# INNODATA INC (INOD) FY 2021 MD&A

Verbatim Item 7 Management's Discussion and Analysis from INNODATA INC's 10-K for fiscal year 2021.

SEC filing source: https://www.sec.gov/Archives/edgar/data/903651/000141057822000489/inod-20211231x10k.htm
Accession: 0001410578-22-000489
Filing date: 2022-03-24
Report date: 2021-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/INOD/
All MD&A years: /company/INOD/mda/
Next year: /company/INOD/mda/fy2022/ (FY 2022)

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

The following discussion should be read in conjunction with our consolidated financial statements and the related notes thereto included elsewhere in this Report. In addition to historical information, this discussion includes forward-looking information that involves risks and assumptions based upon management’s current expectations. Our actual results could differ materially from the results referred to in any forward-looking statements. See “Cautionary Note Regarding Forward-Looking Statements” included elsewhere in this Report.

Executive Overview

We are a global data engineering company. We operate in three reporting segments: Digital Data Solutions (DDS), Synodex and Agility.

The following table sets forth certain financial data for the two years ended December 31, 2021 and 2020:

​

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​

For a summary of our Critical Accounting Estimates and Policies, please refer to Note 1 of the Notes to our Consolidated Financial Statements, which are included elsewhere in this Report.

Results of Operations

Amounts in the MD&A below have been rounded. All percentages have been calculated using rounded amounts.

Year Ended December 31, 2021 Compared to the Year Ended December 31, 2020

Revenues

Total revenues were $69.7 million and $58.2 million for the years ended December 31, 2021 and 2020, respectively, an increase of $11.5 million or approximately 20%.

Revenues from the DDS segment were $52.6 million and $42.0 million for the years ended December 31, 2021 and 2020, respectively, an increase of $10.6 million or approximately 25%.  The increase was due to higher volume from one client, partially offset by lower volume from two clients.

Revenues from the Synodex segment were $4.2 million and $4.8 million for the years ended December 31, 2021 and 2020, respectively, a decrease of $0.6 million or approximately 13%. The decrease was primarily due to lower volume from three clients.

Revenues from the Agility segment were $13.0 million and $11.4 million for the year ended December 31, 2021 and 2020 respectively, an increase of $1.6 million or approximately 14%. The increase was attributable to higher revenues from subscriptions to our Agility media database.

One client in the DDS segment generated approximately 11% and 14% of the Company’s total revenues in the fiscal years ended December 31, 2021 and 2020, respectively. No other client accounted for 10% or more of total revenues during these periods. Further, in the years ended December 31, 2021 and 2020, revenues from non-U.S. clients accounted for 45% and 54% of the Company’s revenues respectively.

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Direct Operating Costs

Direct operating costs consist of direct and indirect labor costs, occupancy costs, data center hosting fees, content acquisition costs, depreciation and amortization, travel, telecommunications, computer services, and supplies, realized gain (loss) on forward contracts, foreign currency remeasurement gain (loss), and other direct expenses that are incurred in providing services to our clients.

Direct operating costs were $43.5 million and $38.4 million for the years ended December 31, 2021 and 2020, respectively, an increase of $5.1 million or approximately 13%. These cost increases primarily supported our current and growth initiatives. Direct operating costs increases include labor related costs of $5.6 million, higher amortization of capitalized developed software and depreciation of $0.8 million, and a reversal of a one-time charge of $0.4 million in the prior year for an assessment of retroactive foreign social security contributions that was successfully adjudicated. These cost increases were offset in part by the favorable impact of foreign exchange rate fluctuations of $0.6 million, and continuing cost optimizations resulting in a reduction of occupancy and technology related costs of $1.1 million. Direct operating costs as percentage of total revenues were approximately 62% and 66% for the years ended December 31, 2021 and 2020, respectively. The decrease in direct operating costs as a percentage of revenues during the year was primarily due to increased revenue, offset in part by an increase in direct operating costs.

