Intrusion Inc Q4 FY2021 Earnings Call

Thank you, operator, and good afternoon, everyone. Thank you for joining us to discuss Intrusion's fourth quarter and full year 2021 results. With me on today's call are Tony Scott, Chief Executive Officer; and Franklin Byrd, Chief Financial Officer. The call is being webcast and will be archived on the Investor Relations section of our website. Before I turn the call over to Tony, I'd like to note that today's discussion will contain forward-looking statements based on the business environment as we currently see it. And as such, it does include certain risks and uncertainties. Please refer to our SEC filings for more information on the specific risk factors that could cause our actual results to differ materially from the projections described in today's conference call. Any forward-looking statements that we make on this call are based on information that we believe as of today, and we undertake no obligation to update these statements as a result of new information or future events. In addition to U.S. GAAP reporting, we report certain financial measures that do not conform to generally accepted accounting principles. During the call, we may use non-GAAP measures if we believe it is useful to investors or we believe it will help investors better understand our performance or business trends. And with that, I'd like to turn the call over to Tony.

Good afternoon, everyone, and thank you for joining us today. I'm pleased to update you on our recent performance and our progress concerning our previously announced strategy. In January 2022, we outlined our strategic priorities and medium-term plan for Shield. We enjoyed the opportunity to highlight Shield's unique cybersecurity offering and demonstrate how we are driving the business forward. While there is still much work to be done, I'm pleased to say that we are making tremendous progress on our stated initiatives. First, we took swift and direct action in the fourth quarter to realign our sales and marketing resources while ensuring our ability to participate in the growing demand for cybersecurity threat protection. These actions were necessary to stabilize expenses and to rightsize the organization. Second, we are in active and fruitful conversations with several strategic and premier channel partners that can help expand Shield's exposure, generate revenue, and can be a force multiplier for Intrusion's sales and marketing. Additionally, we have realigned our messaging and marketing to highlight how INTRUSION Shield products complement existing cybersecurity solutions that an organization may already have in place. And third, as you saw in our 8-K and press release, we improved our financial flexibility by entering a $10 million unsecured notes offering with Streeterville Capital in the first quarter of 2022. As a reminder, we aim to raise a total of $15 million to $20 million in the year. The proceeds of our fundraising, combined with our existing financial tools, will enable us to invest in Shield and ensure that it's the best positioned solution to address modern cybersecurity challenges, including zero-day attacks. As a result of these actions, Intrusion is a more stable, efficient, and disciplined enterprise that possesses the ability and agility to respond appropriately to rising demand and customer needs while preserving financial prudence and accountability. We remain focused on driving operational excellence, developing innovative new products, and generating value for our customers and our shareholders. Before I turn the call over to Franklin to discuss our financial performance in more detail, I'd like to take a moment to provide a high-level overview of our progress with Shield and our expectations for our legacy consulting business. Shield adoption continues to gain traction, and we expect it will continue to become a greater portion of our revenue moving forward. Additionally, we are engaged in an increasing number of customer pilots and proof-of-concept installations working with and through our channel partners. While we are encouraged by the positive early feedback we are receiving, it's still too early to quantify the impact these trials will have on our full 2022 results. Still, we are setting a solid foundation for the company to build upon in 2022 and beyond as we create a solid base of annually recurring revenue. Further, when I introduced myself to everyone in January, I mentioned that we are working on several new innovative Shield products that we plan to unveil in the second half of the year. These offerings include a cloud-based product, a Shield endpoint product, and a high availability, high throughput option that will be hardware-based. I'm pleased to say that the development of these new products remains on track and on schedule. We still expect to roll out these products in the second half of 2022, with some having demo capability in the coming quarter. Finally, let me turn to our consulting business. While that business was limited by a continuing resolution, otherwise known as a CR from the government sector in 2021, which restricted funding for new projects, this business still performed well in the year and remains a healthy part of our business. We continue to invest. And as the CR has now ended and there's a full budget, we expect an increase in revenue for our consulting business. The combination of an increasing number of proof-of-concept demos and the end of the continuing resolution established a strong foundation for the business and could result in upside to our 2022 results. In summary, we recognize that we still have work to do along our plan for developing our organization, raising needed capital, developing an enhanced product offering, and delivering sustainable results. However, I'm pleased by all the progress we have made so far. We realigned our sales and marketing resources, developed relationships with several strategic and premier channel partners, and improved our financial flexibility by entering into a $10 million financing agreement with Streeterville Capital. Shield continues to accelerate with a growing number of prototypes and demos, and we expect healthy growth in our consulting business in 2022. The cybersecurity landscape is changing rapidly, with zero-day attacks being more prevalent, and Shield is uniquely suited to help enterprises adapt to the changing environment and see the previously unseen threats to their networks. Going forward, we will continue to refine our messaging while utilizing value-added channel partners in our executive-led direct sales model to drive Shield's growth. I'm excited about what Intrusion will do in 2022, and I look forward to updating you on our progress. And with that, I'd like to turn the call over to Franklin to discuss the financials in more detail. Franklin, over to you.

