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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes [ X ]   No [   ]

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such period that the registrant was required to submit such files). Yes [ X ]   No [   ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company or an emerging growth company. See the definitions of "large accelerated filer", "accelerated filer", and "smaller reporting company" and "emerging growth company" in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.          [  ]

Indicate by check mark whether the registrant is a shell company (as defined in rule 12(b)-2 of the Exchange Act).    Yes  [  ]  No [X]

Securities registered pursuant to Section 12(b) of the Act:

 

There were 20,553,913 shares of common stock, with a par value of $0.01 per share outstanding as of July 31, 2020.

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GSE SYSTEMS INC. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

The accompanying notes are an integral part of these consolidated financial statements.

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)

(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY

(in thousands)

(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY

(in thousands)

(unaudited)

GSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

GSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1 - Summary of Significant Accounting Policies

Basis of Presentation

GSE Systems, Inc. is a leading provider of professional and technical engineering, staffing services and simulation software to clients in the power and process industries. References in this report to "GSE" or "we" or "our" or "the Company" are to GSE Systems, Inc. and our subsidiaries, collectively.

The consolidated interim financial statements included herein have been prepared by GSE and are unaudited. In the opinion of our management, all adjustments and reclassifications of a normal and recurring nature necessary to present fairly the financial position, results of operations and cash flows for the periods presented, have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP") have been condensed or omitted.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. GAAP for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X. The accompanying balance sheet data for the year ended December 31, 2019 was derived from our audited financial statements, but it does not include all disclosures required by U.S. GAAP.

The results of operations for interim periods are not necessarily an indication of the results for the full year. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2019, filed with the U.S. Securities and Exchange Commission on June 11, 2020.

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as reported amounts of revenues and expenses during the reporting period. Our most significant estimates relate to revenue recognition on contracts with customers, allowance for doubtful accounts, product warranties, valuation of goodwill and intangible assets acquired including the determination of fair value in impairment tests, valuation of long-lived assets to be disposed of, valuation of contingent consideration issued in business acquisitions, valuation of stock-based compensation awards and the recoverability of deferred tax assets. Actual results of these, and other items not listed, could differ from these estimates and those differences could be material.

COVID-19

GSE employees began working remotely during the first quarter of 2020, due to the COVID-19 pandemic, and will continue to do so, when available and as mandated by local, state and federal regulations. Employees almost entirely work from home for our Performance Improvement Solutions ("Performance") segment, except when required to be at the client site for essential project work. Our Performance contracts, which are considered an essential service, are permitted to and mostly continue without pause; however, we have experienced certain delays on new business. For our staff augmentation, we have seen certain contracts for our Nuclear Industry Training and Consulting ("NITC") customers paused and or delayed as clients shrink their own on-premise workforces to the minimum operating levels in response to the pandemic; as a result, our NITC business has seen its billable employee base decline since the start of the pandemic. Although we cannot fully estimate the length or gravity of the impact of the COVID-19 pandemic to our business at this time, we have experienced delays in commencing new projects and thus our ability to recognize revenue has been delayed for some contracts. We have also had order reductions or other negative changes to orders due to the pandemic. We routinely monitor our operating expenses as a result of contract delays and have made adjustments to keep our gross profit at a sustainable level. As a result of the COVID-19 pandemic, we expect our financial results for the fiscal year 2020 to be lower than fiscal 2019 and forecasts we prepared at the beginning of the 2020 year.

Going Concern

As a result of the COVID-19 pandemic, we are experiencing a negative impact on our financial position and results of operations. We are likely to continue to experience delays in commencing work on outstanding orders or loss of orders altogether, disruption of our business as a result of worker illness or mandated shutdowns, our ability to refinance existing indebtedness and our ability to access new capital, and this has caused us to violate our debt covenants as of June 30, 2020. We received $10 million from the Paycheck Protection Program ("PPP") and indicated without these funds, the risk of employee terminations, layoffs and other drastic cost reductions exists. While the PPP funds have provided us with additional liquidity, these funds did not prevented us from failing to meet our minimum EBITDA covenant on our Citizens Bank credit facility at June 30, 2020 or other debt covenants requirement in the future. Including the proceeds from the PPP, we believe we have sufficient cash to meet our operating requirement needs for at least the next twelve months; however since some of our loan covenants are related to operating performance, and our operating performance is being significantly impacted by the COVID-19 pandemic, we believe it is probable we will not remain in compliance with our debt covenants throughout the remainder of fiscal 2020. As a result of the June 30, 2020 minimum EBITDA covenant violation and future expected debt covenant violations, we have classified our debt as short-term in our consolidated balance sheets as of June 30, 2020 and December 31, 2019, which creates substantial doubt regarding our ability to continue as a going concern.  

We are currently in negotiations with the Bank to resolve the minimum EBITDA debt covenant for the quarter ended June 30, 2020, as well as addressing future covenant requirements. To resolve these matters, the Bank may charge us additional fees and require us to pay a portion of our outstanding debt on accelerated payment terms.

