Innerworkings (INWK) 10-Q2020 Q1 Quarterly report

The accompanying unaudited condensed consolidated financial statements of InnerWorkings, Inc. and subsidiaries (the “Company”) included herein have been prepared to conform to the rules and regulations of the Securities and Exchange Commission (the “SEC”) and generally accepted accounting principles in the United States (“GAAP”) for interim financial information. Footnote disclosures that would substantially duplicate the disclosures included in the December 31, 2019 audited financial statements have been omitted from these interim unaudited financial statements pursuant to such rules and regulations. In the opinion of management, all adjustments considered necessary for a fair presentation of the accompanying unaudited financial statements have been included, and all adjustments are of a normal and recurring nature. The operating results for the three month period ended March 31, 2020 are not necessarily indicative of the results to be expected for the full year ending December 31, 2020. These condensed consolidated interim financial statements and notes should be read in conjunction with the Company’s condensed consolidated financial statements and notes thereto as of and for the year ended December 31, 2019 included in the Company’s Annual Report on Form 10-K filed with the SEC on March 17, 2020.

During 2018, the Argentinian economy was classified as highly inflationary under GAAP due to multiple years of increasing inflation, resulting in the remeasurement of our Argentinian operations into U.S. dollars.  The application of highly inflationary accounting did not have a material impact on the Company’s condensed consolidated financial statements for the three months ended March 31, 2020 and 2019.

Accounts receivable are uncollateralized customer obligations due under normal trade terms. Payment terms with customers are generally 30 to 90 days from the invoice date. Accounts receivable are stated in the condensed consolidated financial statements at the amount billed to the customer, less an estimate for potential credit losses. Interest is not generally accrued on outstanding balances.

The Company records an allowance for credit losses at the time that accounts receivable are initially recorded based on consideration of the current economic environment, expectation of future economic conditions, the Company’s historical collection experience and a loss-rate approach whereby the allowance is calculated using an estimated historical loss rate formulated by the age of the financial asset and multiplying it by the asset’s amortized cost at the balance sheet date. The Company reassesses its allowance at each reporting period. Aged receivables are written off when it becomes evident, based on age or unique customer circumstance, that such amounts will not be collected and all reasonable collection efforts have been exhausted. The accounts receivable allowance expense is recorded within selling, general, and administrative expenses on the Company's Condensed Consolidated Statement of Comprehensive Loss.

The Company believes its allowances are appropriately stated considering the quality of its financial asset portfolio as of March 31, 2020. While credit losses have historically been within expectations and the provisions established, the Company cannot guarantee that its credit loss experience will continue to be consistent with historical experience.

The Company primarily generates revenue from the procurement of marketing materials for customers. Service revenue including creative, design, installation, warehousing and other services has not been material to the Company’s overall revenue to date. Products and services may be sold separately or in bundled packages. For bundled packages, the Company accounts for individual products and services separately if they are distinct - that is, if a product or service is separately identifiable from

The Company includes any fixed charges per its contracts as part of the total transaction price. The transaction price is allocated between separate products and services in a bundle based on their standalone selling prices. The standalone selling prices are generally determined based on the prices at which the Company separately sells the products and services.

Revenue is measured based on consideration specified in a contract with a customer. Contracts may include variable consideration (for example, customer incentives such as rebates), and to the extent that variable consideration is not constrained, the Company includes the expected amount within the total transaction price and updates its assumptions over the duration of the contract. The constraint will generally not result in a reduction in the estimated transaction price.

The Company’s performance obligations related to the procurement of marketing materials are typically satisfied upon shipment or delivery of its products to customers, at which time the Company recognizes revenue. Payment is typically due from the customer at this time or shortly thereafter. Unbilled revenue represents shipments or deliveries that have been made to customers for which the related account receivable has not yet been invoiced. The Company does not have material future performance obligations that extend beyond one year.

Some service revenue, including stand-alone creative and other services, may be recognized over time but the difference between recognizing that revenue over time versus at a point in time when the service is completed and accepted by the customer is not material to the Company’s overall revenue to date.

The Company capitalizes certain setup costs related to new customers as fulfillment costs. Capitalized contract costs are amortized over the expected period of benefit using the straight-line method which is generally three years.

Contract liabilities are referred to as deferred revenue in the condensed consolidated financial statements. We record deferred revenue when cash payments are received in advance of satisfying our performance obligations, and we recognize revenue as these obligations are satisfied.

For the three months ended March 31, 2020 and 2019, the amount of amortization was $0.1 million and $0.1 million, respectively, and there was no impairment loss in relation to the costs capitalized in either period presented.

