our Performance Improvement Solutions segment primarily encompasses our power plant high-fidelity simulation solutions, engineering services for ASME programs, thermal performance optimization and plan design modifications, and interactive computer basedcomputer-based tutorials/simulation focused on the process industry. This segment includes various simulation products, engineering services, and operation training systems delivered across the industries we serve:serve, primarily nuclear and fossil fuel power generation, as well as the process industries. Our simulation solutions include the following: (1) simulation software and services, including operator training systems, for the nuclear power industry, (2) simulation software and services, including operator training systems, for the fossil power industry, and (3) simulation software and services for the process industries used to teach fundamental industry processes and control systems to newly hired employees and for ongoing workforce development and training. GSE and its predecessors have been providing these services since 1976.
Our engineering solutions include the following: (1) in-service testing for engineering programs focused on ASME OM code including Appendix J, balance of plant programs, and thermal performance; (2) in-service inspection for specialty engineering including ASME Section XI; (3) software solutions; and (4) mechanical design, civil/structural design, electrical, instrumentation and controls design, digital controls/cyber security, and fire protection for nuclear power plant design modifications. Our True North and DP Engineering businesses typically work as either the engineer of choice or specialty engineer of choice for our clients under master services agreements. GSE and its predecessors have been providing these engineering solutions and services since 1995.
On February 15, 2019, through its wholly-owned subsidiary GSE Performance Solutions, Inc., the Company entered into the DP Engineering Purchase Agreement, to purchase 100% of the membership interests in DP Engineering. For reporting purposes, DP Engineering is included in our Performance segment due to similarities in services provided including engineering solutions and implementation of design modifications to nuclear power sector.
On May 11, 2018, GSE, through GSE Performance Solutions, Inc., entered into the True North Purchase Agreement to purchase 100% of the membership interests in True North. For reporting purposes, True North is included in our Performance Improvement Solutions segment due to similarities in services provided including technical engineering solutions to the nuclear and fossil fuel power sector.
Nuclear Industry Training and Consulting (approximately 57%45% of revenue)
Nuclear Industry Training and Consulting provides highly specialized, and skilled nuclear operations instructors, procedure writers, technical engineers, and other consultantsexpert-professionals to the nuclear power industry. These employees work at our clients' facilities under client direction. Examples of these highly skilled positions are senior reactor operations instructors, procedure writers, project managers, work management specialists, planners and training material developers. This business is managed through the Hyperspring and the newly acquired Absolute subsidiaries. The business model, management focus, margins and other factors clearly separate thisthe business line from the rest of the Company's product and service portfolio. GSE and its predecessors have been providing these training and consulting services since 1997.
Business Strategy
Our objective is to providecreate a powerful technology-enabledleading specialty engineering, expert staffing and training/consulting servicestechnology delivery platform focused primarily on the nuclear power industry. We offer our differentiated suite of products and services to adjacent markets such as the fossil power and the process industries where our offerings are a natural fit, withdelivering a clear and compelling value proposition forto the market. Our primary growth strategy is twofold: (1) seek acquisitions to accelerate our overall growth in a manner that is complementary to our core business and (2) expand organically within our core markets by leveraging our market leadership position and drive increased usage and product adoption via new products and services. To accomplish this objective, we will pursue the following activities:
Pursue roll-up acquisition strategy. We intend to complementhave complemented our organic growth strategy through selective acquisitions including, but not limited to, the following: technical engineering; training, staffing and consulting service businesses focused onfor the power industry, with a particular nuclear; value added components forfocus on nuclear power plants;power; and software utilized in the power industry, both domestic and international. We arehave been focusing our efforts on acquisitions that would enhance our existing portfolio of products and services, strengthen our relationships with our existing customers, and potentially expand our footprint to include new customers in our core served industries. We have made severalthree acquisitions since 20112017 and believe the opportunity exists to acquire more businesses that are complementary to ours, allowing us to accelerate our growth strategy.
In January 2011,February 2019, we acquired DP Engineering, a software company called EnVision Systems Inc., which provided interactive multi-media tutorialsspecialized provider of high-value engineering services and simulation models, primarilysolutions to the process industries. We have integrated the technology assets from this acquisition and expanded the firm's application to other industries, and we intend to repeat this successful process.nuclear power industry. In November 2014,May 2018, we acquired Hyperspring, which enabled GSETrue North, a leading provider of specialty engineering solutions to offer highly skilled nuclear operations and consulting personnel with unique know-how to our client base ofthe nuclear power plants. This deepened our relationship with existing clientsindustry and won business for us at new client sites in the nuclear industry. This acquisition has proven to be synergistic, enabling cross selling domestically, and in 2015, the expansion of these offerings to international customers for the first time. In September 2017, we acquired Absolute, a provider of technical consulting and staffing solutions to the global nuclear power industry, located in Navarre, Florida and on May 11, we acquired True North Consulting, LLC, a leading provider of specialty engineering solutions to the nuclear power industry, located in Montrose, Colorado.industry. The acquisitions of Absolute, and True North and DP Engineering are expected to strengthen the Company's global leadership in the nuclear services area. The acquisitions addadded new capabilities to the GSE solution offering and bring new highly complementary customers to GSE, while at the same time deepening GSE relationships with existing clients. TheThese acquisitions, together with our earlier acquisition of Absolute and True NorthHyperspring in November 2014, are a significant proof point of the thesis that GSE is a compelling platform for consolidating a fragmented vendor ecosystem for nuclear power. TheWe believe the acquisitions addsadd significant scale and focus to the business, while positioning GSE as a "go to" provider of technical and consulting solutions to the power industry, in particular nuclear power.
Expand our total addressable market. Our focus on growth means introducing product capabilities or new product and service categories that create value for our customers and therefore expand our total addressable market. Currently we are working on initiatives to expand our solution offerings in both of our business segments whichthat may include, but not be limited to, the following: expanding our software product portfolio to the industries we serve withinclude enhanced power and process simulation tools and systems that are complementary to our core offerings; delivering enhanced learning management systems/solutions; offering fully outsourced training solutions to our customers; adding work flow process improvement solutions; tailoring operational reporting and business intelligence solutions to address the unique need of our end user markets; and adding new services to broaden our market reach.
