Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q, including information incorporated herein by reference, contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that are not historical facts. This includes, without limitation, statements regarding our financial position, business strategy and management’s plans and objectives for future operations. These statements constitute projections, forecasts and forward-looking statements, and are not guarantees of performance. Such statements can be identified by the fact that they do not relate strictly to historical or current facts. When used in this Quarterly Report on Form 10-Q, words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “possible,” “potential,” “predict,” “project,” “should,” “strive,” “would” and similar expressions may identify forward-looking statements, but the absence of these words does not mean that a statement is not forward-looking. When we discuss our strategies or plans, we are making projections, forecasts or forward-looking statements. Such statements are based on the beliefs of, as well as assumptions made by and information currently available to, our management.
All forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those that we expect, including:
•potential failure to comply with privacy and information security regulations governing the client datasets that we process and store;
•the ability to operate in highly competitive markets, and potential adverse effects of this competition;
•
risk of decreased revenues if we do not adapt our pricing models to compete successfully;
•the ability to attract, motivate and retain qualified employees, including members of our senior management team;
•the ability to maintain a high level of client service and expand operations;
•potential issues with our product offerings that could cause legal exposure, reputational damage and an inability to deliver services;
•the ability to develop and successfully grow revenues from new products such as Nebula, improve existing products and adapt our business model to keep pace with industry trends;
•risk that our products and services fail to interoperate successfully with third-party systems;
•potential unavailability of third-party technology that we use in our products and services;
•potential disruption of our products, offerings, website and networks;
•difficulties resulting from our implementation of new consolidated business systems;
•the ability to deliver products and services following a disaster or business continuity event;
•the outbreak of disease or similar public health threat, such as COVID-19;
•potential unauthorized use of our products and technology by third parties and/or data security breaches and other incidents;
•potential intellectual property infringement claims;
•the ability to comply with various trade restrictions, such as sanctions and export controls, resulting from our international operations;
•consequences of our substantial levels of indebtedness, including the pending maturity and potential acceleration thereof in June 2024;
•potential impairment charges related to goodwill, identified intangible assets and fixed assets;
•impacts of laws and regulations on our business;
•macroeconomic conditions, including inflationary pressures, rising interest rates, exchange rate volatility, and recessionary fears;
•potential litigation and regulatory proceedings involving us;
•expectations regarding the time during which we will be an emerging growth company or smaller reporting company;
•the potential liquidity and trading of our public securities; and
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•other risks and uncertainties indicated in the section titled “Risk Factors” in this Quarterly Report on Form 10-Q.
The forward-looking statements contained in this Quarterly Report on Form 10-Q and in any document incorporated by reference are based on current expectations and beliefs, which we believe to be reasonable, concerning future developments and their potential effects on us. There can be no assurance that future developments affecting us will be those that we have anticipated. These forward-looking statements involve a number of risks, uncertainties (many of which are beyond our control) or other assumptions that may cause actual results or performance to be materially different from those expressed or implied by these forward-looking statements. These risks and uncertainties include, but are not limited to, those factors described in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in our consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2022. Should one or more of these risks or uncertainties materialize, or should any of our assumptions prove incorrect, actual results may vary in material respects from those projected in these forward-looking statements. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required under applicable securities laws.
In addition, statements that include phrases such as “we believe” and similar phrases reflect our beliefs and opinions on the relevant subject. These statements are based upon information available to us as of the date of this Quarterly Report on Form 10-Q, and while we believe such information forms a reasonable basis for these statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain and investors are cautioned not to unduly rely upon these statements.
Throughout this section, unless otherwise specified or where the context requires otherwise, references to “we,” “us,” “our,” “Company,” “KLDiscovery,” “KLD,” or “KLDiscovery Inc.” refer to KLDiscovery Inc. and its consolidated subsidiaries. The following overview provides a summary of the sections included in this Management’s Discussion and Analysis of Financial Condition and Results of Operations:
•Executive Summary — a general description of our business and key highlights for the three months ended March 31, 2023.
•Results of Operations — an analysis of our results of operations in our condensed consolidated financial statements.
•Liquidity and Capital Resources — an analysis of our cash flows, sources and uses of cash, and commitments and contingencies.
Overview
KLD is a leading global provider of eDiscovery, information governance and data recovery solutions to corporations, law firms, insurance agencies and individuals. We provide technology solutions to help our clients solve complex legal, regulatory and data challenges. We have broad geographical coverage in the eDiscovery and data recovery industries with 25 locations in 16 countries, as well as 9 data centers and 13 data recovery labs globally. Our integrated proprietary technology solutions enable the efficient and accurate collection, processing, transmission, review and/or recovery of complex and large-scale enterprise data. In conjunction with proprietary technology, we provide immediate expert consultation and 24/7/365 support wherever a customer is located worldwide, which empowers us to become a “first-call” partner for mission-critical, time-sensitive, or nuanced eDiscovery and data recovery challenges. We are continuously innovating to provide a more reliable, secure and seamless experience when tackling various “big data” volume, velocity, and veracity challenges. A key example of our purpose-built innovation is Nebula, our flagship, end-to-end artificial intelligence/machine learning, or AI/ML, powered solution that serves as a singular platform of engagement for legal data.