The following table is a summary of the Company's costs to fulfill and contract liabilities (in thousands):

The Company incurs certain incremental costs to obtain a contract that the Company expects to recover. The Company applies a practical expedient and recognizes the incremental costs of obtaining contracts as an expense when incurred if the amortization period of the assets that the Company otherwise would have recognized is one year or less. These costs would primarily relate to commissions paid to our account executives and are included in selling, general and administrative expenses.

No incremental costs to obtain a contract incurred by the Company during the three months ended March 31, 2020 and 2019 were required to be capitalized.

ASC 606 requires that the Company disclose the aggregate amount of transaction price that is allocated to performance obligations that have not yet been satisfied as of March 31, 2020. The Company does not have material future performance

The following is a rollforward of goodwill for each reportable segment for the quarter ended March 31, 2020 (in thousands): 

As of March 31, 2020, the Company performed an interim impairment assessment due to a triggering event caused by a sustained decrease in the Company's stock price and lower outlook due to the deterioration in economic conditions caused by COVID-19. The Company determined a fair value for its North America reporting unit that considered both the discounted cash flow and guideline public company methods. The Company further compared the fair value of the reporting unit to its carrying value. The fair value for the North America reporting unit was less than its carrying value and resulted in a non-cash goodwill impairment charge of $7.2 million. No tax benefit was recognized on such charge, and this charge had no impact on the Company's cash flows or compliance with debt covenants.

The following is a summary of the Company’s intangible assets as of March 31, 2020 and December 31, 2019 (in thousands):

Amortization expense related to these intangible assets was $0.6 million and $0.5 million for the three months ended March 31, 2020 and 2019, respectively.

 

As of March 31, 2020, estimated amortization expense for the remainder of 2020 and each of the next five years and thereafter is as follows (in thousands):

On August 10, 2018, the Company approved a plan to reduce the Company's cost structure while driving value for its clients and stockholders. The plan was adopted as a result of the Company's determination that its selling, general and administrative costs were disproportionately high in relation to its revenue and gross profit. At the time of adoption, the plan was expected to be completed by the end of 2019 and the Company expected to incur pre-tax cash restructuring charges of $20.0 million to $25.0 million and pre-tax non-cash restructuring charges of $0.4 million. Where required by law, the Company consults with each of the affected country’s local Works Councils prior to implementing the plan. On February 21, 2019, the Board of Directors approved a two-year extension to the restructuring plan through the end of 2021.

On February 24, 2020, the Company approved an increase in the size of the 2018 Restructuring Plan. From adoption through completion of the plan, the Company expects to incur pre-tax cash restructuring charges of $35.0 million to $45.0 million and pre-tax non-cash restructuring charges of $0.5 million. Cash charges are expected to include $9.0 million to $12.0 million for employee severance and related benefits, $8.0 million to $10.0 million for consulting fees and lease and contract terminations,

The following table summarizes the accrued restructuring activities for this plan for the three months ended March 31, 2020 (in thousands):

The Company recorded the following restructuring costs by segment (in thousands):

On December 14, 2015, the Company approved a global realignment plan that allowed the Company to more efficiently meet client needs across its international platform. Through improved integration of global resources, the plan created back office and other efficiencies and allowed for the elimination of approximately 100 positions. In connection with these actions, the Company incurred total pre-tax cash restructuring charges of $6.7 million, the majority of which were recognized during 2016. These cash charges included approximately $5.6 million for employee severance and related benefits and $1.1 million for lease and contract terminations and other associated costs. The charges were all incurred by the end of 2016 with the final payouts occurring during the three months ended March 31, 2020.

The following table summarizes the accrued restructuring activities for this plan for the three months ended March 31, 2020 (in thousands), all of which relate to EMEA:

The Company's tax provision for interim periods is determined using an estimate of its annual effective tax rate, adjusted for discrete items. The Company’s reported effective income tax rate was 17.6% and 40.9% for the three months ended March 31, 2020 and 2019, respectively. The Company’s effective income tax rate differs from the U.S. federal statutory rate each year due to certain operations that are subject to tax incentives, state and local taxes, valuation allowances, impacts of the Tax Reform Act, and foreign tax rates that are different than the U.S. federal statutory tax rate. In addition, the effective tax rate can be impacted each period by discrete factors and events such as a write-off of a deferred tax asset for stock‑based compensation due to the expiration of unexercised stock options and prior year provision to return adjustments.

   

Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will expire unutilized. At the end of each reporting period, the Company reviews the realizability of its deferred tax assets. There were no material valuation adjustments for the three months ended March 31, 2020 and 2019. Additionally, the Company continues to incur losses in jurisdictions which have valuation allowances against tax loss carryforwards, so a tax benefit has not been recognized in the financial statements for these losses.