Initiatives such as these will broaden our scope and enable us to engage more deeply with the segments we serve.serve and adjacent segments. We have delivered a compelling solution, the GSE GPWRTM Generic Pressurized Water Reactor simulation technology, proving that our modeling technology can be sold in generic form via traditional license terms and conditions to the nuclear industry ecosystem. We have both upgraded and expanded the EnVision™ library of simulation and eLearning tutorials for the process industries with specific new products for training clients in the upstream segment of the oil and gas industry including launching a new cloud-based training platform, EnVision™ Learning On-Demand, that significantly extends the capabilities of its industry leading EnVision™ tutorials and simulations. We continue to provide cutting edge training systems by adapting our technology to systems tothat meet the specific needs of customers such as U.S. government laboratories.
Research and development (R&D). We invest in R&D to deliver unique solutions that add value to our end-user markets. We have delivered nuclear core and Balance-of-Plant modeling and visualization systems to the industry. To address the nuclear industry's need for more accurate simulation of both normal and accident scenarios, we provide our DesignEP® and RELAP5-HD® solutions. Our entire JADETM suite of simulation software, including industry leading JTOPMERET® and JElectricTM software, provides the most accurate simulation of Balance-of-Plant and electrical systems available to the nuclear and fossil plant simulation market. The significant enhancements we have made to our SimExec® and OpenSimTM platforms enables customers to be more efficient in the daily operation of their simulators. We are bringing SimExec® and OpenSimTM together into a next generation unified environment that will add new capabilities as requested by clients and driven by market need.
We intend to continue to make pragmatic and measured investments in R&D that first and foremost are driven by the market and are complementary to advancingcomplement our growth strategy. Such investments in R&D may result in on-going enhancement of existing solutions as well as the creation of new solutions to serve our target markets, ensuring that we add greater value in anthat is easier to use, fashion, at lower total cost of ownership than any alternative available to customers. GSE has pioneered a number of industry standards over our lifetime and willintends to continue to be one of the most innovative companies in our industry.
Strengthen and develop our talent while delivering high-quality solutions. Our experienced employees and management team are our most valuable resources. Attracting, training, and retaining top talent is critical to our success. To achieve our talent goals, we intend to remain focused on providing our employees with entrepreneurial opportunities to increase client contact within their areas of expertise and to expand our business withinand deepen our service offerings. We will also continue to provide our employees with training, personal and professional growth opportunities, performance-based incentives including opportunities for stock ownership, bonuses and competitive benefits as benchmarked to our industry and locations.
Continue to deliver industry-recognized high-quality services. We have developed a strong reputation for quality services based upon our industry-recognized depth of experience, ability to attract and retain quality professionals, and exceptional expertise across multiple service sectors. We have received numerous industry certificates and awards including being recognizedover the years for outstanding workservice.
Cyber security. Global cyber security threats can range from uncoordinated individual attempts to gain unauthorized access to our information technology (IT) systems to sophisticated and targeted measures known as advanced persistent threats. While we employ comprehensive measures to prevent, detect, address and mitigate these threats (including access controls, data encryption, vulnerability assessments, continuous monitoring of our IT networks and systems, and maintenance of backup and protective systems), cyber security incidents, depending on projects by Bechtel's Nuclear, Security & Environmental global business unit (NS&E) at the Bechtel Supply Chain Recognition awards in April 2016. In addition, we have a recognized high-value brand as one of the most respected providers of softwaretheir nature and services to the nuclear industry, as evidenced by our marquee client base and significant market wins over the past years. A recently conducted survey of clients with projects underway and/or just delivered validates our brand with a Net Promoter Score of +72, a compelling score for an industrial technology and services company.
Expand international operations in selected markets. We believe there are additional opportunities for us to market our software and services to international customers, and to do so in a cost-effective manner. For example, we believe partnerships with Value Added Resellers (VAR)scope, could significantly expand our sales pipeline for the EnVision™ software suite. In 2016, we entered into a reseller agreement with an entitypotentially result in the Middle Eastmisappropriation, destruction, corruption or unavailability of critical data and confidential or proprietary information (our own or that has an established track record of success selling simulationthird parties) and workforcethe disruption of business operations. The potential consequences of a material cyber security incident include reputational damage, litigation with third parties, civil or regulatory liability for loss of sensitive or protected information such as personal data, incident response costs, diminution in the value of our investment in research, development solutions to the process industries throughout the region. Such VARs may yield positiveand engineering, loss of intellectual property, and increased cyber security protection and remediation costs, which in turn could adversely affect our competitiveness and results for our pursuit of international nuclear opportunities globally (see industry trends below). We may explore the creation of appropriate joint ventures to target nuclear new-build and maintenance programs in key regions.operations.
Employees. As of March 31, 2018,2019, we had approximately 447521 employees, which includes approximately 160286 in our Performance Improvement segment and 287approximately 235 in our Nuclear Industry Training and Consulting segment. We have approximately 100 licensed engineers and other advanced degreed professionals. To date, we have been able to locate and engage highly qualified employees as needed and we expect our growth efforts to be addressed through attracting top talent.
Backlog. As of March 31, 2018,2019, we had approximately $72.4$68.9 million of total gross revenue backlog, which included $41.5$47.9 million of Performance Improvement Solutions backlog and $30.9$21.0 million of Nuclear Industry Training and Consulting backlog. With respect to our backlog, it includes only those amounts that have been funded and authorized and does not reflect the full amounts we may receive over the term of such contracts. Our backlog includes future expected revenue at contract rates, excluding contract renewals or extensions that are at the discretion of the client. We calculate backlog without regard to possible project reductions or expansions or potential cancellations unless and until such changes may occur.
Backlog is expressed in terms of gross revenue and, therefore, may include significant estimated amounts of third-party or pass-through costs to subcontractors and other parties. Because backlog is not a defined accounting term, our computation of backlog may not necessarily be comparable to that of our industry peers.
Products and Services
Performance Improvement Solutions
To assist our clients in creating world-class internal training and engineering improvement processes, we offer a set of integrated and scalable products and services whichthat provide a structured program focused on continuous skills improvement for experienced employees to engineering services, which includeincluding plant design verification and validation.validation, ASME code compliance, and design plant modification work. We provide the right solutions to solve our clients' most pressing needs.
For workforce development and training, students and instructors alike must have a high degree of confidence that their power plant simulator truly reflects plant behavior across the entire range of operations. To achieveearn this confidence, GSE's simulation solution starts with the most robust engineering approach possible. Using state-of-the-art modeling tools combined with our leading nuclear power modeling expertise, GSE provides simulation solutions that achieve unparalleled fidelity and accuracy. The solutions that GSE provides are also known for ease of use, resulting in increased productivity byfor end-users. For these reasons, GSE has delivered more nuclear power plant simulators than any other company in the world.