Key factors affecting our performance
Our operating results, financial performance and future growth will depend on a variety of factors, including, among others, maintaining our history of product innovation, increasing adoption of Nebula, maintaining and growing our client base while driving greater penetration, growth in the number of our matters, particularly large matters and establishing our partner channel for Nebula. Some of the more important factors are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022 as filed with the SEC on March 16, 2023 (our “Annual Report”), as supplemented by the additional discussion below.
Key business metrics
The following are among the key operational and financial metrics we use to measure and evaluate our performance, identify trends affecting our business, formulate business plans, and make strategic decisions.
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Clients
We have a strong track record of growing our client base, and we believe that our ability to increase the number of clients utilizing our Legal Technology solutions, including Nebula, is an important indicator of our market penetration, our business growth, and our future opportunities.
We define Legal Technology clients as each primary law firm and corporation to which we provided services in a litigation matter that we billed during the past two years. We define Nebula clients, each of which is included in the number of Legal Technology clients, as the total number of primary law firm, corporation, insurance company and service provider clients to which we provided legal technology solutions for a matter that we billed for use of our Nebula solution during the two years prior to the applicable date.
The following table sets forth the number of Legal Technology clients and Nebula clients as of the dates shown:
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|
|
|
|
|
|
|
|
|
|
March 31, |
|
|
|
2023 |
|
|
2022 |
|
Legal Technology clients |
|
|
6,091 |
|
|
|
5,563 |
|
Nebula clients |
|
|
1,718 |
|
|
|
1,293 |
|
Number and size of matters
We believe our ability to continuously grow the number of matters on our platform over time is an important measure of scale for our business and is indicative of our future growth prospects.
We define Legal Technology matters as the total number of matters on which our Legal Technology solutions were used in the twelve months preceding the applicable date. Matters refer to a range of activities that include collecting, tracking, analyzing, and exchanging relevant data. Legal Technology solutions currently drive the majority of our revenue, and provide the foundation for additional adoption of our proprietary technology solutions and other offerings. We define Nebula matters, which are included in the number of Legal Technology matters, as the total number of matters on which our Nebula solution was used in the twelve months preceding the applicable date. Nebula is our ecosystem of proprietary technology solutions that enables clients to collect, process, store, analyze, and govern their data on a single platform. Nebula comprises a steadily growing component of our revenue and we expect Nebula adoption to increase and the number of Nebula matters to grow in the long term as we continue to introduce new product capabilities and cross-sell Nebula to our existing clients.
The following table sets forth the number of Legal Technology matters and Nebula matters as of the dates shown:
|
|
|
|
|
|
|
|
|
|
|
March 31, |
|
|
|
2023 |
|
|
2022 |
|
Legal Technology matters |
|
|
8,078 |
|
|
|
7,877 |
|
Nebula matters |
|
|
1,231 |
|
|
|
1,009 |
|
Our comprehensive product offerings, technology-enabled service offerings and reputation as a trusted partner to our clients enable us to capture matters of large size and complexity. For the three months ended March 31, 2023 and 2022, 48% and 48% of Legal Technology revenue, respectively, was produced by matters that generated revenues of greater than $500,000, and 78% and 79% of our Legal Technology revenue, respectively, was produced by matters that generated revenues of greater than $100,000 during the relevant period.
Legal Technology net revenue retention
We calculate our Legal Technology net revenue retention rate by dividing (1) total Legal Technology revenue in the twelve-month period from accounts that generated Legal Technology revenue during the corresponding immediately preceding twelve month period by (2) total Legal Technology revenue in the immediately preceding twelve month period generated from those same accounts. Our Legal Technology net revenue retention rate includes revenue from use of Nebula.
|
|
|
|
|
|
|
Twelve Months Ended March 31, |
|
|
2023 |
|
2022 |
Legal Technology net revenue retention |
|
95% |
|
109% |
For the three months ended March 31, 2023 and 2022, our Legal Technology revenue was $82.0 million and $72.4 million, respectively, and our data recovery revenue was $8.7 million and $9.5 million, respectively.