The computation of basic and diluted loss per share is as follows (in thousands, except per share amounts):

In the fourth quarter of 2017, the Company began providing marketing execution services to Enova International, Inc. ("Enova"). David Fisher, a member of the Company's Board of Directors, is the Chairman and Chief Executive Officer of Enova and has a direct ownership interest in Enova. The total amount billed for such services during the three months ended March 31, 2020 and 2019 was $3.7 million and $2.7 million, respectively. The amounts receivable from Enova were $2.3 million and $4.6 million as of March 31, 2020 and December 31, 2019, respectively.

 

The Company is self-insured for medical claims which is subject to stop-loss protection. An actuarial calculation of the estimated claims incurred but not reported is provided to the Company each period. The estimated claims incurred is currently updated semi-annually as it is immaterial in relation to the liability due to the limited population of claims since moving to the self-funded model on January 1, 2020. Further, the Company considered COVID-19's effect on insurance claims and recorded an immaterial additional liability based on actuarial estimates of the impact it will have on our claims. As of March 31, 2020, the medical claims liability was $1.1 million, and the liability is recorded within other current liabilities on the Company's Condensed Consolidated Balance Sheet.

In October 2013, the Company removed the former owner of Productions Graphics from his role as President of Productions Graphics, the Company’s French subsidiary. He had been in that role since the Company’s 2011 acquisition of Productions Graphics, a European business then principally owned by him. In December 2013, the former owner of Productions Graphics initiated a wrongful termination claim in the Commercial Court of Paris seeking approximately €0.7 million (approximately $1.0 million) in fees and damages. The Company disputes the allegations of the former owner of Productions Graphics and intends to vigorously defend these matters. In February 2014, based on a review the Company initiated into certain transactions associated with the former owner of Productions Graphics, the Company concluded that he had engaged in fraud by inflating the results of the Productions Graphics business in order to induce the Company to pay him €7.1 million in contingent consideration pursuant to the acquisition agreement. In light of those findings, in February 2014, the Company filed a criminal complaint in France seeking to redress the harm caused by his conduct and this proceeding is currently pending. In addition, in September 2015, the Company initiated a civil claim in the Paris Commercial Court against the former owner of Productions Graphics, seeking civil damages to redress these same harms. In addition to these pending matters, there may be other potential

In January 2014, a former finance employee of Productions Graphics initiated wrongful termination and overtime claims in the Labor Court of Boulogne-Billancourt, and he currently seeks damages of approximately €0.6 million (approximately $0.7 million). The Company disputes these allegations and intends to vigorously defend these matters. In addition, the Company’s criminal complaint in France, described above, seeks to redress harm caused by this former employee in light of his participation in the fraudulent transactions described above. The labor claim has been stayed in deference to the Company’s related criminal complaint.

On July 16, 2019, the Company and certain of its direct and indirect subsidiaries entered into a loan and security agreement (the “ABL Credit Agreement”) with Bank of America, N.A., as administrative agent, lender, issuing bank and collateral agent, and JPMorgan Chase Bank, N.A. and PNC Bank, National Association, as lenders (the “ABL Credit Facility”).

The ABL Credit Facility consists of a $105.0 million asset-based revolving line of credit, of which up to (i) $15.0 million may be used for UK Revolver Loans (as defined in the ABL Credit Agreement), (ii) $10.5 million may be used for Swingline Loans (as defined in the ABL Credit Agreement), and (iii) $10.0 million may be used for letters of credit. The ABL Credit Agreement provides that the revolving line of credit may be increased by up to an additional $20.0 million following satisfaction of certain conditions. The ABL Credit Facility matures on July 16, 2024. Advances under the ABL Credit Facility bear interest at either: (a) LIBOR (as defined in the ABL Credit Agreement), plus an applicable margin ranging from 2.00% to 2.50% for US LIBOR Loans and UK LIBOR Loans (each as defined in the ABL Credit Agreement); (b) the US Base Rate (as defined in the ABL Credit Agreement), plus an applicable margin ranging from 1.00% to 1.50% for US Base Rate Loans (as defined in the ABL Credit Agreement); or (c) the UK Base Rate (as defined in the ABL Credit Agreement), plus an applicable margin ranging from 2.00% to 2.50% for UK Base Rate Loans (as defined in the ABL Credit Agreement).