For virtual commissioning, designers of first-of-a-kind plants or existing plants need a highly accurate dynamic simulation platform to model a wide variety of design assumptions and concepts from control strategies to plant behavior to human factors. Because new builds and upgrades to existing plants result in deployment of new technology, being deployed, often involving the integration of disparate technologies for the first time, a high-fidelity simulator allowsenables designers to seemodel the interaction between systems for the very first time.in advance of construction. With our combination of simulation technology and expert engineering, GSE was chosen to build first-of-a-kind simulators for the AP1000, PBMR, and small modular reactors such as those being built by NuScale.
Examples of the types of simulators we sell include, but are not limited to, the following:
| ● | Universal Training Simulators:These products complement the Self-Paced Training Tutorials by reinforcing what the student learned in the tutorial, putting it into practice on the Universal Simulator. The simulation models are high fidelity and engineering correct, but represent a typical plant or typical process, rather than the exact replication of a client's plant. We have delivered over 360 such simulation models to clients consisting of major oil companies and educational institutions. |
| ● | Part-Task Training Simulators: Like theour Universal Simulators, we provide other unique training solutions such as a generic nuclear plant simulator and VPanel® displays, which replicate control room hardware and simulator solutions specific to industry needs such as severe accident models to train on and aid in the understanding of events like the Fukushima Daiichi accident. |
| ● | Plant-Specific Operator Training Simulators: These simulators provide an exact replication of the plant control room and plant operations. They provide the highest level of realism and training available, and allow users to practice their own plant-specific procedures. Clients can safely practice startup, shutdown, and other normal operations, as well as response to abnormal events we all hope they never have to experience in real life. Since our inception, we have delivered over 480 plant-specific simulators to clients in the nuclear power, fossil power and process industries worldwide. |
Nuclear Industry Training and Consulting
As our customers' experienced staff retire, access to experts that can help operate and train existing and new employees in how to operate their plants is essential to ensure safe ongoing plant operations. In addition, operating and training needs change over time and sometimes our clients require fixed priced discrete projects or specialized courses in contrast to straight staff augmentation. The industry needs operating personnel, including procedure writers, engineers, operators and instructors who can step in and use as well as update the client's operating methods, procedures, training material and more. Finding technical professionals and instructors, who know the subject, can perform the work or teach it to others and can adapt to the client's culture, is critical. GSE provides qualified professionals, instructors and turnkey projects/courses that work within the client's system and complement the operating or training methods they already have in place. Examples of our training program courses include senior reactor operator certification, generic fundamentals training, and simulation supervisor training. In addition, we also provide expert support through consulting or turnkey projects for procedure writing, technical engineers, project managers, training material upgrade and development, outage execution, planning and scheduling, corrective actions programs, and equipment reliability.
We bring together the collection of skills we have amassed over more than 40 years beginning with its traditional roots in custom high-fidelity simulation and training solutions for the power industries, extended through the acquisition of specialized engineering capabilities, enhanced by the entry and intermediate level training solutions of EnVision and the extensive nuclear industry training and consulting services of Absolute and Hyperspring.
Results of Operations
The following table sets forth the results of operations for the periods presented expressed in thousands of dollars and as a percentage of revenue. Effective January 1, 2018, we adopted ASU 2014-09 which is the new revenue standard. The comparative period revenue has not been restated and continues to be reported under the accounting standards in effect for those periods.
(in thousands) | | Three months ended March 31, |
| | 2018 | | % | | 2017 | | % |
Revenue | | $ | 22,895 | | 100.0 % | | $ | 16,342 | | 100.0 % |
Cost of revenue | | | 17,997 | | 78.6 % | | | 12,220 | | 74.8 % |
| | | | | | | | | | |
Gross profit | | | 4,898 | | 21.4 % | | | 4,122 | | 25.2 % |
Operating expenses: | | | | | | | | | | |
Selling, general and administrative | | | 4,527 | | 19.8 % | | | 3,592 | | 22.0 % |
Research and development | | | 329 | | 1.4 % | | | 402 | | 2.4 % |
Restructuring charges | | | 917 | | 4.0 % | | | 45 | | 0.3 % |
Depreciation | | | 103 | | 0.4 % | | | 76 | | 0.5 % |
Amortization of definite-lived intangible assets | | | 150 | | 0.7 % | | | 64 | | 0.4 % |
Total operating expenses | | | 6,026 | | 26.3 % | | | 4,179 | | 25.6 % |
| | | | | | | | | | |
Operating loss | | | (1,128) | | (4.9)% | | | (57) | | (0.4)% |
| | | | | | | | | | |
Interest income, net | | | 22 | | 0.1 % | | | 27 | | 0.2 % |
Loss on derivative instruments, net | | | (156) | | (0.7)% | | | (160) | | (1.0)% |
Other income (expense), net | | | 25 | | 0.1% | | | (3) | | 0.0% |
| | | | | | | | | | |
Loss before income taxes | | | (1,237) | | (5.4)% | | | (193) | | (1.2)% |
| | | | | | | | | | |
Provision for income taxes | | | 259 | | 1.1 % | | | 73 | | 0.4 % |
| | | | | | | | | | |
Net loss | | $ | (1,496) | | (6.5)% | | $ | (266) | | (1.6)% |
Results of Operations - three months ended March 31, 20182019 versus three months ended March 31, 20172018
Revenue. Revenue for the three months ended March 31, 20182019 totaled $22.9$22.2 million, which was 40.1% greater3.1% less than the $16.3$22.9 million of revenue for the three months ended March 31, 2017.2018. The year over year increasedecrease in revenue was primarily driven by the respective increasesdue to decrease in the two segmentsNITC segment listed below:
(in thousands) | Three months ended | Three months ended | |
| March 31, | |
| 2018 | | 2017 | March 31, | |
| | | | | | 2019 | | 2018 | |
Revenue: | | | | | | | | | | | |
Performance Improvement Solutions | $ | 9,901 | | $ | 9,670 | | $ | 12,190 | | | $ | 9,901 | |
Nuclear Industry Training and Consulting | | 12,994 | | | 6,672 | | | 10,004 | | | | 12,994 | |
Total revenue | $ | 22,895 | | $ | 16,342 | | $ | 22,194 | | | $ | 22,895 | |
Performance Improvement Solutions revenue increased 2.4%23.1% to $12.2 million for the three months ended March 31, 2019 from $9.9 million for the three months ended March 31, 2018 from $9.7 million for the three months ended March 31, 2017.2018. The change was mainly driven by an increase of $0.4$3.7 million due to more work performed for some major projects,acquisitions of TNC and DP Engineering, which was partially offset by a decrease of $0.2 million from international subsidiaries as a result of the winding down of our international subsidiaries.subsidiaries, and a decrease of $1.2 million in GSE Performance due to major project completion in first quarter of 2019. We recorded total Performance Improvement Solutions orders of $5.9$4.6 million and $4.9$5.9 million for the three months ended March 31, 20182019 and 2017,2018, respectively.