Direct operating costs for the DDS segment were $31.8 million and $28.5 million for the years ended December 31, 2021 and 2020, respectively, an increase of $3.3 million or approximately 12%. These cost increases primarily supported our current and growth initiatives. Direct operating costs increases include labor related costs of $4.1 million, a reversal of a one-time charge of $0.4 million in the prior year for an assessment of retroactive foreign social security contributions that was successfully adjudicated, and other increases of $0.3 million. These cost increases were offset in part by the favorable impact of foreign exchange rate fluctuations of $0.6 million, and continuous cost optimization resulting in a reduction of occupancy and technology related costs of $0.9 million. Direct operating costs for the DDS segment as a percentage of DDS segment revenues were approximately 60% and 68% for the years ended December 31, 2021 and 2020, respectively. The decrease in direct operating costs of the DDS segment as a percentage of DDS segment revenues during the year was primarily due to increased revenue, offset in part by an increase in direct operating costs.

Direct operating costs for the Synodex segment were approximately $4.4 million and $3.4 million for the years ended December 31, 2021 and 2020, respectively, an increase of $1.0 million or approximately 29%. The increase was primarily due to labor-related costs supporting current and future growth initiatives. Direct operating costs for the Synodex segment as a percentage of segment revenues were approximately 105% and 71% for the years ended December 31, 2021 and 2020, respectively. The increase in direct operating costs of the Synodex as a percentage of Synodex segment revenues during the year was primarily due to decreased revenues and increased direct operating costs.

Direct operating costs for the Agility segment were approximately $7.3 million and $6.5 million for the years ended December 31, 2021 and 2020, respectively, an increase of $0.8 million or approximately12%. This increase was primarily due to higher depreciation and amortization of capitalized developed software of $0.7 million and an increase in labor related costs of $0.1million. Direct operating costs for the Agility segment as a percentage of Agility segment revenues were approximately 56% and 57% for the years ended December 31, 2021 and 2020, respectively. The decrease in direct operating costs of the Agility as a percentage of Agility segment revenues during the year was primarily due to higher revenue from subscriptions to our Agility intelligent data platform and newswire products, offset in part by an increase in direct operating costs.

Selling and Administrative Expenses

Selling and administrative expenses consist of management and administrative payroll and related costs including, commissions, bonuses and stock-based compensation, marketing costs, new services research and related software development, third-party software, advertising and trade conferences, professional fees and consultant costs, and other administrative overhead costs.

Selling and administrative expenses were approximately $27.9 million and $18.7 million for the years ended December 31, 2021 and 2020, respectively, an increase of $9.2 million or approximately 49%. These cost increases supported our business growth strategies for sales expansion and product expansion. Selling and administrative cost increases include payroll-related costs for new hires, including commissions, incentives and stock-based compensation to promote retention, and recruiting fees, of $7.5 million; marketing programs and activities to improve our visibility in the market of $1.6 million, and other increases of $0.1 million. Selling and administrative expenses as a percentage of total revenues were approximately 40% and 32% for the years ended December 31, 2021 and 2020, respectively. The increase in selling and administrative expenses as a percentage of revenues during the year was primarily due to increased selling and administrative costs, offset in part by an increase in revenues.

Selling and administrative expenses for the DDS segment were approximately $15.5 million and $12.4 million for the years ended December 31, 2021 and 2020 respectively, an increase of $3.1 million or approximately 25%. These cost increases supported our

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business growth strategies for sales expansion and product expansion. Selling and administrative cost increases include payroll-related costs for new hires, including commission, incentives and stock-based compensation to promote retention, and recruiting fees, of $2.6 million; marketing programs and activities to improve our visibility in the market of $0.6 million, offset in part by other decreases of $0.1 million. Selling and administrative expenses for the DDS segment as a percentage of DDS segment revenue were approximately 29% and 30% for the years ended December 31, 2021 and 2020, respectively. The increase in selling and administrative expenses as a percentage of revenues was due to increased selling and administrative expenses, offset by an increase in revenues.

Selling and administrative expenses for the Synodex segment were $1.3 million and $0.9 million for the years ended December 31, 2020 and 2021 respectively, an increase of $0.4 million or approximately 44%. This increase was primarily due to payroll related costs of new hires. Selling and administrative expenses for the Synodex segment as a percentage of Synodex segment revenues were approximately 31% and 19% for the years ended December 31, 2021 and 2020, respectively. The increase in selling and administrative expenses as a percentage of revenues was due to increased selling and administrative expenses and a decrease in revenues.