Note 2 - Recent Accounting Policies

Accounting pronouncements recently adopted

In January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2017-04, Simplifying the Test for Goodwill Impairment ("ASU 2017-04"). ASU 2017-04 simplifies the accounting for goodwill impairment by eliminating Step 2 of the current goodwill impairment test, which required a hypothetical purchase price allocation. Goodwill impairment will now be the amount by which the reporting unit's carrying value exceeds its fair value, limited to the carrying value of the goodwill. ASU 2017-04 is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2019.

We adopted the new standard and began using the simplified approach on January 1, 2020.

Accounting pronouncements not yet adopted

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses, which introduces new guidance for credit losses on instruments within its scope. The new guidance introduces an approach based on expected losses to estimate credit losses on certain types of financial instruments, including, but not limited to, trade and other receivables, held-to-maturity debt securities, loans and net investments in leases. The new guidance also modifies the impairment model for available-for-sale debt securities and requires the entities to determine whether all or a portion of the unrealized loss on an available-for-sale debt security is a credit loss. The standard also indicates that entities may not use the length of time a security has been in an unrealized loss position as a factor in concluding whether a credit loss exists. The ASU is effective for public companies for fiscal years beginning after December 15, 2019 and interim periods within those fiscal years. Early adoption is permitted for all entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. On October 16, 2019, the FASB voted to defer the deadlines for private companies and certain small public companies, including smaller reporting companies, to implement the new accounting standards on credit losses. The new effective date is January 1, 2023. We are currently evaluating the effects, if any, that the adoption of this guidance will have on our consolidated financial position, results of operations and cash flows.

Note 3 - Basic and Diluted Loss per Common Share

Basic loss per share is computed by dividing net loss by the weighted average number of outstanding shares of common stock for the period. Diluted net loss per share adjusts the weighted average shares outstanding for the potential dilution that could occur if outstanding vested stock options were exercised and restricted stock units ("RSU") were vested, unless the impact of potential dilutive common shares outstanding are anti-dilutive. Since we experienced a net loss in each period presented, basic and diluted net loss per common share were the same.

The number of common shares and common share equivalents used in the determination of basic and diluted loss per common share were as follows:

Note 4 - Paycheck Protection Program Loan

We entered into the Paycheck Protection Program Loan (the "PPP Loan") agreement with Citizens Bank, (our or the "Bank") which was approved by the bank and funded on April 24, 2020, pursuant to the Paycheck Protection Program under the Coronavirus Aid, Relief and Economic Security Act (the "CARES Act"). The PPP Loan matures on April 24, 2022 and bears interest at a rate of 1.0% per annum. Monthly amortized principle and interest payments are due for any portion of the loan balance that is not forgiven and deferred for ten months after the last day of the covered period, August 9, 2021.

The PPP Loan funds were received on April 24, 2020. The PPP Loan contains events of default and other provisions customary for a loan of this type. The Payroll Protection Program provides that (1) the use of PPP Loan amount shall be limited to certain qualifying expenses, (2) 100% of the principal amount of the loan is guaranteed by the Small Business Administration ("SBA") and (3) an amount up to the full principal amount may qualify for loan forgiveness in accordance with the terms of CARES Act. We are not yet able to determine the amount that might be forgiven. To the extent the loan amount is not forgiven under the PPP, we are obligated to make equal monthly payments of principal and interest, beginning after determination of forgiveness by the Bank. We may apply for forgiveness any time on or before the maturity date of the loan. The SBA provides for certain customary events of default, including if The Company (i) Fails to do anything required by the Note and other Loan Documents (ii) does not disclose, or anyone acting on its behalf does not disclose, any material fact to the Bank or the SBA (iii) makes, or anyone acting on its behalf makes, a materially false or misleading representation to lender or the SBA (iv) reorganizes, merges, consolidates or otherwise changes ownership or business structure without the Bank’s prior written consent (v) Takes certain prohibited actions after the Bank makes a determination that the PPP Loan is not entitled to full forgiveness. Upon default the Bank may require immediate payment of all amounts owing under the PPP Loan or file suit and obtain judgment.

As of June 30, 2020, the Company was in full compliance with all requirements in order to apply for forgiveness under the PPP Loan.

We have classified the full $10 million of the PPP Loan as long-term in our consolidated balance sheet as of June 30, 2020 and recorded $18 thousand in interest expense during the three and six months ended June 30, 2020.

Note 5 - Contract Receivables

 

Contract receivables represent our unconditional rights to consideration due from our domestic and international customers. We expect to collect all contract receivables within the next twelve months.

The components of contract receivables were as follows:

Management reviews collectability of receivables periodically and records an allowance for doubtful accounts to reduce the Company's receivables to their net realizable value when management determines it is probable that we will not be collect all amounts according to the contractual terms of the receivable. The allowance for doubtful accounts is based on historical trends of past due accounts, write-offs, specific identification and review of customer accounts. During the six months ended June 30, 2020 and 2019, we recorded bad debt expense of $93 thousand and $0, respectively.