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Our Legal Technology net revenue retention rate is impacted by our usage-based pricing model, and revenue could fluctuate in any given period due to frequency of matters, client upsell, cross-sell, and churn. We believe global macroeconomic challenges, including inflation and the war in Ukraine, had a significant adverse impact on the Company and the overall market in 2022. Large jobs were delayed and significant revenue opportunities that we typically rely on were not as abundant as we expected. Our revenues increased during the first quarter of this year as we saw an uptick in large jobs. In the long-term, we plan to increase our net revenue retention rate by increasing the number of solutions that we sell on a subscription-basis, as well as broadening the scope of our Nebula offerings, to promote strong product adoption. As we expand our products beyond eDiscovery to other information governance solutions such as big data hosting and processing, including through Nebula, we expect clients to leverage our technology earlier in the data lifecycle, providing further opportunity for us to increase our product and service penetration and client retention. Furthermore, we plan to establish and broaden our channel partnerships over time and leverage these strong relationships to further our awareness of our products and overall usage within the industry.
KEY COMPONENTS OF OUR RESULTS OF OPERATIONS
Revenue
The Company primarily generates revenue from selling solutions that fall into the following categories:
(1)Legal Technology, including Nebula and our expansive suite of technology solutions, such as our end-to-end eDiscovery technology solutions, managed review solutions, collections, processing, analytics, hosting, production, and professional services; and
(2)Data recovery solutions, which provides data restoration, data erasure and data management services.
The Company generates the majority of its revenues by providing Legal Technology solutions to our clients. Most of the Company’s eDiscovery contracts are time and materials types of arrangements, while others are subscription-based, fixed-fee arrangements.
Time and materials arrangements are based on units of data stored or processed. Unit-based revenues are recognized as services are provided, based on either the amount of data stored or processed, the number of concurrent users accessing the information or the number of pages or images processed for a client, at agreed upon per unit rates. The Company recognizes revenues for these arrangements utilizing a right-to-invoice practical expedient because it has a contractual right to consideration for services completed to date.
Certain of the Company’s eDiscovery contracts are subscription-based, fixed fee arrangements, which have tiered pricing based on the quantity of data hosted. For a fixed monthly fee, the Company’s clients receive a variety of optional eDiscovery solutions, which are included in addition to the data hosting. The Company recognizes revenues for these arrangements based on predetermined monthly fees as determined in its contractual agreements, utilizing a right-to-invoice practical expedient because the Company has a contractual right to consideration for services completed to date.
Other eDiscovery agreements are time and material arrangements that require the client to pay us based on the number of hours worked at contractually agreed-upon rates. The Company recognizes revenues for these arrangements based on hours incurred and contracted rates utilizing a right-to-invoice practical expedient because it has a contractual right to consideration for services completed to date.
Data recovery engagements are mainly fixed fee arrangements requiring the client to pay a pre-established fee in exchange for the successful completion of such engagement on a predetermined device. For the recovery performed by the Company’s technicians, the revenue is recognized at a point in time, when the recovered data is sent to the customer.
Data erasure engagements are also fixed fee arrangements for which revenue is recognized at a point in time when the certificate of erasure is sent to the customer.
The Company offers term license subscriptions to Ontrack PowerControls software to customers with on-premises installations of the software pursuant to contracts that are historically one to four years in length. The term license subscriptions include maintenance and support, as well as access to future software upgrades and patches. The license and the additional support services are deemed to be one performance obligation, and thus revenue for these arrangements is recognized ratably over the term of the agreement.
For the three months ended March 31, 2023 and 2022, our Legal Technology revenue was $82.0 million and $72.4 million, respectively, and our data recovery revenue was $8.7 million and $9.5 million, respectively. For the three months ended March 31, 2023 and 2022, Legal Technology revenue from our technology solutions other than Nebula was $73.8 million and $66.2 million respectively, and revenue from Nebula was $8.2 million and $6.1 million, respectively.
We currently expect non-Nebula Legal Technology revenues to remain relatively consistent over time and that Nebula revenue will continue to accelerate, with Nebula growing as a larger percentage of the mix of total revenue over time.
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Cost of Revenues
Cost of revenue consists primarily of technology infrastructure costs, personnel costs and amortization of capitalized developed technology costs. Infrastructure costs include hardware, software, occupancy and cloud costs to support our legal technology and data recovery solutions. Personnel costs include salaries, benefits, bonuses, and stock-based compensation as well as costs associated with document reviewers which are variable based on managed review revenue. We intend to continue to invest additional resources in our infrastructure to expand the capability of solutions and enable our customers to realize the full benefit of our solutions. The level, timing and relative investment in our cloud infrastructure could affect our cost of revenue in the future. Additionally, cost of revenue in future periods could be impacted by fluctuations in document reviewer costs associated with managed review revenue.