Selling and administrative expenses for the Agility segment were $11.1 million and $5.4 million for the years ended December 31, 2021 and 2020, respectively, an increase of $5.7 million or approximately 106%. These cost increases supported our business growth strategies for sales expansion and product expansion. Selling and administrative cost increases include payroll-related costs for new hires, including commission, incentives and stock-based compensation to promote retention, and recruiting fees, of $4.5 million; marketing programs and activities to improve our visibility in the market of $1.0 million, and other increases of $0.2 million. Selling and administrative expenses for the Agility segment as a percentage of Agility segment revenues were approximately 85% and 47% for the years ended December 31, 2021 and 2020, respectively. The increase in selling and administrative expenses as a percentage of revenues was due to increased selling and administrative expenses, offset in part by increased revenues.

Goodwill Impairment

On September 30, 2021, we performed our annual goodwill assessment for the Agility segment in accordance with the provisions of the FASB’s Accounting Standards Update (“ASU”) 2017-04, “Intangibles – Goodwill and Other (Topic 350)”, by using a single-step approach that evaluates the carrying value of the reporting unit and compares it against the reporting unit’s fair value. The Company determined that there was no impairment of long-lived intangible assets as of September 30, 2021.

Gain on PPP Loan Forgiveness

On May 4, 2020, we received loan proceeds of $579,700 under the Paycheck Protection Program (“PPP”) which was established as part of the Coronavirus Aid, Relief and Economic Security Act of 2020, as amended (“CARES Act”). On May 21, 2021, the Small Business Administration approved our loan forgiveness application for 100% of the loan proceeds.

Income Taxes

We recorded a provision for income taxes of approximately $0.8 million and $0.4 million for the years ended December 31, 2021 and 2020, respectively. Tax-related charges primarily consisted of a provision for foreign taxes recorded in accordance with the local tax regulations by our foreign subsidiaries. Effective income tax rates are disproportionate primarily due to the valuation allowance recorded on the deferred taxes on the U.S. and Canadian entities. See Note 4, “Income Taxes” of the notes to the consolidated financial statements for additional information.

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The reconciliation of the U.S. statutory rate with the Company’s effective tax rate for the years ended December 31, 2021 and 2020 are summarized in the table below:

​

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​

Despite access to overseas earnings and the resulting toll charge, we intend to indefinitely reinvest earnings and profits in our foreign subsidiaries on account of the foreign jurisdiction withholding taxes that we would have to incur on the actual remittances. Unremitted foreign earnings and profits amounted to approximately $50.0 million at December 31, 2021. If such foreign earnings and profits are repatriated in the future, or are no longer deemed to be indefinitely reinvested, we would have to accrue the applicable amount of foreign jurisdiction withholding taxes associated with such remittances.

We have a valuation allowance on all of our U.S. deferred tax assets on account of continuing losses incurred by our U.S. entity. In addition, we also have a valuation allowance on the deferred tax assets of our Canadian subsidiaries. Our Canadian subsidiaries also have research and development credits available to reduce taxable income in future years, which may be carried forward indefinitely. The potential benefits from these balances have not been recognized for financial statement purposes.

Tax Assessments

In September 2015, our Indian subsidiary was subject to an inquiry by the Service Tax Department in India regarding the classification of services provided by this subsidiary, asserting that the services provided by this subsidiary fall under the category of online information and database access or retrieval services (OID Services), and not under the category of business support services (BS Services) that are exempt from service tax as historically indicated in the subsidiary’s service tax filings. We disagree with the Service Tax Department’s position. In November 2019, the Commissioner of Central Tax, GST & Central Excise issued an order confirming the Service Tax Department’s position. We are vigorously contesting this order in an appeal to the Customs, Excise and Service Tax Appellate Tribunal. In the event the Service Tax Department is ultimately successful in proving that the services fall under the category of OID Services, the revenues earned by our Indian subsidiary for the period July 2012 through November 2016 would be subject to a service tax of between 12.36% and 15%, and this subsidiary may also be liable to pay interest and penalties. The revenue of our Indian subsidiary during this period was approximately $63.0 million. In accordance with new rules promulgated by the Service Tax Department, as of December 1, 2016 service tax is no longer applicable to OID or BS Services. Based on our assessment, in consultation with our tax counsel, we have not recorded any tax liability for this case.

In a separate action relating to service tax refunds, in October 2016, our Indian subsidiary received notices from the Indian Service Tax Department in India seeking to reverse service tax refunds of approximately $160,000 previously granted to our Indian subsidiary for three quarters in 2014, asserting that the services provided by this subsidiary fall under the category of OID Services and not BS Services. The appeal was determined in favor of the Service Tax Department. We disagree with the basis of this decision and are contesting it vigorously. We expect delays in our Indian subsidiary receiving further service tax refunds until this matter is adjudicated with finality, and currently have service tax credits of approximately $1.0 million recorded as a receivable. Based on our assessment, in consultation with our tax counsel, we have not recorded any tax liability for this case.