Nuclear Industry Training and Consulting revenue increased 94.8%decreased (23.0%) to $13.0$10.0 million for the three months ended March 31, 20182019 from $6.713.0 million for the three months ended March 31, 20172018. The increasedecrease in sales was primarily attributeddue to the acquisition of Absolute, which contributed $7.4 million to the current period revenue. The increase was partially offset by a decrease of $1.1 million from Hyperspring due to lower demand for staff augmentation needssupport from two major customers. Nuclear Industry Training and Consulting orders totaled $18.8$9.8 million, with $9.7 million attributable to Absolute, and $14.9$18.8 million for the three months ended March 31, 20182019 and 2017,2018, respectively. In the first quarter of 2019, the Company has increased the business development team to grow sales and to make us more responsive to the needs of our new and existing customers.
At March 31, 2018,2019, backlog was $72.4$68.9 million: $41.5$47.9 million for the Performance Improvement Solutions segment and $30.9$21.0 million for Nuclear Industry Training and Consulting. At December 31, 2017,2018, the Company's backlog was $71.4$69.0 million: $46.3$47.8 million for the Performance Improvement Solutions segment and $25.1$21.2 million for Nuclear Industry Training and Consulting.
Gross profit. Gross profit was $4.9$4.7 million, or 21.4%21.3%, for the three months ended March 31, 2018,2019, compared to $4.1$4.9 million, or 25.2%21.4% for the same period in 2017.2018.
(in thousands) | Three months ended | Three months ended | |
| March 31, | March 31, | |
| 2018 | | % | | 2017 | | % | 2019 | | | % | | 2018 | | | % | |
Gross profit: | | | | | | | | | | | | | | | | | | | | | |
Performance Improvement Solutions | $ | 3,251 | | 32.8% | | $ | 3,044 | | 31.5% | | $ | 3,699 | | | | 30.3 | % | | $ | 3,251 | | | | 32.8 | % |
Nuclear Industry Training and Consulting | | 1,647 | | 12.7% | | | 1,078 | | 16.2% | | | 1,037 | | | | 10.4 | % | | | 1,647 | | | | 12.7 | % |
Total gross profit | $ | 4,898 | | 21.4% | | $ | 4,122 | | 25.2% | | $ | 4,736 | | | | 21.3 | % | | $ | 4,898 | | | | 21.4 | % |
The increase in gross margin percentageprofit for Performance Improvement Solutions for the three months ended March 31, 20182019 as compared to the same period in 20172018 was mainly dueprimarily driven by the acquisitions of True North and DP Engineering as well as cost savings realized on certain large projects through percentage of completion contracts, which were not expected to increased software sales which generally have a higher gross margin percentage than SDB sales.recur in the foreseeable future. For the three months ended March 31, 2019 and 2018, our revenue on training and 2017, our software salesconsulting services through T&M or fixed-price contracts accounted for 9%41% and 5%16% of the segment revenue, respectively.
The decrease in gross profit margin during 20182019 for Nuclear Industry Training and Consulting was primarily driven by lower margin from Hyperspring and Absolute projects. For the three months ended March 31, 2018, Absolute contributed 57.1% of the segment revenue with a gross profit margin of 11.2%.
Selling, general and administrative expenses. Selling, general and administrative (SG&A) expenses totaled $4.5$4.4 million and $3.6$4.5 million for the three months ended March 31, 2019 and 2018, and 2017, respectively. FluctuationsSignificant changes in the components of SG&A spending were as follows:
($ in thousands) | Three months ended | | Three months ended | |
| March 31, | | March 31, | |
| 2018 | | % | | 2017 | | % | | 2019 | | | % | | | 2018 | | | % | |
Selling, general and administrative expenses: | | | | | | | | | | | | | | | | | | | | | |
Corporate charges | $ | 3,337 | | 73.7% | | $ | 2,442 | | 68.0% | | $ | 3,233 | | | | 73.1 | % | | $ | 3,337 | | | | 73.7 | % |
Business development expenses | | 918 | | 20.3% | | | 685 | | 19.0% | | | 944 | | | | 21.3 | % | | | 918 | | | | 20.3 | % |
Facility operation & maintenance (O&M) | | 271 | | 6.0% | | | 211 | | 5.9% | | | 245 | | | | 5.6 | % | | | 271 | | | | 6.0 | % |
Contingent consideration accretion | | - | | 0.0% | | | 254 | | 7.1% | |
Others | | 1 | | 0.0% | | | - | | 0.0% | | | 1 | | | | 0.0 | % | | | 1 | | | | 0.0 | % |
Total | $ | 4,527 | | 100.0% | | $ | 3,592 | | 100.0% | | $ | 4,423 | | | | 100.0 | % | | $ | 4,527 | | | | 100.0 | % |
Corporate charges increased $0.9decreased $(0.1) million due primarily to $1.0 million of additional general and administrative expenses relate to our acquisitions of True North and DP Engineering, $0.6 million of acquisition related expense, offset by $0.5 million of savings as a result of our international restructuring plan along with other corporate cost saving initiatives and $1.2 million of decrease due to $0.3 millionchange on the fair value of higher bonus expense mainly due to a new post earnout bonus plan in 2018 for certain Hyperspring employees, $0.3 million of higher one-time professional fees associated with the adoption of the new revenue standard (ASC 606) and the impact of the Tax Cuts and Jobs Act and $0.2 million of general administrative expenses attributable to Absolute, which was acquired in September 2017.contingent consideration.
The increase in business development expenses was primarily due to the acquisition of Absolute.