Operating expenses
Our operating expenses consist of research and development, sales and marketing, general and administrative and amortization and depreciation expenses. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, share-based compensation and sales commissions. Operating expenses also include occupancy, software expense and professional services. We intend to continue to increase our investment in research and development to further develop our proprietary technology and support further penetration and adoption of our offerings, including our end-to-end Nebula platform, including through hiring additional personnel. We expect these investments to cause research and development expense to slightly increase over the prior year, while staying fairly consistent as a percentage of revenue in 2023 and thereafter. We expect sales and marketing expense to decline in the next year as we realize the full year benefits of the optimization of data recovery personnel as we unified our inbound and business development teams. The optimization of personnel combined with anticipated increased revenue will result in slightly decreasing sales and marketing expense as a percentage of revenue in the next year and normalizing as a percentage of revenues thereafter. We also expect general and administrative expense to decrease in the next year due to savings associated with the consolidation of our real estate footprint, as well as vacated lease costs and public offering costs that are not expected to recur in 2023. General and administrative expense as a percentage of revenue is expected to decline over time due to our ability to scale as revenues increase and as a result of historical cost-cutting measures.
Interest Expense
Interest expense consists primarily of interest payments and accruals relating to outstanding borrowings. We expect interest expense to vary each reporting period depending on the amount of outstanding borrowings and prevailing interest rates.
Income Tax Provision
The income tax provision is primarily related to foreign tax activity and U.S. deferred taxes for tax deductible goodwill and other indefinite-lived liabilities. We maintain a valuation allowance on our federal and state deferred tax assets as we have concluded that it is not more likely than not that the deferred assets will be utilized.
Non-U.S. GAAP Financial Measures
We prepare financial statements in accordance with U.S. GAAP. We also disclose and discuss other non-U.S. GAAP financial measures such as EBITDA and adjusted EBITDA. Our management believes that these measures are relevant and provide useful supplemental information to investors by providing a baseline for evaluating and comparing our operating performance against that of other companies in our industry.
Our management believes EBITDA and Adjusted EBITDA reflect our ongoing operating performance because the isolation of non-cash charges, such as amortization and depreciation, and other items, such as interest, income taxes, equity compensation, acquisition and transaction costs, restructuring costs, systems establishment costs and costs associated with strategic initiatives which are incurred outside the ordinary course of our business, provides information about our cost structure and helps us to track our operating progress. We encourage investors and potential investors to carefully review our U.S. GAAP financial measures and compare them with our EBITDA and adjusted EBITDA. The non-U.S. GAAP financial measures that we use may not be comparable to similarly titled measures reported by other companies and in the future, we may disclose different non-U.S. GAAP financial measures in order to help our investors meaningfully evaluate and compare our results of operations to our previously reported results of operations or to those of other companies in our industry.
EBITDA and Adjusted EBITDA
We define EBITDA as net income (loss) plus interest (income) expense, income tax expense (benefit), extinguishment of debt, impairment losses, and depreciation and amortization. We view adjusted EBITDA as an operating performance measure and as such, we believe that the most directly comparable U.S. GAAP financial measure is net loss. In calculating adjusted EBITDA, we exclude from net loss certain items that we believe are not reflective of our ongoing business as the exclusion of these items allows
20
us to provide additional analysis of the financial components of the day-to-day operation of our business. We have outlined below the type and scope of these exclusions:
•Acquisition, financing and transaction costs generally represent earn-out payments, rating agency fees and letter of credit and revolving facility fees, as well as professional service fees and direct expenses related to acquisitions and public offerings. Because we do not acquire businesses or effect financings on a regular or predictable cycle, we do not consider the amount of these costs to be a representative component of the day-to-day operating performance of our business.
•Stock compensation and other primarily represent portions of compensation paid to our employees and executives through stock-based instruments. Determining the fair value of the stock-based instruments involves a high degree of judgment and estimation and the expenses recorded may not align with the actual value realized upon the future exercise or termination of the related stock-based awards. Additionally, stock compensation is a non-cash expense. Therefore, we believe it is useful to exclude stock-based compensation to better understand the long-term performance of our core business.
•Change in fair value of Private Warrants relates to changes in the fair market value of the Private Warrants issued in conjunction with the Business Combination. We do not consider the amount to be representative of a component of the day-to-day operating performance of our business.
•Restructuring costs generally represent non-ordinary course costs incurred in connection with a change in a contract or a change in the makeup of our personnel often related to an acquisition, such as severance payments, recruiting fees and retention charges. We do not consider the amount of restructuring costs to be a representative component of the day-to-day operating performance of our business.
•Systems establishment costs relate to non-ordinary course expenses incurred to develop our IT infrastructure, including system automation and enterprise resource planning system implementation. We do not consider the amount to be representative of a component of the day-to-day operating performance of our business.
Our presentation of adjusted EBITDA should not be construed as an inference that our future results will be unaffected by any of these adjustments, or that our projections and estimates will be realized in their entirety or at all. In addition, because of these limitations, adjusted EBITDA should not be considered as a measure of liquidity or discretionary cash available to us to fund our cash needs, including investing in the growth of our business and meeting our obligations.