Thanks, Tony. Revenue for the fourth quarter of 2021 was $1.6 million, which is in line with our fourth quarter 2020 results. Full-year revenue of $7.3 million increased 10% year-over-year. The increase in our full-year revenue was primarily due to the Shield revenue that we received in 2021. As a reminder, we introduced Shield in 2021, and we are pleased with the early progress we are making with that product. During the fourth quarter, Shield accounted for 12% of our revenue, which is relatively in line with the third quarter of 2021. As Tony mentioned, we are pleased with the traction we're seeing on Shield, and we expect the revenue contribution to continue to improve moving forward. Gross margin for the fourth quarter was 65%, an improvement from 58% for the fourth quarter of 2020. The full-year gross margin was 64%, expanded from 59% in 2020. The improvement in gross margin is primarily due to the increase in Shield sales. We expect the gross margin to continue at its healthy levels and possibly improve further as Shield adoption continues. Fourth-quarter operating expenses were $4.9 million, which is in line with our fourth quarter 2020 results. As a reminder, the fourth quarter 2020 operating expenses included a $1.1 million non-cash write-off for the abandonment of a prior office lease. Operating expenses for the full year were $24.2 million, up 132% from 2020. The increase in operating expenses was largely driven by the higher sales and marketing costs. While our sales and marketing expenses were not aligned with our Shield adoption rate for the first part of 2021, we quickly corrected those issues and recalibrated our go-to-market strategy. Operating expenses for the fourth quarter were at the lowest levels in all of 2021, and we expect operating expenses to remain stable following our swift action to rightsize our sales and marketing resources. Additionally, we expect headcount trends to be steady for the near future. Net loss for the fourth quarter was $3.9 million or $0.20 per share compared to a net loss of $3.9 million or $0.23 per share for the fourth quarter of 2020. The full-year net loss was $18.8 million or $1.05 per share compared to a net loss of $6.5 million or $0.45 per share in 2020. Turning to the balance sheet. As of December 31, 2021, we had cash and cash equivalents of $4.1 million, down from $16.7 million in the prior year. As of December 31, 2021, working capital was $2.1 million, down from $16.2 million in the prior year. As Tony just highlighted, last week, we closed on a financing where we sold a 7% unsecured note under Securities Purchase Agreement with Streeterville Capital. The aggregate principal amount of this note was $5.4 million, and we received $5 million less certain reimbursed expenses. We also received an option to sell a second 7% unsecured note on similar terms as the first note. Our option to sell the second note is subject to certain conditions, including that within 180 days of issuance, we obtain stockholder approval under NASDAQ rules for the issuance of more than 19.99% of our outstanding common stock in connection with potential redemptions of the notes. Each note has an 18-month maturity. And 6 months after a note has been issued, the noteholder can submit a redemption notice for up to $500,000 per note, which we can choose to satisfy subject to certain exceptions and limitations in cash, common stock, or a combination of both. This financing enables us to meet our operational needs while prudently investing in our new Shield products. Additionally, our ATM facility remains in place, and we will utilize it opportunistically to finance our operating activities, invest in Shield as well as potential note repayments. Before turning the call over to the operator for Q&A, I'd like to echo some of Tony's earlier remarks. Despite a challenging 2021, we still delivered double-digit top line growth and healthy gross margin expansion driven by our Shield product's growth. We acted swiftly to realign our sales and marketing resources and our go-to-market strategy, and our expenses declined to manage those levels as a result. We are encouraged by the interest in our Shield products and the ending of the continuing resolution as a tailwind for our consulting business. 2022 will be an exciting year for Shield, and I look forward to updating you on our progress.