Contingent consideration accretion mainly represented fair value adjustments of the contingent consideration liability related to our 2014 Hyperspring acquisition. The earnout period expired in November 2017, and the final payment was made in January 2018, therefore no contingent consideration adjustment was recorded for the current period.
Research and development. Research and development costs consist primarily of software engineering personnel and other related costs. Research and development costs, net of capitalized software, totaled $329,000$240,000 and $402,000$329,000 for the three months ended March 31, 20182019 and 2017,2018, respectively. Before capitalization of software development costs, research and development totaled $434,000$350,000 and $431,000$434,000 for three months ended March 31, 2019 and 2018, and 2017, respectively.
Restructuring charges. On December 27, 2017, theour Board of GSE Systems, Inc.Directors approved an international restructuring plan to streamline and optimize the Company'sour global operations and we announced weoperations. We expected restructuring charges to total $1.8$2.2 million, excluding any tax impacts and cumulative translation adjustments. We recorded $0.7 million in the fourth quarter of 2017. For the three months ended March 31, 2018,2019, we did not incur any restructuring charges totaled $0.9 million, including severance expense of $0.3 million, lease termination costs of $0.5 million and other costs of $0.1 million.charges. As of March 31, 2018,2019, we had recorded accumulatedincurred total restructuring charges of $1.7$2.0 million since 2017, and we expect to record the remaining restructuring charges of approximately $0.1$0.2 million bybefore the end of June 2018. These2019. The restructuring charges exclude cumulative translation adjustment losses of approximately $1.4$1.7 million, assuming currency rates at March 31, 2018, and2019, which will be recorded as a charge against net income upon liquidation of the respective foreign subsidiaries. We also expect to recognize tax benefits related to the liquidation of these subsidiaries that maywe anticipate will offset thea majority of the currency translation adjustment losses. Under the restructuring plan, the Company expects a total of $1.6 million cash outflow in 2018, which primarily includes severance expense, facility closing costs, and other restructuring costs. For the three months ended March 31, 2017,2019, the Company made payments related to our restructuring for employee termination benefits totaling $0.1 million that had been previously accrued for. For the three months ended March 31, 2018, we recorded restructuring charges of $45,000,$0.9 million, which represented true-up adjustments related to the restructuring plan initiated in 2015.
Depreciation. Depreciation expense totaled $103,000$91,000 and $76,000$103,000 for the three months ended March 31, 2019 and 2018, and 2017, respectively. The increase in 2018 was primarily attributable to our acquisition of Absolute.
Amortization of definite-lived intangible assets. AmortizationTotal amortization expense related to definite-lived intangible assets totaled $150,000$0.5 million and $64,000$0.2 million for the three months ended March 31, 2019, and 2018, and 2017, respectively. Amortization expense increased $118,000 due to our acquisition of Absolute. The increase in amortization was partially offset by lower amortization of customer-related intangible assets that were recorded when we acquired Hyperspring in 2014.
LossImpairment on goodwill and definite-lived intangible assets. Due to the interim impairment test performed on the goodwill and definite-lived intangible assets obtained through business combination with DP Engineering, the Company recognized an impairment charge of $2.1 million related to goodwill and $3.4 million related to definite-lived intangible assets, both initially recognized upon the acquisition of DP Engineering for the three months ended March 31, 2019 (See Note 9). There was no impairment recognized for the three months ended March 31, 2018.
Gain (Loss) on derivative instruments, net. LossGain (loss) on derivative instruments relates to the Company's foreign exchange contracts and remeasurement of foreign currency-denominated contract receivables, billings in excess of revenue earned, and subcontractor accruals. These amounts are remeasured into the functional currency using the current exchange rate at the end of the period. For the three months ended March 31, 2019, we recognized a gain of $102,000 on the change in fair value of foreign exchange contracts, and a gain of $17,000 from the remeasurement of contract receivables, billings in excess of revenue earned and subcontractor accruals. For the three months ended March 31, 2018, we recognized a loss of $118,000 on the change in fair value of foreign exchange contracts, and a loss of $38,000 from the remeasurement of contract receivables, billings in excess of revenue earned and subcontractor accruals. For
Interest (expense) income, net. Interest expense totaled $222,000 and $0 for the three months ended March 31, 2017, we recognized a loss2019 and 2018, respectively. Interest income totaled $14,000 and $22,000 for the three months ended March 31, 2019 and 2018, respectively. The Company drew down under its five-year term loan of $86,000 on$14.3 million in February 2019 to finance the changeacquisition of DP Engineering, and has recorded interest expense of $83,000 related to the term loan for the period of time this additional debt was outstanding during the three months ended March 31, 2019. Interest expense is expected to increase in fair value of foreign exchange contracts, and a loss of $74,000the future as the debt from the remeasurementacquisition of contract receivables, billings in excessDP Engineering was only outstanding for a half of revenue earned and subcontractor accruals.the three months ended March 31, 2019.
Other (expense) income, net. The Company recognized $25,000$22,000 of other income, net and $3,000$25,000 of other expense,income, net for the three months ended March 31, 2019 and 2018, and 2017, respectively.
(Benefit) Provision for income taxes. Income tax expensebenefit was $259,000,$(1.8) million, or an effective income tax rate of 30.4%, for the three months ended March 31, 2019, compared to $0.3 million, or an effective income tax rate of (20.9%), for the three months ended March 31, 2018, compared to $73,000, or an effective income tax rate of (37.8%), for the three months ended March 31, 2017.2018. The Company's income tax provision for interim periods is determined using an estimate of its annual effective tax rate, adjusted for discrete items arising in that quarter. Tax expense in 2019 is comprised mainly of the tax impact of the loss for impairment, federal income tax expense, foreign income tax expense, and state tax expense. Tax expense in 2018 is comprised mainly of federal income tax expense, foreign income tax expense, and state taxes. Tax expense in 2017 is comprised mainly of foreign income tax expense, Alternative Minimum Tax, state taxes, and deferred tax expense relating to the tax amortization of goodwill.expense.
The difference in our effective tax rate and the U.S. statutory federal income tax rate of 21% was primarily due to our China subsidiary which had taxable income for the three months ended March 31, 2018 and thepermanent differences, accruals related to uncertain tax positions for certain U.S. and foreign tax contingencies.contingencies, a change in valuation allowance in our China subsidiary, discrete item adjustments for the U.S. and foreign taxes, including the tax impact of the loss for impairment, and the excess book deduction related to stock options and restricted stock units that were exercised or vested during the year.