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The use of EBITDA and adjusted EBITDA instead of U.S. GAAP measures has limitations as an analytical tool, and adjusted EBITDA should not be considered in isolation, or as a substitute for analysis of our results of operations and operating cash flows as reported under U.S. GAAP. For example, EBITDA and adjusted EBITDA do not reflect:
•our cash expenditures or future requirements for capital expenditures;
•changes in, or cash requirements for, our working capital needs;
•interest expense, or the cash requirements necessary to service interest or principal payments, on our indebtedness;
•any cash income taxes that we may be required to pay;
•any cash requirements for replacements of assets that are depreciated or amortized over their estimated useful lives and may have to be replaced in the future; or
•all non-cash income or expense items that are reflected in our statements of cash flows.
See “—Results of Operations” below for reconciliations of adjusted EBITDA to net loss.
RESULTS OF OPERATIONS
For the three months ended March 31, 2023 compared with the three months ended March 31, 2022
The results for the periods shown below should be reviewed in conjunction with our unaudited condensed consolidated financial statements included in “Item 1. Financial Statements.”
The following table sets forth statements of operations data for each of the periods indicated:
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|
|
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For the Three Months Ended March 31, |
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(in millions) |
|
2023 |
|
|
2022 |
|
|
|
|
|
|
|
|
Revenues |
|
$ |
90.7 |
|
|
$ |
81.9 |
|
Cost of revenues |
|
|
43.6 |
|
|
|
43.3 |
|
Gross profit |
|
|
47.1 |
|
|
|
38.6 |
|
Operating expenses |
|
|
35.7 |
|
|
|
35.4 |
|
Income from operations |
|
|
11.4 |
|
|
|
3.2 |
|
Interest expense |
|
|
15.8 |
|
|
|
12.7 |
|
Change in fair value of Private Warrants |
|
|
(0.2 |
) |
|
|
(0.2 |
) |
Loss before income taxes |
|
|
(4.2 |
) |
|
|
(9.2 |
) |
Income tax provision |
|
|
0.3 |
|
|
|
0.4 |
|
Net loss |
|
|
(4.5 |
) |
|
|
(9.6 |
) |
Total other comprehensive income (loss), net of tax |
|
|
0.8 |
|
|
|
(2.1 |
) |
Comprehensive loss |
|
|
(3.7 |
) |
|
|
(11.7 |
) |
Adjusted EBITDA
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|
|
|
|
|
|
|
|
|
|
For the Three Months Ended March 31, |
|
(in millions) |
|
2023 |
|
|
2022 |
|
Net Loss |
|
$ |
(4.5 |
) |
|
$ |
(9.6 |
) |
Interest expense |
|
|
15.8 |
|
|
|
12.7 |
|
Income tax provision |
|
|
0.3 |
|
|
|
0.4 |
|
Depreciation and amortization expense |
|
|
6.6 |
|
|
|
7.8 |
|
EBITDA (1) |
|
$ |
18.2 |
|
|
$ |
11.3 |
|
Acquisition, financing and transaction costs |
|
|
1.8 |
|
|
|
1.4 |
|
Stock compensation and other |
|
|
0.8 |
|
|
|
1.1 |
|
Change in fair value of Private Warrants |
|
|
(0.2 |
) |
|
|
(0.2 |
) |
Restructuring costs |
|
|
0.1 |
|
|
|
0.1 |
|
Systems establishment costs |
|
|
0.2 |
|
|
|
0.4 |
|
Adjusted EBITDA (1) |
|
$ |
20.9 |
|
|
$ |
14.1 |
|
_______________________________
(1)EBITDA and adjusted EBITDA are non-GAAP measures. See “—Non-U.S. GAAP Financial Measures.”
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Revenues
Revenues increased by $8.8 million, or 10.7%, to $90.7 million for the three months ended March 31, 2023 as compared to $81.9 million for the three months ended March 31, 2022. This is due to an increase in Legal Technology revenue of $9.6 million resulting from an increase of $7.6 million from our technology solutions other than Nebula and an increase of $2.0 million from Nebula due to higher volume, partially offset by a decrease in data recovery revenue of $0.9 million as a result of a lower volume of large jobs.
Cost of Revenues
Cost of revenues increased by $0.3 million, or 0.7%, to $43.6 million for the three months ended March 31, 2023 as compared to $43.3 million for the three months ended March 31, 2022. This increase is primarily due to increased software expense of approximately $0.8 million and increased personnel expenses of $0.6 million due to increased bonuses and managed review wages, partially offset by decreased amortization of $1.2 million associated with acquired intangibles that have fully amortized. As a percentage of revenue, our cost of revenues for the three months ended March 31, 2023 decreased to 48.1% as compared to 52.9% for the three months ended March 31, 2022, and was primarily due to the higher revenue combined with the decrease in amortization expense.