During the month of July 2020, we invoiced $3.0 million of the unbilled amounts as of the period ended June 30, 2020. We expect to bill the remaining unbilled amounts during the remainder of fiscal 2020.

As of June 30, 2020, we had two customers that accounted for 12% and 11% of our consolidated contract receivables. As of December 31, 2019, we had two customers that accounted for 13% and 10% of our consolidated contract receivables.

Note 6 - Goodwill and Intangible Assets

Goodwill

We review goodwill for impairment annually as of December 31 and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. We test goodwill at the reporting unit level. A reporting unit is an operating segment, or one level below an operating segment, as defined by U.S. GAAP. We have determined that we have two reporting units, which are the same as our two operating segments, Performance and NITC.

We reviewed our goodwill for impairment as of the first quarter of fiscal 2020, due to the COVID-19 interim triggering event. Based upon our analysis, we determined the fair value of our goodwill at the reporting unit level exceeded the carrying value and determined no impairment charge was required as of the period ended March 31, 2020. No other triggering event was noted during the three months ended June 30, 2020.

Intangible Assets Subject to Amortization

Amortization of intangible assets other than goodwill is recognized on a straight-line basis over the estimated useful life of the intangible assets, except for customer relationships, which are recognized in proportion to the related projected revenue streams. Intangible assets with definite lives are reviewed for impairment if indicators of impairment arise. GSE does not have any intangible assets with indefinite useful lives other than goodwill.

During the first quarter of fiscal 2020, we determined that the impact of the COVID-19 pandemic on our operations was an indicator of a triggering event that could result in an impairment of our long-lived assets. As such, we performed an interim analysis to determine if an impairment existed as of the period ended March 31, 2020 by its individual asset groupings, which management determined to be at the subsidiary level. We used a discounted cash flow analysis to test for impairment and concluded that the carrying value of the definite-lived intangible assets of DP Engineering exceeded its fair value by $4.3 million, and we recorded an impairment for this amount as of the three months ended March 31, 2020. Management determined no additional triggering impact occurred during the three months ended June 30, 2020.

Changes in the gross carrying amount, accumulated amortization and impairment of definite-lived intangible assets were as follows:

Amortization expense related to definite-lived intangible assets totaled $444 thousand and $638 thousand for the three months ended June 30, 2020 and 2019 and $1.1 million and $1.2 million for the six months ended June 30, 2020 and 2019, respectively. The following table shows the estimated amortization expense of our definite-lived intangible assets for the next five years and thereafter:

 

Note 7 - Fair Value of Financial Instruments

 

ASC 820, Fair Value Measurement, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

 

The levels of the fair value hierarchy established by ASC 820 are:

Level 1:  inputs are quoted prices, unadjusted, in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2:  inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. A Level 2 input must be observable for substantially the full term of the asset or liability. The Monte Carlo model was used to calculate the fair value of level 2 instrument liability award. The inputs used are current stock price, expected term, risk-free rate, number of trials, volatility and interest rates.

Level 3:  inputs are unobservable and reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.

As of June 30, 2020 and December 31, 2019, we considered the recorded value of certain of our financial assets and liabilities, which consist primarily of cash and cash equivalents, contract receivable and accounts payable, to approximate fair value based upon their short-term nature.

As of June 30, 2020, we had four standby letters of credit totaling $1.2 million, which represent performance bonds on four contracts.

For the three and six months ended June 30, 2020 and 2019, we did not have any transfers between fair value Level 1, Level 2 or Level 3. We did not hold any non-financial assets or non-financial liabilities subject to fair value measurements on a recurring basis as of June 30, 2020.

Money market funds as of  both June 30, 2020 and December 31, 2019 are included in cash and cash equivalents in the respective consolidated balance sheets.

The following table presents assets and liabilities measured at fair value at June 30, 2020:

The following table presents assets and liabilities measured at fair value at December 31, 2019:

Note 8 - Derivative Instruments

In the normal course of business, our operations are exposed to fluctuations in foreign currency values and interest rate changes. We may seek to control a portion of these risks through a risk management program that includes the use of derivative instruments.

Foreign Currency Risk Management

We utilize forward foreign currency exchange contracts to manage market risks associated with fluctuations in foreign currency exchange rates and to minimize credit exposure by limiting counterparties to nationally recognized financial institutions.

As of June 30, 2020, we had no foreign exchange contracts outstanding.

Interest Rate Risk Management

For the periods presented, we did not elect to designate any of our derivative contracts as hedges. Changes in the fair value of the derivative contracts are included in gain (loss) on derivative instruments, net in the consolidated statements of operations.

The foreign currency denominated contract receivables, billings in excess of revenue earned and subcontractor accruals that are related to the outstanding foreign exchange contracts are remeasured at the end of each period into our functional currency, using the current exchange rate at the end of the period. The gain or (loss) resulting from such remeasurement is also included in gain (loss) on derivative instruments, net in the consolidated statements of operations.