The ABL Credit Agreement contains a minimum fixed charge coverage ratio financial covenant that must be maintained when excess availability falls below a specified amount. In addition, the ABL Credit Agreement contains negative covenants limiting, among other things, additional indebtedness, transactions with affiliates, additional liens, sales of assets, dividends, investments and advances, prepayments of debt, mergers and acquisitions, and other matters customarily restricted in such agreements. The ABL Credit Agreement also contains customary events of default, including payment defaults, breaches of representations and warranties, covenant defaults, events of bankruptcy and insolvency, failure of any guaranty or security document supporting the ABL Credit Agreement to be in full force and effect, and a change of control of the Company’s business. The usage and total commitment of these Loans shall not exceed the respective borrowing base set forth in the ABL Credit Agreement.

Within the ABL Credit Agreement, there is a cash dominion requirement for the United States ("US") and United Kingdom ("UK"). In the United States, Bank of America, N.A. (the agent) shall only exercise cash dominion and apply all customer collections of the US borrowers to US obligations when a Trigger Period exists, as defined in the ABL Credit Agreement. In the United Kingdom, all customer collections of the UK borrowers will be applied on a daily basis to any outstanding UK obligations and any credit balance will be transferred back to an account of the UK borrowers. The customer collections of the UK borrowers are only applied against the UK obligations. As a result of the cash dominion, the amount outstanding under the ABL Credit

The Company's deferred financing fees of approximately $2.0 million are presented as an asset and amortized on a straight-line basis over the term of the ABL Credit Agreement. Amortization of deferred financing fees is recorded in interest expense and was approximately $0.1 million.

The Company has determined that the interest rate reset features embedded in the ABL Credit Agreement constitute an embedded derivative (collectively, the “ABL Embedded Derivative”) which has been bifurcated from the ABL Credit Facility and recorded as a derivative liability at fair value, with a corresponding discount recorded to the associated debt. The Company recorded immaterial interest expense for the amortization of the ABL Embedded Derivative discount through March 31, 2020.

The following schedule shows the change in fair value of the ABL Embedded Derivative at March 31, 2020 (in thousands):

On February 22, 2016, the Company entered into a Revolving Credit Facility (the “Facility”) with Bank of America N.A. to support ongoing working capital needs of the Company's operations in China. The Facility includes a revolving commitment amount of $5.0 million whereby maturity dates vary based on each individual drawdown. On July 16, 2019, the Company modified the Facility to decrease the total revolving commitment amount from $5.0 million to $1.0 million. All other terms of the Facility remained unchanged. Outstanding borrowings under the Facility are guaranteed by the Company’s assets. Borrowings and repayments are made in renminbi, the official Chinese currency. The applicable interest rate is 110% of the People’s Bank of China’s base rate. The terms of the Facility include limitations on use of funds for working capital purposes as well as customary representations and warranties made by the Company. At March 31, 2020, the Company had $0.5 million of unused availability under the Facility.

On July 16, 2019, the Company and certain of its direct and indirect subsidiaries entered into a loan and security agreement (the “Term Loan Credit Agreement”) with TCW Asset Management Company LLC, as administrative agent and collateral agent, and the financial institutions party thereto as lenders (the “Term Loan Credit Facility”).

The Term Loan Credit Facility consists of a $100.0 million term loan facility. The Term Loan Credit Facility matures on July 16, 2024. Principal on the Term Loan Credit Facility is due in quarterly installments, commencing on September 30, 2019, in an amount equal to $1.3 million per quarter during the first year of the Term Loan Credit Facility and $2.5 million each quarter

The Company’s obligations under the Term Loan Credit Agreement are guaranteed by certain of its subsidiaries pursuant to a guaranty included in the Term Loan Credit Agreement. As security for the Company’s and its subsidiaries’ obligations under the Term Loan Credit Agreement, each of the Company and the subsidiaries party thereto have granted: (i) a first priority lien on substantially all its tangible and intangible personal property (other than the assets described in the following clause (ii)), including the capital stock of certain of the Company’s direct and indirect subsidiaries, and (ii) a second priority lien on its accounts receivable, chattel paper (to the extent evidencing accounts receivable), inventory, deposit accounts, general intangibles related to the foregoing and proceeds related thereto. The priority of the liens is described in the Intercreditor Agreement.

The Term Loan Credit Agreement contains a minimum fixed charge coverage ratio financial covenant, a maximum total leverage ratio financial covenant, a minimum liquidity financial covenant and a maximum capital expenditures covenant, each of which must be maintained for the periods described in the Term Loan Credit Agreement. In addition, the Term Loan Credit Agreement contains negative covenants limiting, among other things, additional indebtedness, transactions with affiliates, additional liens, sales of assets, dividends, investments and advances, prepayments of debt, mergers and acquisitions, and other matters customarily restricted in such agreements. The Term Loan Credit Agreement also contains customary events of default, including payment defaults, breaches of representations and warranties, covenant defaults, events of bankruptcy and insolvency, failure of any guaranty or security document supporting the Term Loan Credit Agreement to be in full force and effect, and a change of control of the Company’s business. The principal outstanding as of March 31, 2020 is $96.3 million.