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Net Income (Loss)

We had a net loss of $1.8 million during the year ended December 31, 2021, compared to a net income of $0.6 million during the year ended December 31, 2020.  The $2.4 million change was due to higher operating expenses of $14.3 million and an increase in tax provision of $0.4 million, partially offset by higher revenues of $11.6 million, gain on loan forgiveness of $0.6 million and net interest income of $0.1 million.

Net income for the DDS segment was $5.0 million for the year ended December 31, 2021, compared to a net income of $0.3 million for the year ended December 31, 2020. The $4.7 million improvement was due to higher revenues of $10.6 million, a gain on loan forgiveness of $0.6 million and net interest income of $0.1 million, partially offset by higher operating expenses of $6.4 million and tax provision of $0.2 million.

Net loss for the Synodex segment was $1.5 million for the year ended December 31, 2021, compared to net income of $0.5 million for the year ended December 31, 2020. The $2.0 million change was primarily due to higher operating expenses of $1.4 million and lower revenue of $0.6 million.

Net loss for the Agility segment was $5.3 million for the year ended December 31, 2021, compared to a net loss of $0.2 million for the year ended December 31, 2020. The $5.1 million increase in loss was primarily due to higher operating costs of $6.5 million and an increase in tax provision of $0.2 million, partially offset by an increase in revenues of $1.6 million.

Liquidity and Capital Resources

Selected measures of liquidity and capital resources, expressed in thousands, are as follows:

​

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​

On December 31, 2021, we had cash and cash equivalents of $18.9 million, of which $12.6 million was held by our foreign subsidiaries, and $6.3 million was held in the U.S. Despite the passage of the new tax law under which we may repatriate funds from overseas after paying the toll charge, it is our intent, as of December 31, 2021, to indefinitely reinvest the overseas funds in our foreign subsidiaries due to the withholding tax that we would have to incur on the actual remittances.

We have used, and plan to use, our cash and cash equivalents for (i) capital investments; (ii) the expansion of our other operations; (iii) technology innovation; (iv) product management and strategic marketing; (v) general corporate purposes, including working capital; and (vi) possible business acquisitions. As of December 31, 2021, we had working capital of approximately $12.7 million, as compared to working capital of approximately $13.5 million as of December 31, 2020. The decrease in working capital is due to higher liabilities associated with payroll-related accruals.

Gain on PPP Loan Forgiveness

On May 4, 2020, we received loan proceeds of $579,700 under the PPP which was established as part of the CARES Act. On May 21, 2021, the Small Business Administration approved our loan forgiveness application for 100% of the loan proceeds.

Proceeds from stock option exercises for the year ended December 31, 2021 were $2.2 million.

We did not have any material commitments for capital expenditures as of December 31, 2021.

We believe that our existing cash and cash equivalents and cash flows from operations will provide sufficient sources of liquidity to satisfy our financial needs for at least 12 months from the date of issuance of these financial statements. However, as we have no bank facilities or lines of credit, reductions in our cash and cash equivalents from operating losses, capital expenditures, adverse legal decisions, acquisitions or otherwise could materially and adversely affect the Company.

Net Cash Provided by Operating Activities

Cash provided by our operating activities for the year ended December 31, 2021 was $5.1 million and was the result of the net loss of $1.8 million, the effect of adjustments for non-cash items of $4.6 million and sources of working capital of $2.3 million.

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Adjustments for non-cash items primarily consisted of $2.9 million for depreciation and amortization, stock-based compensation of $1.8 million, pension cost of $ 0.5 million, offset in part by a gain on loan forgiveness of $0.6 million. Working capital activities primarily consisted of sources from a $4.4 million increase in accounts payable, accrued expenses and other, a $0.7 million increase in accrued salaries, wages and related benefits, a $0.5 million increase in prepaid expenses and other current assets and a $0.3 million increase in other assets, offset by a $1.9 million increase in accounts receivable and $1.7 million decrease in income and other taxes. Refer to the Consolidated Statements of Cash Flows for further details.