We recognized a net gain (loss) on our derivative instruments as outlined below:

During the six months ended June 30, 2020, we realized a gain of $17 thousand for foreign exchange contracts due to their close out during fiscal 2020, and we recorded a loss of $74 thousand related to the change in the fair value of foreign exchange contracts for the six months ended June 30, 2019.

Note 9 - Stock-based Compensation

We recognize compensation expense for all equity-based compensation awards issued to employees and directors that are expected to vest. Stock compensation is calculated based upon the fair value of awards as of the grant date. During the three months ended June 30, 2020 and 2019, we recognized $177 thousand and $499 thousand of stock-based compensation expense related to equity awards, respectively. We recognized $324 thousand and $1.1 million of stock-based compensation expense related to equity awards for the six months ended June 30, 2020 and 2019, respectively, under the fair value method. In addition to the equity-based compensation expense recognized, the Company also recognized $0 and $60 thousand of stock-based compensation related to the change in the fair value of cash-settled restricted stock units (RSUs) during the three months ended June 30, 2020 and 2019, respectively. During the six months ended June 30, 2020, the Company recorded stock-based compensation expense of $6 thousand and income of $33 thousand for the same period ended 2019 for the fair value of cash-settled RSUs, respectively.

During three and six months ended June 30, 2020, we granted approximately 10,000 and 40,000 time-based RSUs with an aggregate fair value of approximately $10 thousand and $31 thousand, respectively. For three and six months ended June 30, 2019, we granted approximately 200,000 and 500,000 time-based RSUs with an aggregate fair value of $600 thousand and $1.4 million, respectively. A portion of the time-based RSUs vest quarterly in equal amounts over the course of eight quarters, and the remainder vest annually in equal amounts over the course of three years. The fair value of the time-based RSUs is expensed ratably over the requisite service period, which ranges from one to three years.

GSE’s 1995 long-term incentive program ("LTIP") provides for the issuance of performance-vesting and time-vesting restricted stock units to certain executives and other Company employees. Vesting of the performance-vesting restricted stock units ("PRSU") is contingent upon the employee's continued employment and the Company's achievement of certain performance goals during designated performance periods as established by the Compensation Committee of the Company's Board of Directors. We recognize compensation expense, net of estimated forfeitures, for PRSU's on a straight-line basis over the performance period based on the probable outcome of achievement of the financial targets. At the end of each reporting period, we estimate the number of PRSUs that are expected to vest, based on the probability and extent to which the performance goals will be met, and take into account these estimates when calculating the expense for the period. If the number of shares expected to be earned changes during the performance period, we make a cumulative adjustment to compensation expense based on the revised number of shares expected to be earned.

During the three months ended June 30, 2020, we did not grant any performance-based RSUs to employees and during the six months ended June 30, 2020 we granted approximately 510,000 performance-based RSUs with an aggregate fair-value of $600 thousand to key employees. Based upon our current forecasts, we expect these performance-based RSUs to vest and recognized stock-based compensation expense related to these awards of $50 thousand and $62 thousand for the three and six months ended June 30, 2020. These awards vest over three years based upon achieving certain financial metrics during fiscal 2022. Approximately 50% of these awards are based upon obtaining certain revenue targets, and the remainder are based upon achieving certain Adjusted EBITDA targets. During the three months ended June 30, 2019, we did not grant any performance-based RSUs to employees and during the six months ended June 30, 2019, we granted approximately 350,000 performance-based RSUs to key employees with an aggregate fair-value of $926 thousand. These awards vest over three years based upon achieving certain financial metrics achieved during fiscal 2021 for revenue and Adjusted EBITDA.

We did not grant any stock options for three and six months ended June 30, 2020 and 2019.

Note 10 - Debt

On December 29, 2016, we entered a 3-year and $5.0 million revolving line of credit facility and amended it on with Citizens Bank National Association (the “Bank") to fund general working capital needs and acquisitions. We amended this facility on May 11, 2018 with the Citizens Bank National Association (the “Bank") to fund general working capital needs and acquisitions. We amended this facility on Amended and Restated Credit and Security Agreement (the “Credit Agreement" or the “Credit Facility”) to (a) expand the $5.0 million revolving line of credit to include a letter of credit sub-facility and not subject to a borrowing base ("the RLOC") and (b) to add a $25.0 million term loan facility, available to finance permitted acquisitions over the following 18 months. The credit facility is subject to certain financial covenants and reporting requirements, matures in five years on May 11, 2023 and bears interest at the one-month USD LIBOR, plus a margin that varies depending on our overall leverage ratio. The RLOC has required monthly payments of only interest, with principal due at maturity, while our term loan draws require monthly payments of principal and interest, based on an amortization schedule. We are not required to maintain a restricted cash collateral account at Citizens Bank for the RLOC. Our obligations under the Credit Agreement are guaranteed by our wholly-owned subsidiaries Hyperspring, Absolute, True North, DP Engineering and by any future material domestic subsidiaries (collectively, "the Guarantors").  