Gross Profit
Gross profit increased by $8.5 million, or 22.0%, to $47.1 million for the three months ended March 31, 2023 as compared to $38.6 million for the three months ended March 31, 2022. Gross profit increased primarily due to the factors noted above. As a percentage of revenue, our gross profit for the three months ended March 31, 2023 increased to 51.9% as compared to 47.1% for the three months ended March 31, 2022, and was due to the increase in revenue noted above that was greater in percentage than the comparable increase in cost of revenues.
Operating Expenses
Operating expenses increased by $0.3 million, or 0.8%, to $35.7 million for the three months ended March 31, 2023 as compared to $35.4 million for the three months ended March 31, 2022. This increase is primarily the result of a $1.0 million increase in professional services, partially offset by a $0.4 million decrease in occupancy expense due to the consolidation of our real estate footprint and a $0.3 million decrease in marketing costs primarily associated with the optimization of our digital marketing program. As a percentage of revenue, our operating expenses for the three months ended March 31, 2023 decreased to 39.4% as compared to 43.2% for three months ended March 31, 2022.
Interest Expense
Interest expense increased by $3.1 million, or 24.4%, to $15.8 million for the three months ended March 31, 2023 as compared to $12.7 million for the three months ended March 31, 2022. The increase is primarily due to an increase in the variable interest rate on borrowings under the Amended 2021 Credit Agreement, which resulted in a $2.7 million increase in expense, and an increase in the debt balance due to the quarterly accruals of Paid in Kind ("PIK") interest on the Convertible Debentures issued by the Company, which resulted in a $0.2 million increase in interest expense.
Change in Fair Value of Private Warrants
For the three months ended March 31, 2023 the Company recorded a gain to the Private Warrants liability of $0.2 million and for the three months ended March 31, 2022 the Company recorded a loss of $0.2 million.
Income Tax Provision
During the three months ended March 31, 2023 and 2022, the Company recorded an income tax provision of $0.3 million and $0.4 million, respectively, resulting in an effective tax rate of (7.1)% and (4.3)%, respectively. These effective tax rates differ from the U.S. federal statutory rate primarily due to the effects of foreign tax rate differences, U.S. state and local income taxes and the valuation allowance against our domestic deferred tax assets. The effective rate for the three months ended March 31, 2023 decreased from the three months ended March 31, 2022 primarily due to a change in the allocation of our pre-tax earnings and losses among countries with differing statutory tax rates.
A valuation allowance has been established against our net U.S. federal and state deferred tax assets, including net operating loss carryforwards. As a result, our income tax provision is primarily related to foreign taxes and U.S. deferred taxes for tax deductible goodwill and other indefinite-lived liabilities.
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Net Loss
Net loss for the three months ended March 31, 2023 was $(4.5) million compared to $(9.6) million for the three months ended March 31, 2022. Net loss decreased for the three months ended March 31, 2023 as compared to the three months ended March 31, 2022 due to the factors noted above.
Liquidity and Capital Resources
Our primary cash needs are and have been to meet debt service requirements and to fund working capital and capital expenditures. We fund these requirements from cash generated by our operations, as well as funds available under our revolving credit facility discussed below. We may also seek to access the capital markets opportunistically from time-to-time depending on, among other things, financial market conditions. Although our eDiscovery solutions and information archiving services are billed on a monthly basis in arrears with amounts typically due within 30 to 45 days, the eDiscovery industry tends towards longer collectability trends. As a result, we have typically collected the majority of our eDiscovery accounts receivable within 90 to 120 days, which is consistent within the industry. With respect to our data recovery services, they are billed as the services are provided, with payments due within 30 days of billing. We typically collect our data recovery services accounts receivables within 30 to 45 days. Lastly, the majority of our data recovery software is billed monthly in advance with amounts typically due within 30 to 45 days; however, depending on the client contract, billing can occur annually, quarterly or monthly. Long outstanding receivables are not uncommon due to the nature of our Legal Technology services as litigation cases can continue for years, and in certain instances, our collections are delayed until the customer has received payment for their services in connection with a legal matter or the case has been settled. These long-outstanding invoices are a function of the industry in which we operate, rather than indicative of an inability to collect. We have experienced no material seasonality trends as it relates to collection of our accounts receivable. As of March 31, 2023, we had $26.3 million in cash compared to $32.6 million as of December 31, 2022. We expect to finance our operations over the next 12 months primarily through existing cash balances and cash flow from operating activities.
Our Debentures mature in December 2024 and our Initial Term Loans and Revolving Credit Loans mature on February 8, 2026, unless the Debentures are outstanding six months prior to the December 19, 2024 maturity date thereof, in which case the loans outstanding under the Amended 2021 Credit Agreement mature on June 19, 2024. Our ability to refinance and/or replace our outstanding debt securities and credit facilities on acceptable terms, or at all, will depend on, among other things, our financial performance and credit ratings, general economic factors, including inflation and then-current interest rates, the condition of the credit and capital markets and other events, some of which may be beyond our control.