Because of its net operating loss carryforwards, the Company is subject to U.S. federal and state income tax examinations from the year 19972000 and forward. The Company is subject to foreign tax examinations by tax authorities for years 2011 forward for Sweden, 20142015 forward for China, and 2015 forward for both India and 2016 forward for the UK.
An uncertain tax position taken or expected to be taken in a tax return is recognized in the consolidated financial statements when it is more likely than not (i.e., a likelihood of more than 50%) that the position would be sustained upon examination by tax authorities that have full knowledge of all relevant information. A recognized tax position is then measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Interest and penalties related to income taxes are accounted for as income tax expense.
The Company has recorded full valuation allowance for its U.K. and Swedish net deferred tax assets at March 31, 2018.27
Critical Accounting Policies and Estimates
In preparing the Company's consolidated financial statements, management makes several estimates and assumptions that affect the Company's reported amounts of assets, liabilities, revenues and expenses. The Company's most significant estimates relate to revenue recognition on contracts with customers, allowance for doubtful accounts, product warranties, valuation of goodwill and intangible assets acquired, valuation of long-lived assets to be disposed of, valuation of contingent consideration issued in business acquisitions, valuation of stock based compensation awards, and the recoverability of deferred tax assets. These critical accounting policies and estimates are discussed in the Management'sManagement’s Discussion and Analysis of Financial Condition and Results of Operations section in our most recent Annual Report on Form 10-K. For all of these policies, management cautions that future events rarely develop exactly as forecast, and the best estimates may require adjustment.
Liquidity and Capital Resources
As of March 31, 2018,2019, the Company'sCompany’s cash and cash equivalents and restricted cash totaled $12.4$11.3 million compared to $20.1$12.1 million at December 31, 2017.2018.
For the three months ended March 31, 20182019 and 2017,2018, net cash (used in) provided byused in operating activities was $(5.5)$(0.6) million and $1.1$(5.5) million, respectively. The year over year change of $6.6$4.9 million in cash flows (used in) provided byused in operating activities was primarily driven by the loss on impairment, change in the fair value of contingent consideration, the change in contract receivables, billing in excess of revenue earned and accounts payable and accrued expenses, which was mainly due to timing differences of cash collections and payments. The majority of the cash outflows from operations was due to a significant increase in our contract receivables and unbilled revenues during the first quarter of 2018. These contract receivables and unbilled revenues related to a limited number of our larger customers, and the majority were billed or collected during April and May of 2018.billing.
Net cash used in investing activities totaled $0.4$(13.6) million and $0.1$(0.4) million for the three months ended March 31, 20182019 and 2017,2018, respectively. The increase in cash outflow in 20182019 was primarily due to $0.3 million increase in lease improvements and furniture and fixtures as we entered into a new lease agreement in December 2017 and relocated mostdriven by the acquisition of our corporate functions, including finance, legal, and R&D to a new office in Columbia, Maryland in March 2018.DP Engineering, the net cash consideration of which was $14.8 million.
For the three months ended March 31, 2019 and 2018, and 2017, net cash used inprovided by (used in) financing activities totaled $1.7$13.5 million and $1.2$(1.7) million, respectively. The increase in the cash outflowinflow from financing activities iswas largely driven by the increaseproceeds from issuance of $1.1 million in contingent consideration payments toa term loan of $14.3 million; the former Hyperspring owners as we paid off the earnout, whichincrease was partially offset by a decreasean increase of $0.6$0.1 million in the Company's withholding of RSUs in order to pay employees'employees’ payroll withholding taxes on vested RSUs.RSUs, and repayments of $0.7 million on the term loan.
At March 31, 2018,2019, the Company had cash and cash equivalents and restricted cash of $12.4$11.3 million. The Company believes that its (i) cash and cash equivalents and (ii) cash generated from normal operations will be sufficient to fund its working capital and other requirements for at least the next twelve months.
Line of Credit Facilities
Citizens Bank
The Company entered into a three-year, $5.0 million revolving line of credit facility (RLOC) with Citizens Bank, National Association (the Bank) on December 29, 2016, to fund general working capital needs. Working capital advances bear interest of one-month LIBOR plus 2.25% per annumOn May 11, 2018, GSE and letter ofPerformance Solutions (collectively, the Borrower) entered into an Amended and Restated Credit and Security Agreement (the Credit Agreement) with the Bank, amending and restating the Company's existing Credit and Security Agreement with the Bank, which included a $5.0 million asset-based revolving credit fees are 1.25% per annum. The Company isfacility between the Borrower and the Bank, to now include (a) a $5.0 million revolving credit facility not required to maintain a restricted cash collateral account at Citizens Bank for outstanding letters of credit and working capital advances.
The maximum availability under the RLOC is subject to a borrowing base, equal to 80% of eligible accounts receivable, and is reduced for any issued and outstanding lettersincluding a letter of credit sub-facility, and working capital advances.(b) a $25.0 million delayed draw term loan facility available to be drawn upon for up to 18 months and to finance certain permitted acquisitions by the Company.
On May 11, 2018, upon acquisition of True North, the Company drew down approximately $10.3 million to fund the transaction, $0.5 million of which was repaid to the Bank on the same day. On February 15, 2019, upon acquisition of DP Engineering, the Company drew down approximately $14.3 million to fund the transaction. At March 31, 2018,2019, the outstanding balance of the long-term debt was $22.1 million.
At March 31, 2019, there were no outstanding borrowings on the RLOC and twofour letters of credit totaling $0.7$1.9 million. The amount available at March 31, 2018,2019, after consideration of the borrowing base, letters of credit and working capital advances was approximately $4.3$3.1 million.
The credit facility agreement is subject to standard financial covenants and reporting requirements. At March 31, 2018,2019, the Company was in compliance with its financial covenants.
On May 11, 2018, GSE entered into an amended and restated credit agreement with Citizen's Bank, consisting of a five-year $5 million revolving line of credit and a five-year $25 million delayed draw term loan facility to fund acquisitions approved by the Lender. At close, we drew down approximately $10.3 million to fund the acquisition of True North. Interest will be based on a LIBOR spread of 200 to 275 basis points, depending on pre-defined leverage thresholds defined in the agreement.