 

On June 28, 2019, we entered into the Fifth Amendment and Reaffirmation Agreement, which changed our fixed charge coverage ratio from 1.25 to (i) 2.75 to 1.00 for the period ending March 31, 2020; (ii) 2.50 to 1.00 for the periods ending June 30, 2020 and September 30, 2020; (iii) 2.25 to 1.00 for the periods ending December 31st, March 31st, June 30th and September 30^th, thereafter.  

 

On January 8, 2020, due to an expected violation of our covenants, we entered into the Sixth Amendment and Reaffirmation Agreement and with an effective date of December 31, with our Bank to relax the fixed charge coverage ratio and leverage ratio and delay testing of both financial covenants. We agreed to an additional covenant, requiring us to maintain a consolidated Adjusted EBITDA target of $4.25 million, tested quarterly as of December 31, 2019, March 31, 2020 and June 30, 2020. Further, we agreed to maintain a minimum USA liquidity of at least $5.0 million in the aggregate, tested bi-weekly as of the fifteenth and the last day of each month, beginning on December 31, 2019 and until June 30, 2020. In addition to the revised covenants, we agreed to make accelerated principal payments of $3.0 million on January 6, 2020; $1.0 million on March 31, 2020; and $0.5 million on June 30, 2020.  

 

On April 17, 2020, we entered into the Seventh Amendment and Reaffirmation Agreement and effective March 31, 2020, which requires us to maintain a minimum fixed charge coverage ratio of 1.25 to 1.00, tested quarterly as of the last day of each quarter, beginning with the quarter ending June 30, 2021. In addition, we agreed to not exceed a maximum leverage ratio, tested quarterly as of the last day of each quarter and beginning with the quarter ending September 30, 2020 as follows:  (i) 3.00  to 1.00 for the period ending on September 30, 2020; (ii) 2.50 to 1.00 for the period ending on December 31, 2020; and (iii) 2.25 to 1.00 for the period ending on March 31, 2021 and for the periods ending December 31, March 31, June 30 and September 30, thereafter. We additionally agreed to make accelerated principal payments of $0.75 million on April 17, 2020 and $0.5 million on June 30, 2020.  

 

We incurred $20 thousand of debt issuance costs and $50 thousand of debt amendment fees related to the sixth and seventh amendments to our Credit Agreement during the six months ended June 30, 2020.

 

Revolving Line of Credit (“RLOC”)

 

We intend to continue using the RLOC for short-term working capital needs and the issuance of letters of credit in connection with business operations. Letter of credit issuance fees range between 1.25% and 2.00% of the value of the letter of credit, depending on our overall leverage ratio. We pay an unused RLOC fee quarterly based on the average daily unused balance. 

 

As of June 30, 2020, we had outstanding borrowings of $3.5 million under the RLOC and four letters of credit totaling $1.2 million outstanding to certain of our customers. The amount available under our RLOC as of June 30, 2020, after consideration of letters of credit, was approximately $0.3 million. 

We were in breach of our debt covenants as of June 30, 2020. The Bank may declare the obligations under the Credit Agreement to be immediately due and payable and may terminate the credit facilities.

 

Term Loan 

 

As discussed in Note 4, we acquired DP Engineering on February 15, 2019 for approximately $13.5 million in cash from proceeds of $14.3 million from a term loan with the Bank to finance the acquisition. The loan matures five years from the borrowing date and bears interest at the adjusted USD LIBOR, plus a margin ranging between 2.00% and 2.75% depending on our overall leverage ratio. There were no debt issuance costs or loan origination fees associated with this transaction. 

 

Additionally, to fund the acquisition of True North, we borrowed $10.3 million on May 11, 2018, $0.5 million of which was repaid to the Bank on the same day. The loan matures in five years from the borrowing date and bears interest at the adjusted one-month USD LIBOR, plus a margin ranging between 2.00% and 2.75% depending on our overall leverage ratio. We incurred $0 in debt issuance costs and $75 thousand of loan origination fees related to this transaction. Debt issuance costs and loan origination fees are reported as a direct deduction from the carrying amount of the loan and amortized over the term of the loan using the effective interest method. 

 

As discussed in Note 1, due to the violation of our Q2 minimum EBITDA covenant violation and our forecasted future debt covenant violations, we are in technical default of our credit agreement. While we work with our bank to resolve this issue, our debt has been classified as current in our consolidated balance sheets as of June 30, 2020 and December 31, 2019.

 

The Credit Agreement contains customary covenants, as described above, and restrictions typical for a financing of this type, that, among other things, restricts our ability to incur additional debt, pay dividends, make distributions, make certain investments and acquisitions, repurchase our stock and prepay certain indebtedness, create liens, enter into agreements with affiliates, modify the nature of our business, enter into sale-leaseback transactions, transfer and sell material assets and merge or consolidate. Non-compliance with one or more of the covenants and restrictions after any applicable grace period could result in the obligations under the Credit Agreement becoming immediately due and payable and termination of the facilities. If an event of default under the Credit Agreement occurs and is continuing, then the Bank may declare the obligations under the Credit Agreement to be immediately due and payable and may terminate the credit facilities. 