The Company has determined the interest rate reset features embedded in the Term Loan Credit Agreement constitute an embedded derivative (collectively, the “Term Loan Embedded Derivative”) which has been bifurcated from Term Loan Credit Facility and recorded as a derivative liability at fair value, with a corresponding discount recorded to the associated debt. The Company recorded immaterial interest expense for the amortization of the Term Loan Embedded Derivative discount through March 31, 2020.

The following schedule shows the change in fair value of the Term Loan Embedded Derivative at March 31, 2020 (in thousands):

In connection with the closing of the Term Loan Credit Agreement, the Company issued a Warrant (as defined below) to Macquarie US Trading LLC, an affiliate of TCW Asset Management Company LLC, to purchase fully paid and non-assessable shares of common stock of the Company. The Warrant is initially exercisable for an aggregate of 1,335,337 shares of the Company’s common stock with a per share exercise price of $0.01 (the “Initial Warrant”). The Initial Warrant is exercisable on or after (A) the date which is 10 days after the earlier of (x) the date that the Company delivers its financial statements for the fiscal quarter ended March 31, 2020 to the administrative agent and (y) May 15, 2020 (the “First Quarter Reporting Period End Date”) through (B) July 16, 2024. The initial warrant has not been exercised.

In addition, if either (x) the Total Leverage Ratio (as defined in the Term Loan Credit Agreement) as of March 31, 2020 for the four (4) consecutive fiscal quarter period then ended is greater than 4.25 to 1.00 or (y) the Company fails to deliver financial statements to the administrative agent as required by the Term Loan Credit Agreement for the fiscal quarter ended March 31, 2020, then from the First Quarter Reporting Period End Date through July 16, 2024, the Warrant shall also be exercisable for an additional 2.49% of the Company’s common stock calculated on a fully-diluted basis (the “Additional Warrant” or “Contingent Warrant” and together with the Initial Warrant, the “Warrant”). The Company did not trigger any of the provisions defined in the Term Loan Credit Agreement that would cause the Additional Warrant to be exercisable at March 31, 2020.

The Warrant may be exercised on a cashless basis, and the number of shares for which the Warrant are exercisable and the associated exercise price are subject to certain proportional adjustments as set forth in the Warrant. In addition, the holder of the Warrant is entitled to certain piggyback registration rights.

In the event that the Total Leverage Ratio is less than 4.00 to 1.00 at any time between April 1, 2020 and March 31, 2021 (the “Buyback Period”) based on financial statements delivered to agent pursuant to the terms of the Term Loan Credit Agreement, and calculated on a pro forma basis factoring in the repurchase described in the Warrant, then on any day during the Buyback Period, the Company shall be permitted, upon 5 business days prior written notice given to Holder, to repurchase either (x) any portion of the Warrant not yet exercised and/or (y) any shares of common stock received from the Company pursuant to prior exercise of the Warrant, in each case at the Applicable Buyback Price (as defined in the Warrant) by paying cash to the Holder (“Buyback Option”).

The Initial Warrant was recorded as a liability at fair value and will be treated as a discount on the associated debt. The following schedule shows the change in fair value of the Initial Warrant at March 31, 2020 (in thousands):

The Additional Warrant is no longer outstanding as of March 31, 2020 and therefore has no associated fair value.

The fair value of the Company’s Initial Warrant liability recorded in the Company’s financial statements is determined using the Black-Scholes-Merton option pricing model. The quoted price of the Company’s common stock in an active market, volatility and expected life is a Level 3 measurement. Volatility is based on the actual market activity of the Company’s stock. The expected life is based on the remaining contractual term of the Initial Warrant, and the risk-free interest rate is based on the implied yield available on U.S. Treasury Securities with a maturity equivalent to the Initial Warrant’s expected life. The fair value of the Company's Initial Warrant liability may significantly fluctuate based on the unobservable inputs described above including the Company's share price, expected volatility and risk-free interest rate.