Cash provided by our operating activities for the year ended December 31, 2020 was $5.7 million and was the result of the net income of $0.6 million, the effect of adjustments for non-cash items of $3.4 million and sources of working capital of $1.6 million. Adjustments for non-cash items primarily consisted of $2.3 million for depreciation and amortization, stock-based compensation of $0.9 million and $0.2 million for other non-cash items. Working capital activities primarily consisted of sources from a $1.4 million increase in accrued salaries, wages and related benefits, a $0.8 million increase in income and other taxes, offset by a $0.6 million increase in prepaid expenses and other current assets. Refer to the Consolidated Statements of Cash Flows for further details.

Our days’ sales outstanding were 56 days and 62 days December 31, 2021 and 2020, respectively. We calculate DSO by first dividing the total revenues for the period by average net accounts receivable, which is the sum of net accounts receivable at the beginning of the period and net accounts receivable at the end of the period, to yield an amount we refer to as the “accounts receivable turnover”. Then we divide the total number of days within the period reported by the accounts receivable turnover to yield DSO expressed in number of days.

Net Cash Used in Investing Activities

Cash used in our investing activities was $4.4 million and $1.4 million for the years ended December 31, 2021 and 2020, respectively. These capital expenditures were principally for the purchase of technology equipment including servers, network infrastructure and workstations, and expenditures for capitalized developed software. Capital expenditures for the year ended December 31, 2021 amounting to $4.4 million consisted of $2.1 million for the Agility segment, $1.7 million for the DDS segment and $0.6 million for the Synodex segment.

For calendar year 2022, we anticipate that capital expenditures for ongoing technology, equipment, new platform development, and infrastructure upgrades will approximate to $11.0 million, a portion of which we may finance.

Net Cash Used in Financing Activities

Cash provided by financing activities for the year ended December 31, 2021 was proceeds from stock option exercises of $2.2 million. Cash paid for withholding taxes on net settlement exercises of stock options for the year ended December 31, 2021 was $0.8 million. Payments of long-term obligations were $0.7 million for the year ended December 31, 2021.

Cash provided by financing activities for the year ended December 31, 2020 was proceeds from stock option exercises of $2.6 million and PPP loan proceeds of $0.6 million. Payments of long-term obligations were $0.9 million for the year ended December 31, 2020.

Inflation, Seasonality and Prevailing Economic Conditions

Although most of our revenues are denominated in U.S. dollars, a significant portion of our revenues is denominated in Canadian dollars, Pound Sterling and Euros. In addition, a significant portion of our expenses, primarily labor expenses in the Philippines, India, Sri Lanka, Germany, Canada and Israel, are incurred in the local currencies of the countries in which we operate. For financial reporting purposes, we translate all non-U.S. denominated transactions into U.S. dollars in accordance with U.S. GAAP. Thus, we are exposed to the risk that fluctuations in the value of these currencies relative to the U.S. dollar could have a direct impact on our revenues and our results of operations.

The Philippines and India have at times experienced high rates of inflation as well as major fluctuations in the exchange rate between the Philippine peso and the U.S. dollar and the Indian rupee and the U.S. dollar. As of December 31, 2021, the aggregate notional amount of our hedges against the Indian rupee was approximately $9.7 million, and against the Philippine peso was approximately $10.0 million.

Fluctuations in exchange rates also affect the value of funds held by our foreign subsidiaries. We do not currently intend to hedge these assets.

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Our most significant costs are the salaries and related benefits of our employees in Asia. We are exposed to high inflation in wage rates in the countries in which we operate. We generally perform work for our clients under project-specific contracts, requirements-based contracts or long-term contracts. We must adequately anticipate wage increases, particularly on our fixed-price contracts. There can be no assurance that we will be able to recover cost increases through increases in the prices that we charge for our services to our clients.

Our quarterly operating results are subject to certain fluctuations. We experience fluctuations in our revenue and earnings as we replace and begin new projects, which may have some normal start-up delays, or we may be unable to replace a project entirely. These and other factors may contribute to fluctuations in our operating results from quarter to quarter. In addition, as some of our Asian facilities are closed during holidays in the fourth quarter, we typically incur higher wages, due to overtime, that reduce our margins.

Our Synodex subsidiary experiences seasonal fluctuations in revenues. Typically, revenue is lowest in the third quarter of the calendar year and highest in the fourth quarter of the calendar year. The seasonality is directly linked to the number of life insurance applications received by the insurance companies.