Note 11 - Product Warranty

We accrue for estimated warranty costs at the time the related revenue is recognized and based on historical experience and projected claims. Our System Design and Build contracts generally include a one year base warranty on the systems. The portion of our warranty provision expected to be incurred within 12 months is classified as current within accrued warranty and totals $952 thousand and the remaining $263 thousand is classified as long-term within other liabilities. The activity in the accrued warranty accounts during the current period is as follows:

Note 12 - Revenue

We primarily generate revenue through three distinct revenue streams: (1) System Design and Build ("SDB"), (2) Software and (3) Training and Consulting Services across our Performance and NITC segments. We recognize revenue from SDB and software contracts mainly through our Performance segment. We recognize training and consulting service contracts through both segments.

The following table represents a disaggregation of revenue by type of goods or services for three and six months ended June 30, 2020 and 2019, along with the reporting segment for each category:

SDB contracts are typically fixed-priced, and we receive payments based on a billing schedule established in our contracts. We generally have two main performance obligations: (1) the training simulator build and (2) the Post Contract Support ("PCS") period. Fees for PCS are normally paid in advance of the related service period.

The training simulator build generally includes hardware, software and labor. We recognize revenue for the training simulator build over the construction and installation period, using the cost-to-cost input method. In applying the cost-to-cost input method, we use the actual costs incurred to date, relative to the total estimated costs, to measure the work progress towards the completion of the performance obligation and recognize revenue accordingly. Estimated contract costs are reviewed and revised periodically during the contract period, and the cumulative effect of any change in estimates is recognized in the period in which the change is identified. Estimated losses are recognized in the period such losses are identified. Uncertainties inherent in the performance of contracts include labor availability and productivity, material costs, change order scope and pricing, software modification and customer acceptance issues. The reliability of these cost estimates is critical to our revenue recognition as a significant change in the estimates can cause our revenue and related margins to change significantly from the amounts estimated in the early stages of the project.

The transaction price for Software contracts is generally fixed, and we recognize revenue upon delivery of the software, with fees due in advance or shortly after delivery of the software.

We recognize Training and Consulting Services revenue as services are performed and bill our customers for services that we have provided on a regular basis (i.e.  weekly, biweekly or monthly) and in time with revenue recognition.

Contract liability, which we classify as billing-in-excess of revenue earned, relates to payments received in advance of performance under the contract. Contract liabilities are recognized as revenue as performance obligations are satisfied.

The following table reflects revenue recognized in the reporting periods presented that was included in contract liabilities from contracts with customers as of the beginning of the periods presented:

Note 13 - Income Taxes

The following table presents the provision for (benefit from) income taxes and our effective tax rates:

Our income tax benefit for the interim periods presented is determined using an estimate of our annual effective tax rate, adjusted for discrete items arising in that quarter. Total income tax expense for the six months ended June 30, 2020 was comprised mainly of foreign and state tax expense. Total income tax expense for the six months ended June 30, 2019 was comprised mainly of the tax impact of the loss for impairment, federal, foreign and state tax expense.

Our income effective tax rate was 9.1% and 0.6% for the three and six months ended June 30, 2020, respectively. For the three months ended June 30, 2020, the difference between our income tax expense at an effective tax rate of 9.1% and a benefit at the U.S. statutory federal income tax rate of 21% was primarily due to accruals related to uncertain tax positions for certain U.S. and foreign tax contingencies, a change in tax valuation allowance in our US and China subsidiaries and discrete item adjustments for U.S. and foreign taxes. For the six months ended June 30, 2020, the difference between income tax expense at an effective tax rate of 0.6% and a benefit at the U.S. statutory federal income tax rate of 21% was primarily due to permanent differences, accruals related to uncertain tax positions for certain U.S. and foreign tax contingencies, a change in tax valuation allowance in our US and China subsidiaries, discrete item adjustments for the U.S. and foreign taxes and the tax impact of the loss for impairment.

Because of our net operating loss carryforwards, we are subject to U.S. federal and state income tax examinations from the year 2000 and forward. We are subject to foreign tax examinations by tax authorities for years 2014 and forward in Sweden, 2015 and forward in China, 2015 and forward in India and 2016 and forward in the United Kingdom.

An uncertain tax position taken or expected to be taken in a tax return is recognized in the consolidated financial statements when it is more likely than not (i.e., a likelihood of more than 50%) that the position would be sustained upon examination by tax authorities that have full knowledge of all relevant information. A recognized tax position is then measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Interest and penalties related to income taxes are accounted for as income tax expense.

We recognize deferred tax assets to the extent that it is believed that these assets are more likely than not to be realized. We have evaluated all positive and negative evidence and determined that it will continue to assess a full valuation allowance on its U.S., Swedish U.K., Chinese and Slovakian net deferred assets as of June 30, 2020. We have determined that it is not more likely than not that the Company  will realize the benefits of its deferred taxes in the U.S and foreign jurisdictions.