BB&T Bank
At March 31, 2018, we had two letters of credit with BB&T totaling $0.6 million, which expired and are pending on release by the bank and customer. At March 31, 2018 and December 31, 2017, the cash collateral account with BB&T totaled $0.6 million and $1.0 million, respectively and were classified as restricted cash on the consolidated balance sheets.
Non-GAAP Financial Measures
References to “EBITDA” mean net (loss) income, before taking into account interest expense (income), provision for income taxes, depreciation and amortization. References toAdjusted EBITDA exclude loss on impairment, impact of the change in fair value of contingent consideration, restructuring charges, stock-based compensation expense, impact of the change in fair value of derivative instruments, and acquisition-related expense. EBITDA and Adjusted EBITDA are not measures of financial performance under generally accepted accounting principles ("GAAP")(GAAP). Management believes EBITDA and Adjusted EBITDA, in addition to operating profit, net income and other GAAP measures, are useful to investors to evaluate the Company'sCompany’s results because it excludes certain items that are not directly related to the Company'sCompany’s core operating performance that may, or could, have a disproportionate positive or negative impact on our results for any particular period. Investors should recognize that EBITDA and Adjusted EBITDA might not be comparable to similarly-titled measures of other companies. These measuresThis measure should be considered in addition to, and not as a substitute for or superior to, any measure of performance prepared in accordance with GAAP. ReconciliationA reconciliation of non-GAAP EBITDA and Adjusted EBITDA to the most directly comparable GAAP measures are asmeasure in accordance with SEC Regulation G follows:
(in thousands)
| | Three months ended | | Three months ended | |
| | March 31, | | March 31, | |
| | 2018 | | 2017 | | 2019 | | | 2018 | |
Net loss | Net loss | $ | (1,496) | | $ | (266) | | $ | (4,236 | ) | | $ | (1,496 | ) |
Interest income, net | | (22) | | | (27) | |
Interest expense (income), net | | | | 208 | | | | (22 | ) |
Provision for income taxes | Provision for income taxes | | 259 | | | 73 | | | (1,848 | ) | | | 259 | |
Depreciation and amortization | Depreciation and amortization | | 371 | | | 257 | | | 729 | | | | 371 | |
EBITDA | EBITDA | | (888) | | | 37 | | | (5,147 | ) | | | (888 | ) |
Loss from the change in fair value of contingent consideration | | - | | | 254 | |
Loss on impairment | | | | 5,464 | | | | - | |
Impact of the change in fair value of contingent consideration | | | | (1,200 | ) | | | - | |
Restructuring charges | Restructuring charges | | 917 | | | 45 | | | - | | | | 917 | |
Stock-based compensation expense | Stock-based compensation expense | | 627 | | | 596 | | | 597 | | | | 627 | |
Loss on derivative instruments, net | | 156 | | | 160 | |
Impact of the change in fair value of derivative instruments | | | | (93 | ) | | | 156 | |
Acquisition-related expense | | | | 628 | | | | - | |
Adjusted EBITDA | Adjusted EBITDA | $ | 812 | | $ | 1,092 | | $ | 249 | | | $ | 812 | |
Adjusted Net Income and Adjusted EPS Reconciliation (in thousands, except share and per share amounts)
References to Adjusted net income exclude the impact of gain from loss on impairment, impact of the change in fair value of contingent consideration, restructuring charges, stock-based compensation expense, impact of the change in fair value of derivative instruments, acquisition-related expense, and amortization of intangible assets related to acquisitions. Adjusted Net Income and adjusted earnings (loss) per share ("adjusted EPS")(adjusted EPS) are not measures of financial performance under GAAP.generally accepted accounting principles (GAAP). Management believes adjusted net income and adjusted EPS, in addition to other GAAP measures, provide meaningful supplemental information regarding our operational performance. Our management uses Adjusted Net Income and other non-GAAP measuresare useful to investors to evaluate the performance of our business and makeCompany’s results because they exclude certain operating decisions (e.g., budgeting, planning, employee compensation and resource allocation). This information facilitates management's internal comparisons to our historical operating results as well asitems that are not directly related to the Company’s core operating performance and non-cash items that may, or could, have a disproportionate positive or negative impact on our results of our competitors. Since management finds this measure to be useful, we believe that our investors can benefit by evaluating both non-GAAP and GAAP results.for any particular period, such as stock-based compensation expense. These measures should be considered in addition to, and not as a substitute for or superior to, any measure of performance prepared in accordance with GAAP. A reconciliation of non-GAAP adjusted net income and adjusted EPS to GAAP net income, the most directly comparable GAAP financial measure, is as follows:
(in thousands) | | Three months ended | |
| | March 31, | |
| | 2019 | | | 2018 | |
Net loss | | $ | (4,236 | ) | | $ | (1,496 | ) |
Loss on impairment | | | 5,464 | | | | - | |
Impact of the change in fair value of contingent consideration | | | (1,200 | ) | | | - | |
Restructuring charges | | | - | | | | 917 | |
Stock-based compensation expense | | | 597 | | | | 627 | |
Impact of the change in fair value of derivative instruments | | | (93 | ) | | | 156 | |
Acquisition-related expense | | | 628 | | | | - | |
Amortization of intangible assets related to acquisitions | | | 509 | | | | 150 | |
Adjusted net income | | $ | 1,669 | | | $ | 354 | |
| | | | | | | | |
Diluted loss per common share | | $ | (0.21 | ) | | $ | (0.08 | ) |
| | | | | | | | |
Adjusted earnings per common share – Diluted | | $ | 0.08 | | | $ | 0.02 | |
| | | | | | | | |
Weighted average shares outstanding - Diluted(1) | | | 20,188,580 | | | | 19,902,752 | |
(in thousands) | Three months ended |
| March 31, |
| 2018 | | 2017 |
Net loss | $ | (1,496) | | $ | (266) |
Loss from the change in fair value of contingent consideration | | - | | | 254 |
Restructuring charges | | 917 | | | 45 |
Stock-based compensation expense | | 627 | | | 596 |
Loss on derivative instruments, net | | 156 | | | 160 |
Adjusted net income | $ | 204 | | $ | 789 |
| | | | | |
Loss per share - diluted | $ | (0.08) | | $ | (0.01) |
| | | | | |
Adjusted earnings per share - diluted (a) | $ | 0.01 | | $ | 0.04 |
| | | | | |
Weighted average shares outstanding - Diluted (a) | | 19,902,752 | | | 19,502,057 |
(a)(1) During the three months ended March 31, 20182019 and 2017,2018, the Company reported both a GAAP net loss and positive adjusted net income. Accordingly, there were 388,367237,834 and 407,675388,367 dilutive shares from options and RSUs included in the adjusted earnings per common share calculation, for the three months ended March 31, 2018 and 2017, respectively, that were considered anti-dilutive in determining the GAAP diluted loss per common share.