Tony, the first question, can you give us a little more insight into some of the feedback you received from your ongoing pilot program that you have for Shield? I think in the press release, you mentioned you have 18 pilots or proof of concepts going on right now.

Yes, I'd be happy to. So let me do a little bit of context setting for it. So in the part of Q4 and early in Q1, we've been focusing on really strengthening the relationship with our channel partners and resellers in particular. And in particular, those that have been putting resources in place, going through training, understanding how to sell and use the product, etc. And so that activity has borne fruit and has led to these pilots that we mentioned and proof of concepts. The feedback has been great, and we've learned a number of things from our customers in terms of how they want to use the product and the value that they see in it. So we're encouraged by that feedback. And of course, every customer has special things that they want to see done, and we're taking that into account, and we'll put those requests into our engineering pipeline. But so far, I'm quite pleased with the reception that we're getting.

Understood. That's helpful. And in terms of your new marketing and messaging for Shield, I mean, I know it's still pretty early in terms of the change in approach and how you're marketing this to both people and partners. But is there any insight you can share in terms of maybe the feedback you've received since you've had this change in messaging and kind of how that's opened up your conversations with both potential customers or strategic relationships?

Yes. And again, just to bring everybody into the same conversation, when I came on board and talked to both people internally and some of our external customers and people we had relationships with, I was getting very mixed messages about what Shield did, what it was good for. And there were no bad answers there, but it was confusing, I think, to the marketplace. And in some cases, people thought we were trying to replace an Intrusion detection and prevention device. In other cases, people thought we were a firewall and we were trying to replace whatever firewall technology they had in place and so on. And so our new messaging, which I think is very accurate in terms of where we provide added value, is that we help make all of the other solutions that you may already have in place work better. We help you see things that you're not probably currently seeing and know things about traffic in your network that you probably don't know or see today. And indeed, that's what we're seeing with our customers. They're quite intrigued by the traffic that they now have visibility into that they could not see before. So as a part of that new sales approach, we're not going in saying we're a better firewall or a better IDPS or whatever. We're saying, hey, let us show you how we can make all the other stuff that you have even better. And that seems to resonate. And even in Intrusion, we use our technology in combination with other technologies as well. So we’re not unlike, I think, most other organizations.

Understood. That's helpful. And final question for me is really around your consulting business. It's nice to see that stabilize in a pretty tough environment in 2021. But can you just talk about maybe some of the growth opportunities you see ahead here now that you have the resolution done and out of the way with an official budget in place? And is there opportunities to be able to embed Shield into some of that existing consulting business? And maybe some of the cross-selling opportunities you can see with that product?

Yes. Those familiar with our consulting business know that we primarily focus on the Department of Defense. Since I joined in November, particularly during January and February, we have started to shift our attention toward the civilian side of the federal government, where I have strong relationships from past roles. Additionally, we see great potential to engage with state and local entities. We believe there is significant upside for that legacy consulting business, and we will continue to invest in it. One of the advantages is that, especially on the federal side, they often see trends before anyone else, providing us valuable insights into future developments.

I'm curious in the current global environment whether you guys are getting more incoming calls given heightened tensions with a hacker hotbed in Russia.

Well, let me answer it this way. Any time there are world events that get people's attention, whether it's the hacking of a major institution or anything related to cyber, it tends to increase the number of calls that we get and interest in how we might be able to help. So the current situation is no different, and we have noticed a significant increase in people wondering if something that Intrusion can do can help them. So you hate to, in some ways, be the beneficiary of some of these world events, but nevertheless, it is absolutely a factor.