Amended 2021 Credit Agreement
On February 8, 2021, certain subsidiaries of the Company, or the Loan Parties, entered into a new secured credit agreement, or the 2021 Credit Agreement. Proceeds were used to pay in full all outstanding loans and terminate all lending commitments under the previously outstanding 2016 credit agreement.
On March 3, 2023, the Loan Parties entered into the First Amendment to the 2021 Credit Agreement. The First Amendment to the 2021 Credit Agreement provides for the revision of the benchmark interest rate from LIBOR to the secured overnight financing rate, (“SOFR”). At March 31, 2023, all outstanding indebtedness under the Amended 2021 Credit Agreement automatically converted from a LIBOR based loan to the new SOFR based loan at the end of the then-current applicable Interest Period. Additionally, the First Amendment to the 2021 Credit Agreement provides for the addition of the Term SOFR Adjustment of 0.10%, based on the term of the applicable Interest Period, to be added to the Applicable Rate for both SOFR Loans and Base Rate Loans (capitalized terms as defined in the Amended 2021 Credit Agreement).
The Amended 2021 Credit Agreement provides for (i) initial term loans in an aggregate principal amount of $300 million, or the Initial Term Loans, (ii) delayed draw term loans in an aggregate principal amount of $50 million, or the Delayed Draw Term Loans, and (iii) revolving credit loans in an aggregate principal amount of $40 million, with a letter of credit sublimit of $10 million, or the Revolving Credit Loans. The Delayed Draw Term Loans were available to the Loan Parties at any time prior to February 8, 2023, subject to certain conditions. As of March 31, 2023, there were no outstanding Delayed Draw Term Loans.
The Initial Term Loans bear, and while they were available, the Delayed Draw Term Loans bore, interest, at the Loan Parties’ option, at the rate of (x) with respect to SOFR Rate Loans, the Adjusted SOFR Rate with a 1.00% floor, plus 6.50% per annum, plus the Term SOFR Adjustment of 0.10% or (y) with respect to Base Rate Loans, the Base Rate plus 5.50% per annum, plus the Term SOFR Adjustment of 0.10%.
The Revolving Credit Loans bear interest, at our option, at the rate of (x) with respect to SOFR Rate Loans, the Adjusted SOFR Rate plus 4.00% per annum, or (y) with respect to Base Rate Loans, the Base Rate plus 3.00% per annum. The Initial Term Loans amortize at a rate of 1.00% of the aggregate principal amount of Initial Term Loans outstanding, payable in consecutive quarterly installments of $0.8 million, beginning on June 30, 2021. On March 31, 2023, the balance due was $294.0 million with an interest rate of 4.89833% plus an Adjusted Term SOFR Rate of 6.60%.
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The Initial Term Loans and Revolving Credit Loans are each scheduled to mature on February 8, 2026, unless the Debentures are outstanding six months prior to the December 19, 2024 maturity date thereof, in which case the Amended 2021 Credit Agreement matures on June 19, 2024. The Initial Term Loans may be voluntarily repaid at any time, but may be subject to a prepayment premium. The Initial Term Loans are required to be repaid under certain circumstances, including with Excess Cash Flow (as defined in the Amended 2021 Credit Agreement), the proceeds of an Asset Sale or Casualty Event (each as defined in the Amended 2021 Credit Agreement) and the proceeds of certain refinancing indebtedness.
The obligations under the Amended 2021 Credit Agreement are secured by substantially all of the Loan Parties’ assets. The Amended 2021 Credit Agreement contains customary affirmative and negative covenants as well as a financial maintenance covenant that requires the Loan Parties to maintain a First Lien Net Leverage Ratio (as defined in the Amended 2021 Credit Agreement) of less than or equal to 7.00 to 1.00, tested at the end of each fiscal quarter. The Company was in compliance with all Amended 2021 Credit Agreement covenants as of March 31, 2023.
Revolving Credit Loans
The Amended 2021 Credit Agreement also provides for an unfunded revolver commitment for borrowing up to $40.0 million (the “Revolving Credit Loans”). As of March 31, 2023, there was $39.4 million available capacity for borrowing under the revolving loan commitment due to the $0.6 million of letters of credit outstanding (See Note 8 – Commitments and Contingencies).
Convertible Debentures
On December 19, 2019, the Company issued Convertible Debentures, which mature in 2024, in an aggregate principal amount of $200 million (the “Debentures” or the “Convertible Debentures”). At March 31, 2023 and December 31, 2022, the balance due under the Convertible Debentures was $247.3 million and $244.8 million, respectively.