The table below sets forth the assumptions used within the Black-Scholes-Merton option pricing model to value the Company’s Initial Warrant liability:

The table below sets forth the total fair value of the ABL Credit Facility, ABL Embedded Derivative, Term Loan Credit Facility, Term Loan Embedded Derivative, and Initial Warrant as of March 31, 2020 (in thousands):

Segment information is prepared on the same basis that our Chief Executive Officer, who is our chief operating decision maker ("CODM"), manages the segments, evaluates financial results, and makes key operating decisions. The Company is organized and managed by the CODM as 3 operating segments: North America, EMEA and LATAM. The North America segment includes operations in the United States and Canada; the EMEA segment includes operations in the United Kingdom, continental Europe, the Middle East, Africa, and Asia; and the LATAM segment includes operations in Mexico, Central America, and South America. Other consists of intersegment eliminations, shared service activities, and corporate expenses which are not allocated to the operating segments as management does not consider them in evaluating segment performance.

The table below reconciles Adjusted EBITDA to net loss before income taxes (in thousands):

We are a leading global marketing engineering firm for some of the world's most marketing intensive companies, including those listed in the Fortune 1000. As a comprehensive outsourced global solution, we leverage proprietary technology, an extensive supplier network and deep domain expertise to streamline the creation, production and distribution of marketing and promotional materials, signage and displays, retail experiences, events and promotions and product packaging across every major market worldwide. The items we source generally are procured through the marketing supply chain and we refer to these items collectively as marketing materials. Through our network of global suppliers, we offer a full range of fulfillment and logistics services that allow us to procure marketing materials of virtually any kind. The breadth of our product offerings and services and the depth of our supplier network enable us to fulfill the marketing materials procurement needs of our clients.

We generate revenue by procuring and purchasing marketing materials from our suppliers and selling those products to our clients. We procure products for clients across a wide range of industries, such as retail, financial services, hospitality, consumer packaged goods, non-profits, healthcare, pharmaceuticals, food and beverage, broadcasting, and cable and transportation.

As of March 31, 2020, we had more than 2,100 employees in over 20 countries. For the three months ended March 31, 2020, we generated global revenue from third parties of $197.7 million in the North America segment, $48.2 million in the EMEA segment, and $15.4 million in the LATAM segment.

Our objective is to continue to increase our sales globally by adding new clients and increasing our sales to existing clients through additional marketing services or expanding into new geographic markets. Operationally, we are integrating our product and service offerings, re-evaluating our geographic footprint, and creating synergies across various business units.

The emergence of a novel coronavirus (COVID-19) around the world, and particularly in the United States, Europe, China, and South America presents various risks to the Company. The global impact of the outbreak has been rapidly evolving and many countries have reacted by instituting quarantine measures, mandating business and school closure and restricting travel, all of which have had an adverse effect on the global economy. The Company cannot reasonably estimate with any degree of certainty the future impact COVID-19 may have on the Company’s results of operations, financial position, and liquidity, much of which will depend on when and to what extent current restrictions are lifted and economic conditions improve. In response to the global pandemic, the Company has created a COVID-19 executive task force that has implemented business continuity plans and has taken a variety of actions to ensure the ongoing availability of our services, while also undertaking appropriate health and safety measures for its employees. The task force has authority to make timely, informed decisions relating to our business continuity planning and actions. As a result of these actions, the Company has not experienced disruptions to date in its operations or ability to service our clients. In addition, the Company has been able to respond quickly to our customers’ changing business demands related to the COVID-19 pandemic.

Our unaudited interim condensed consolidated financial statements have been prepared in accordance with U.S. GAAP, which requires us to make estimates and assumptions that affect reported amounts. The estimates and assumptions are based on historical experience and on other factors that we believe to be reasonable. Actual results may differ from those estimates. We review these estimates on a periodic basis to ensure reasonableness. Although actual amounts may differ from such estimated amounts, we believe such differences are not likely to be material. For additional detail regarding our critical accounting policies including revenue recognition, goodwill, other intangible assets, and leases, see our discussion for the year ended December 31, 2019 included in the Company's 2019 Annual Report on Form 10-K. There have been no material changes to these policies as of March 31, 2020.

We generate revenue through the procurement of marketing materials for our clients. Our revenue consists of the prices paid to us by our clients for marketing materials. These prices, in turn, reflect the amounts charged to us by our suppliers plus our gross profit. Our gross profit margin may be fixed by contract or may depend on prices negotiated on a job-by-job basis. Once the client accepts our pricing terms, the selling price is established, and we arrange shipment of the product. The product is shipped directly from our supplier or from our warehouse to a destination specified by our client. The client is invoiced upon shipment or receipt, depending on contract terms, for the product as well as shipping and handling.