Item 3. | Quantitative and Qualitative Disclosure about Market Risk |
Not required of a smaller reporting company.
Item 4. | Controls and Procedures |
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of the end of the period covered by this Quarterly Report on Form 10-Q. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their control objectives. Based on the evaluation of our disclosure controls and procedures as of the end of the period covered by this quarterly report, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective.
On September 20, 2017,February 15, 2019, the Company completed the acquisitionpurchase of Absolute Consulting, Inc. AbsoluteDP Engineering. DP Engineering constitutes 21%17.0% of total assets of the Company at March 31, 2018,2019, and 32%7% of the Company's consolidated revenue for the three months ended March 31, 2018.2019. As permitted by SEC guidance for newly acquired businesses, because it was not possible to complete an effective assessment of the acquired company's controls by the quarter-end, the Company's management has excluded AbsoluteDP Engineering from its evaluation of disclosure controls and procedures from the date of such acquisition through March 31, 2018.2019.
On May 11, 2018, the Company completed the acquisition of True North, LLC (True North). True North constitutes 23.7% of total assets of the Company at December 31, 2018, and 8.6% of the Company's consolidated revenue for the year ended December 31, 2018. As permitted by SEC guidance for newly acquired businesses, because it was not possible to complete an effective assessment of the acquired company's controls by quarter-end, the Company's management has excluded True North from its evaluation of disclosure controls and procedures and management's report on internal control over financial reporting and changes therein below from the date of such acquisition through March 31, 2019. Our management is in the process of reviewing the operations of True North and implementing GSE's internal control structure over the acquired operations.
Changes in Internal Control over Financial Reporting
There were no changes in the Company's internal control over financial reporting that occurred during the most recent fiscal quarter that have materially affected or are reasonably likely to materially affect the Company's internal control over financial reporting.
Limitation of Effectiveness of Controls
Internal control over financial reporting has inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements will not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
PART II - OTHER INFORMATION
None.
The Company has no material changesadded the below risk factor to the disclosuredisclosure.
If we cannot comply with the financial or other restrictive covenants in our credit agreement, or obtain waivers or other relief from our lender, we may cause an event of default to occur, which could result in loss of our sources of liquidity and acceleration of our debt.
In order to fund our recent acquisitions, we borrowed under a delayed-draw term loan. Our ability to generate sufficient cash flow from operations to make scheduled payments on this matter madeour term loan will depend on a range of economic, competitive and business factors, some of which are outside our control. If we are unable to meet our debt service obligations, we may need to refinance or restructure all or a portion of our debt on or before its stated maturity date, sell assets, pay down our outstanding debt and/or raise equity. We may not be able to refinance or restructure any of our debt, sell assets or raise equity, in its Annual Reporteach case on Form 10-K forcommercially reasonable terms or at all, which could cause us to default on our obligations and impair our liquidity. Our inability to generate sufficient cash flow to satisfy our debt obligations or to refinance or restructure our obligations on commercially reasonable terms could have a material adverse effect on our business, financial condition, results of operations and cash flows. Our credit agreement also contains financial and other restrictive covenants. Our ability to comply with the fiscal year ended December 31, 2017.covenants in our credit agreement will depend upon our future performance and various other factors, some of which are beyond our control. We may not be able to maintain compliance with all of these covenants. In that event, we would need to seek an amendment to our credit agreement, a waiver from our lender, utilize cash to pay down outstanding debt and/or refinance or restructure our debt. There can be no assurance that we could obtain future amendments or waivers of our credit agreement, or refinance or restructure our debt, in each case on commercially reasonably terms or at all. Our failure to maintain compliance with the covenants under our credit agreement could result in an event of default, subject to applicable notice and cure provisions. Upon the occurrence of an event of default under our credit agreement, our lender could elect to declare all amounts outstanding thereunder to be immediately due and payable, terminate all commitments to extend further credit and cease making further loans. If we were unable to repay all outstanding amounts in full, our lender could exercise various remedies including instituting foreclosure proceedings against our assets pledged to them as collateral to secure that debt.
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
None
Item 3. | Defaults Upon Senior Securities |
None
Item 4. | Mine Safety Disclosures |
Not applicable.
None.
| | Membership Interest PurchaseFourth Amendment and Reaffirmation Agreement dated as of May 11, 2018, betweenMarch 20, 2019, by and among GSE Systems, Inc., and GSE Performance Solutions, Inc., as Borrowers, GSE True North Consulting, LLC, Donald R. Horn, Jenny C. Horn, GSE Performance Solutions,Hyperspring, LLC, Absolute Consulting, Inc., and Donald R. Horn in his capacityDP Engineering LLC, as Seller Representative. Incorporated herein by reference to Exhibit 2.1 of our Current Report on Form 8-K filed with the SecuritiesGuarantors, and Exchange Commission on May 14, 2018.Citizens Bank, National Association, as Bank. Filed herewith. |
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| | Amended and Restated Credit and Security Agreement, dated as of May 11, 2018, by and among Citizens Bank, National Association, as Bank, and GSE Systems, Inc. and GSE Performance Solutions, Inc., as Borrower. Incorporated herein by reference to Exhibit 99.1 of our Current Report on Form 8-K filed with the Securities and Exchange Commission on May 14, 2018. |
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| | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes- Oxley Act of 2002, filed herewith. |
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| | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |
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| | Certification of the Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith. |
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| 101.INS* | XBRL Instance Document |
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| 101.SCH* | XBRL Taxonomy Extension Schema |
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| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase |
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| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase |
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| 101.LAB* | XBRL Taxonomy Extension Label Linkbase |
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| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: May 15, 20182019
GSE SYSTEMS, INC.
/S/ KYLE J. LOUDERMILK
Kyle J. Loudermilk
Chief Executive Officer
(Principal Executive Officer)
/S/ EMMETT A. PEPE
Emmett A. Pepe
Chief Financial Officer
(Principal Financial and Accounting Officer)
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