Note 14 - Leases

We maintain leases of office facilities and equipment. Leases generally have remaining terms of one to three, whereas leases with an initial term of twelve months or less are not recognized on our consolidated balance sheet. We recognize lease expense for minimum lease payments on a straight-line basis over the term of the lease. Certain leases include options to renew or terminate. Renewal options are exercisable based upon our discretion and vary based on the nature of each lease, with renewal periods generally ranging from one to five years. The term of the lease includes renewal periods, only if we are reasonably certain that we will exercise the renewal option. When determining if a renewal option is reasonably certain of being exercised, we consider several factors, including but not limited to, the cost of moving to another location, the cost of disruption to our operations, the purpose or location of the leased asset and the terms associated with extending the lease.

Operating lease Right-of-Use ("ROU") assets and operating lease liabilities are recognized based on the present value of the future minimum lease payments over the lease term at commencement date. The operating lease ROU assets represent the lease liability, plus any lease payments made at or before the commencement date, less any lease incentives received. Our real estate leases, which are comprised primarily of office spaces, represent a majority of our remaining lease liability. The majority of our lease payments are fixed, although an immaterial portion of payments are variable in nature. Variable lease payments vary based on changes in facts and circumstances related to the use of the ROU and are recorded as incurred. We use an incremental borrowing rate based on rates available at commencement in determining the present value of future payments.

We have lease agreements with lease and non-lease components, which are accounted for as a single lease. We apply a portfolio approach to effectively account for the operating lease ROU assets and liabilities.

Lease contracts are evaluated at inception to determine whether they contain a lease and whether we obtain the right to control an identified asset. The following table summarizes the classification of operating ROU assets and lease liabilities on the consolidated balance sheets (in thousands):

We executed a sublease agreement with a tenant to sublease 3,650 square feet from the office space in Sykesville on May 1, 2019. This agreement is in addition to the 3,822 of square feet previously subleased, which was entered into on April 1, 2017. The sublease does not relieve us of our primary lease obligation. The lessor agreements are both considered operating leases, maintaining the historical classification of the underlying lease. We do not recognize any underlying assets for the subleases as a lessor of operating leases. The net amount received from the sublease is recorded within selling, general and administrative expenses.

The table below summarizes the lease income and expenses recorded in the consolidated statements of operations incurred during the six months ended June 30, 2020 and 2019, (in thousands):

⁽¹⁾ Includes variable lease costs which are immaterial.

⁽²⁾ Includes leases maturing less than twelve months from the report date.

⁽³⁾ Sublease portfolio consists of two tenants, which sublease parts of our principal executive office located at 1332 Londontown Blvd, Suite 200, Sykesville, MD.

The future minimum lease payments under non-cancellable operating leases are reflected below. This table also reflects the reconciliation of the undiscounted cash flows to the discounted operating lease liabilities as recognized at June 30, 2020 in our consolidated balance sheet (in thousands):

We calculated the weighted-average remaining lease term, presented in years below and the weighted-average discount rate for our operating leases. As noted in our lease accounting policy, we use the incremental borrowing rate as the lease discount rate.

The table below sets out the classification of lease payments in the consolidated statement of cash flows.

Note 15 - Segment Information

We have two reportable business segments. Our Performance segment provides simulation, training and engineering products and services delivered across the breadth of industries we serve. The Performance segment provides simulations for both training and engineering applications. Examples of engineering services include, but are not limited to, plant design verification and validation, thermal performance evaluation and optimization programs and engineering programs for plants for the ASME "(American Society of Mechanical Engineers") code and ASME Section XI. We provide these services through GSE, True North and DP Engineering across all market segments. Examples of training applications include turnkey and custom training services, and our contract terms are typically less than two years.

The NITC segment provides specialized workforce solutions primarily to the nuclear industry, working primarily at our clients' facilities. This business is managed through our Hyperspring and Absolute subsidiaries. The business model, management focus, margins and other factors clearly separate this business line from the rest of our products and service portfolio.

Our primary measure of segment performance, as shown in the table below, excludes the loss on impairment of intangible assets and goodwill, the provision for loss on legal settlement (see Note 16) and the change in fair value of contingent consideration, net related to the DP Engineering acquisition in fiscal 2019, which do not accurately represent the ongoing operations of our operating segments. Management believes that excluding these discrete items from the segment measure of performance allows for better period over period comparison.

The following table sets forth the revenue and operating results attributable to each reportable segment and includes a reconciliation of segment revenue to consolidated revenue and operating results to consolidated income before income taxes. Inter-segment revenue is eliminated in consolidation and is not significant:

Note 16 - Commitments and Contingencies

Joyce v. Absolute Consulting, Inc.