We agree to provide our clients with marketing materials that conform to the industry standard of a “commercially reasonable quality,” and our suppliers in turn agree to provide us with products of the same quality. In addition, the quotes we execute with our clients include customary industry terms and conditions that limit the amount of our liability for product defects. Product defects have not had a material adverse effect on our results of operations to date.

 

Our cost of goods sold consists of the price at which we purchase products from our suppliers, facility costs, and personnel costs for creative design services and warehousing. We procure product for our own account and generally take full title and risk of loss upon shipment.

Our gross profit is determined by the selling prices of the product and shipping charges less the cost of the product, direct personnel, warehousing, and shipping and handling costs.

 

Our selling, general and administrative expenses consist of compensation costs for our management team, client engagement personnel, production managers, corporate functions and operational support employees, as well as commissions paid to our account executives. In addition, selling, general and administrative expenses include public company expenses, facilities fees, travel and entertainment expenses, corporate systems fees, and legal and accounting fees.

We accrue for commissions when we recognize the related revenue. Some of our account executives receive a monthly draw to provide them with a more consistent income stream. The cash paid to our account executives in advance of commissions earned is reflected as a prepaid expense on our balance sheet. As our account executives earn commissions, a portion of their commission payment is withheld and offset against their prepaid commission balance, if any.

Adjusted diluted earnings per share, which represents net loss, with the addition of exclusive items that are non-recurring to our operating business, divided by the weighted average shares outstanding plus share equivalents that would arise from the exercise of stock options and restricted stock and other contingently issuable shares, is considered a non-GAAP financial measure under SEC regulations. Diluted loss per share is the most directly comparable financial measure calculated in accordance with GAAP. The Company presents this measure as supplemental information to help our investors better understand trends in our business over time. Our management team uses adjusted diluted earnings per share to evaluate the performance of our business. Adjusted diluted earnings per share is not equivalent to any measure of performance required to be reported under GAAP, nor should this data be considered an indicator of our overall financial performance and liquidity. Moreover, the adjusted diluted earnings per share definition we use may not be comparable to similarly titled measures reported by other companies.

 

 

Third party revenue by segment for each of the periods presented was as follows (dollars in thousands):  

 

 

Cost of goods sold decreased by $7.3 million, or 3.5%, in the three months ended March 31, 2020 over the corresponding period in 2019. Cost of goods sold as a percentage of revenue was 75.7% and 76.8% during the three months ended March 31, 2020 and 2019, respectively.

Gross profit margin was 24.3% and 23.2% during the three months ended March 31, 2020 and 2019, respectively. The increase was primarily driven by operating efficiencies in North America.

Selling, general and administrative expenses decreased by $3.9 million, or 7.0%, in the three months ended March 31, 2020 over the corresponding period in 2019. The decrease was driven by several factors, which included the realization of cost savings and restructuring initiatives. As a percentage of revenue, selling, general and administrative expenses also decreased to 19.9% for the three months ended March 31, 2020 compared to 20.9% for the three months ended March 31, 2019.

Depreciation and amortization expense increased by $0.5 million, or 19.5%, in the three months ended March 31, 2020 over the corresponding period in 2019. The increase is due to additional software development capitalized during the quarter.

On August 10, 2018, the Company approved a plan to reduce the Company's cost structure while driving value for its clients and stockholders. For the three months ended March 31, 2020 and 2019, we incurred $3.6 million and $3.9 million, respectively, in restructuring charges.

Loss from operations increased by $2.1 million in the three months ended March 31, 2020 over the corresponding period in 2019. As a percentage of revenue, loss from operations was (0.9)% and (0.1)% during the three months ended March 31, 2020 and 2019, respectively. The increase is primarily attributable to goodwill impairment charges, partially offset by cost reduction efforts across the regions and higher gross profit.

Other expense decreased by $2.1 million in the three months ended March 31, 2020 over the corresponding period in 2019. The decrease in expense was primarily driven by the change in fair value of the warrant and derivative liabilities, partially offset by foreign exchange losses and an increase in interest expense.

Income tax expense increased by $0.8 million in the three months ended March 31, 2020 over the corresponding period in 2019. Our effective tax rate was 17.6% and 40.9% for the three months ended March 31, 2020 and 2019, respectively. Our effective income tax rate differs from the U.S. federal statutory rate each year due to certain operations that are subject to tax incentives, state and local taxes, valuation allowances, impacts of the Tax Reform Act, and foreign tax rates that are different than the U.S. federal statutory tax rate. In addition, the effective tax rate can be impacted each period by discrete factors and events such as a write-off of a deferred tax asset for stock‑based compensation due to the expiration of unexercised stock options and prior year provision to return adjustments.