The Debentures will mature on December 19, 2024 unless earlier converted, redeemed or repurchased, and bear interest at an annual rate of 4.00% in cash, payable quarterly, and 4.00% in kind, accrued quarterly, on the last business day of March, June, September and December. In addition, on each anniversary of December 19, 2019 (the "Closing Date"), the Company will increase the principal amount of the Debentures by an amount equal to 3.00% of the original aggregate principal amount of the Debentures outstanding (subject to reduction for any principal amount repaid). The additional payment will accrue from the last payment date for the additional payment (or the Closing Date if no prior payment has been made), and will also be payable at maturity, upon conversion and upon an optional redemption.
At any time, upon notice as set forth in the Debentures, the Debentures will be redeemable at the Company’s option, in whole or in part, at a price equal to 100% of the principal amount of the Debentures redeemed, plus accrued and unpaid interest thereon.
The Debentures are convertible into shares of common stock at the option of the Debenture holders at any time and from time to time at a price of $18 per share, subject to certain adjustments. However, in the event the Company elects to redeem any Debentures, the holders have a right to purchase common stock from the Company in an amount equal to the amount redeemed at the conversion price.
The Debentures contain covenants that limit the Company’s ability to, among other things: (i) incur additional debt; (ii) create liens on assets; (iii) engage in certain transactions with affiliates; or (iv) designate the Company’s subsidiaries as unrestricted subsidiaries. The Debentures provide for customary events of default, including non-payment, failure to comply with covenants or other agreements in the Debentures and certain events of bankruptcy or insolvency. If an event of default occurs and continues, the holders of at least 25% in aggregate principal amount of the outstanding Debentures may declare the entire principal amount of all the Debentures to be due and payable immediately. As of March 31, 2023, the Company was in compliance with all Debenture covenants.
Cash Flows
Our net cash flows from operating, investing and financing activities for the three months ended March 31, 2023 and 2022 were as follows:
|
|
|
|
|
|
|
|
|
(in thousands) |
|
Three Months Ended March 31, 2023 |
|
|
Three Months Ended March 31, 2022 |
|
Net cash (used in) provided by: |
|
|
|
|
|
|
Operating activities |
|
$ |
(3,046 |
) |
|
$ |
(3,646 |
) |
Investing activities |
|
$ |
(2,072 |
) |
|
$ |
(2,968 |
) |
Financing activities |
|
$ |
(1,283 |
) |
|
$ |
(1,281 |
) |
Effect of foreign exchange rates |
|
$ |
117 |
|
|
$ |
(170 |
) |
Net decrease in cash |
|
$ |
(6,284 |
) |
|
$ |
(8,065 |
) |
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Cash Flows Used in Operating Activities
Net cash used in operating activities was $3.0 million compared to net cash used in operating activities of $3.6 million for the three months ended March 31, 2023 and 2022, respectively. The decrease in net cash used in operating activities is due to a decreased net loss of $5.1 million, partially offset by a decrease in cash provided by working capital of $3.2 million and decreased non-cash items of $1.3 million. The decrease of $3.2 million in cash provided by working capital is primarily due to a $0.4 million decrease in accounts receivable, a $2.3 million decrease in accounts payable and accrued expenses, a $0.8 million decrease in prepaid expenses and other assets, partially offset by a $0.3 million increase in deferred revenue. Accounts Receivable and Accounts Payable fluctuate from period-to-period depending on the timing of purchases and payments.
Cash Flows Used in Investing Activities
Net cash used in investing activities was $2.1 million for the three months ended March 31, 2023 as compared to net cash used in investing activities of $3.0 million for the three months ended March 31, 2022. The decrease in cash used is due to a $0.9 million decrease in purchases of property and equipment.
Cash Flows Used in Financing Activities
For both the three months ended March 31, 2023 and March 31, 2022, net cash used in financing activities was $1.3 million related to the repayments of long-term debt of $0.8 million and capital lease obligations of $0.5 million.
Capital Resources and Material Cash Requirements
A summary of our capital resources and material cash requirements is presented in Part II, Item 7 of our Annual Report. Other than as described above, there were no material changes to our capital resources and material cash requirements during the three months ended March 31, 2023.
Recent Accounting Pronouncements
There were no changes to our recent accounting pronouncements from those described in our Annual Report.
Critical Accounting Policies and Estimates
We prepare our condensed consolidated financial statements in accordance with U.S. GAAP. In applying accounting principles, it is often required to use estimates. These estimates consider the facts, circumstances and information available, and may be based on subjective inputs, assumptions and information known and unknown to us. Material changes in certain of the estimates that we use could potentially affect, by a material amount, our consolidated financial position and results of operations. Although results may vary, we believe our estimates are reasonable and appropriate. There were no changes to our critical accounting policies from those described in our Annual Report.