On March 29, 2019, a former employee of Absolute Consulting, Inc., filed a putative class action against Absolute and us, Joyce v. Absolute Consulting Inc., case number 1:19 cv 00868 RDB, in the United States District Court for the District of Maryland. The lawsuit alleges that plaintiff and certain other employees were not properly compensated for overtime hours that they worked. The Company has been dismissed from the case, but Absolute intends to vigorously defend this litigation with the Company’s assistance and support. Absolute has entered into a settlement agreement as of August 17, 2020 and, pending court approval, anticipates the probable conclusion of this matter to be dismissal of the case in exchange for Absolute’s payment of a settlement amount and fees totaling $861 thousand. The Company has provisioned for this amount in its financial statements for the period ended June 30, 2020. Certain terms of the settlement agreement would require Absolute to pay up to $639 thousand in additional claims that may be asserted, for a total potential liability not to exceed $1.5 million, however no other claims are known at this time. Absolute continues to deny the allegations and defend the case. The Company has asserted an indemnification claim related to this litigation against the sellers of Absolute, which holds approximately a $1 million escrow balance.

Per ASC 450 Accounting for Contingencies, we review potential items and areas where a loss contingency could arise. In the opinion of management, we are not a party to any legal proceeding, the outcome of which, in management's opinion, individually or in the aggregate, would have a material effect on our consolidated results of operations, financial position or cash flows, other than as noted above. We expense legal defense costs as incurred.

Note 17 - Subsequent Events

See Note 10 - Debt and Note 16 - Commitments and Contingencies for details of subsequent events.

Cautionary Statement Regarding Forward-Looking Statements

This report and the documents incorporated by reference herein contain "forward-looking" statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act") that are based on management's assumptions, expectations and projections about us, and the industry within which we operate, and that have been made pursuant to the Private Securities Litigation Reform Act of 1995 reflecting our expectations regarding our future growth, results of operations, performance and business prospects and opportunities. Wherever possible, words such as "anticipate", "believe", "continue", "estimate", "intend", "may", "plan", "potential", "predict", "expect", "should", "will" and similar expressions, or the negative of these terms or other comparable terminology, have been used to identify these forward-looking statements. These forward-looking statements may also use different phrases. These statements regarding our expectations reflect our current beliefs and are based on information currently available to us. Accordingly, these statements by their nature are subject to risks and uncertainties, including those listed under Item 1A - Risk Factors in our most recent annual report on Form 10-K, which could cause our actual growth, results, performance and business prospects and opportunities to differ from those expressed in, or implied by, these forward-looking statements. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements we make. Except as otherwise required by federal securities law, we are not obligated to update or revise these forward-looking statements to reflect new events or circumstances. We caution you that a variety of factors, including but not limited to the factors described under Item 1A - Risk Factors in our most recent annual report on Form 10-K, could cause our business conditions and results to differ materially from what is contained in forward-looking statements.

Other factors and assumptions not identified above were also involved in the formation of these forward-looking statements and the failure of such other assumptions to be realized, as well as other factors, may also cause actual results to differ materially from those projected. Most of these factors are difficult to predict accurately and are generally beyond our control. You should consider the areas of risk described in Item 1A - Risk Factors in our most recent annual report on Form 10-K in connection with any forward-looking statements that may be made by us. You should not place undue reliance on any forward-looking statements. New factors emerge from time to time, and it is not possible for us to predict which factors will arise.

We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any additional disclosures we make in proxy statements, quarterly reports on Form 10-Q and current reports on Form 8-K filed with the SEC.

GSE is a leading provider of professional and technical engineering, staffing services and simulation software to clients in the power and process industries. We provide customers with simulation, engineering and plant services that help clients reduce risks associated with operating their plants, increase revenue through improved plant and employee performance, and lower costs through improved operational efficiency. In addition, we provide professional services that systematically help clients fill key vacancies in the organization on a short-term basis, primarily in procedures, engineering, technical support and training focused on regulatory compliance and certification in the nuclear power industry. Our operations also include interactive computer-based tutorials and simulation software for the refining, chemical, and petrochemical industries.

In December 2019, a novel strain of coronavirus, the COVID-19 virus, was reported in Wuhan, China. On March 11, 2020, the WHO declared the COVID-19 virus a global pandemic and on March 13, 2020, President Donald J. Trump declared the virus a national emergency in the United States. As of the date of this report, both the health and economic aspects of the COVID-19 virus are highly fluid and the future course of each is uncertain. As such, the ultimate impact the pandemic will have on the Company’s financial condition, liquidity and future results of operations is highly uncertain and subject to change. Management is actively monitoring the situation on its financial condition, liquidity, operations, industry, supplies and workforce. The Company's operating results for the six months ended June 30, 2020 have been impacted by the COVID-19 pandemic, and we expect the financial results for the remainder of fiscal year 2020 will be negatively affected as a result of the pandemic.

During the six months ended June 30, 2020, we determined that the COVID-19 virus was an indicator of a triggering event that could result in an impairment of our assets. Based upon this assessment, we performed an interim analysis of our individual asset groupings at the subsidiary level and concluded that the carrying value of the assets of DP Engineering exceeded its fair value. We used an undiscounted cash flow analysis to test for impairment and calculated that the carrying value exceeded the fair value of the DP Engineering definite-lived intangible assets by $4.3 million and recorded an impairment for this amount as of March 31, 2020.