 

Net loss increased by $0.8 million, or 38.9%, in the three months ended March 31, 2020 over the corresponding period in 2019. Net loss as a percentage of revenue was (1.1)% and (0.8)% during the three months ended March 31, 2020 and 2019, respectively. Net loss as a percentage of gross profit was (4.5)% and (3.3)% during the three months ended March 31, 2020 and 2019, respectively. The increase in net loss is primarily attributable to goodwill impairment charges and foreign exchanges losses, offset by the change in fair value of warrant and derivative liabilities, decrease in operating expenses due to lower commissions expense as a result of restructuring initiatives, bad debt reductions due to collection efforts, and additional cost savings initiatives.

Adjusted EBITDA by segment for each of the periods presented was as follows (dollars in thousands):

While uncertainty exists as to the full impact of the COVID-19 pandemic on our liquidity and capital resources, the Company believes it has maintained sufficient liquidity to satisfy our working capital and other funding requirements with internally generated cash flow and, as necessary, cash on hand and borrowings under our revolving credit facility. In order to ensure adequate liquidity under a range of economic scenarios, we are currently evaluating the possibility of securing additional financing, which may include participation in lending programs established under the Coronavirus Aid, Relief, and Economic Security Act.

The following table presents cash flows for the three months ended March 31, 2020 and 2019, respectively (in thousands):

At March 31, 2020, we had $30.8 million of cash and cash equivalents.

Cash provided by operating activities for the three months ended March 31, 2019 was $5.5 million and consisted of a net loss of $2.0 million, offset by $4.0 million of non-cash items and by $3.6 million provided by working capital and other activities. The most significant impact on working capital and other activities consisted of a decrease in inventories of $9.2 million, a decrease in accounts receivable and unbilled revenue of $3.9 million and a decrease in prepaid expenses and other assets of $0.3 million, partially offset by a decrease in accounts payable of $9.2 million and a decrease in accrued expenses and other liabilities of $0.6 million.

 

 

Cash used in financing activities for the three months ended March 31, 2019 of $3.1 million was primarily attributable to net repayments under the revolving credit facility of $3.8 million and $0.6 million of payments for debt issuance costs, partially offset by $1.3 million in net short-term secured borrowings.

The ABL Credit Agreement contains a minimum fixed charge coverage ratio financial covenant that must be maintained when excess availability falls below a specified amount. The Term Loan Credit Agreement includes a minimum fixed charge coverage ratio financial covenant, a maximum total leverage ratio financial covenant, a minimum liquidity financial covenant and a maximum capital expenditures covenant, each of which must be maintained for the periods described in the Term Loan Credit Agreement. The Company is in compliance with all debt covenants in the ABL Credit Agreement and Term Loan Credit Agreement as of March 31, 2020.

In addition, we will continue to utilize cash, in part, to invest in our innovative technology platform, fund acquisitions of or make strategic investments in complementary businesses and expand our sales force. Although we can provide no assurances, we believe that our available cash and cash equivalents and the funds available under our new debt structure will be sufficient to meet our working capital and operating expenditure requirements for the next 12 months. We may find it necessary to obtain additional equity or debt financing in the future. 

We earn a portion of our operating income outside the United States, which is deemed to be permanently reinvested in foreign jurisdictions. We do not currently foresee a need to repatriate funds; however, should we require more capital in the United States than is generated by our operations locally or through debt or equity issuances, we could elect to repatriate funds held in foreign jurisdictions. Included in our cash and cash equivalents are amounts held by foreign subsidiaries. We had $29.8 million and $39.9 million foreign cash and cash equivalents as of March 31, 2020 and December 31, 2019, respectively, which are generally denominated in the local currency where the funds are held.

We do not have any material off-balance sheet arrangements.

There have been no material changes outside the normal course of business in the contractual obligations disclosed in Item 7 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, under the caption “Contractual Obligations.”

There have been no material changes to the Company's market risks, which include commodity risk, interest rate risk and foreign currency risk subsequent to the filing of the 2019 Annual Report on Form 10-K.

Under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2020. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

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. Based on the evaluation of our disclosure controls and procedures as of March 31, 2020, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

There were no changes in our internal control over financial reporting (as such term is defined in Rules 13a–15(f) and 15d–15(f) under the Exchange Act) during the quarter ended March 31, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Except for the risk factors noted below, there have been no material changes in the risk factors described in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2019.

A significant or prolonged economic downturn or a decline in the demand for marketing materials, could adversely affect our revenue and results of operations.

Our results could be negatively impacted by a global or regional epidemic or similar event.

There were no unregistered sales of the Company's equity securities during the period covered by this report.

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.