That's helpful, Tony. And then in terms of educating your channel partners on the Shield product, I mean can you give us a little color on that process and timeline and when those relationships really start to accelerate sales?

Well, in the case of these resellers that we've been very focused on since November and now during the quarter, we're engaging in sales training or making sure they have all the support materials that they need. We're making sure we have the support processes in place so that when they sell or they have customer questions or whatever, that they're well prepared to both answer those questions and support their customers. We've spent a lot of time making sure that they're equipped with all the tools that they need to both sell and support prospective customers. And the active ones are getting Shield units out in customers' hands and conducting proof of concepts and doing exactly what we hoped they would do, and we'll ramp that up even more in Q2. We just hired a new channel manager who has experience building that kind of capability with cybersecurity products, and we're really looking forward to what he can bring to the table in terms of accelerating us even faster in that space.

That's very helpful. And then last one for me. Just on the sequential decline in sales and marketing expense. I'm curious, is that all head? Or is that lower headcount and a change in how you're actually marketing the product?

It's both. We did a pretty significant reduction in headcount in sales and marketing, but we also eliminated a bunch of expenses that frankly were just not generating results for us. We had a theory of the case about how to go to market that just wasn't working very well, and so we cut out all of the expenses and headcount related to those things that weren't working. And we've kept the things that are working and were working, and we're going to amplify those as I previously outlined. So the answer is it was both.

As the COVID cases seem to be coming down, if this is a return to normal, have you noticed any significant improvement in your sales cycle?

I don't think we noticed any significant changes at this particular point. I do know that we're getting invited to more in-person kinds of things than we were, obviously, during the height of COVID. There seemed to be more events being scheduled, and people are sort of coming out of whatever cave they've been living in for the last couple of years. So I think that will translate into good things for us. But in terms of the cycle itself, I think it's probably a little too early to tell. What I do know, though, is with heightened awareness around cybersecurity and as events take place, people have a renewed sense of urgency, I would say, in terms of improving their cybersecurity posture. And I think in the long run, that bodes well for a shortening of sales cycles, if anything.

Two questions. The first one, there seems to be a lot of confusion about this offering, $10 million. I wonder if you could go over the whole conversion price. And that when it was announced, it had a very big impact on the stock. The second question is, will you be able to announce some of our partners and our channel partners that we are relying on? So those two questions, if you would.

Sure. So let me start with kind of our theory of the case, and then I'll have Franklin comment on the specifics of the deal. But when I came in, in November, and I've done my due diligence, there were a couple of things that stood out and that we actually formed our strategy around. The first one was it was clear to me that we were going to have to invest in some new product offerings, and as I previously announced, cloud and endpoint and so on. And I knew that it was going to take us around half a year to get those products in shape where we could demo and ultimately sell them. And so when you do the math, you pretty quickly figure out that we didn't have the money in the bank at that particular point to fund those activities, and so a capital raise becomes a necessity. And so our strategy is playing out, and we're right on plan with where I thought we needed to be and where we had planned to be. And so our strategy was to raise enough capital to get through the cycle of the 6-month product development and realignment of resources. We've talked before about fixing messaging and marketing and our go-to-market strategy and all of those kinds of things. So after making the announcement that we planned to raise capital, we were approached by all sorts of different folks with all kinds of different ways that we could satisfy that capital need. And at the end of the day, we chose one that I think best satisfied our cost of capital and our immediate needs. Our whole theory of the case is hinged on the new products that we've announced, particularly the cloud product, where revenue comes in the form of annual recurring revenue. I know from my previous experience that the market values annual recurring revenue at 6 to 8 times more valuable than traditional revenue. So if we have a product that's generating $1 million in ARR, the enterprise value is 6 to 7 times greater than $1 million of just ordinary income. So our whole strategy is based on products that will generate ARR, and that presumably moves the stock up to a place that it's not been yet, and this vehicle that we've chosen gives us the best return when that happens. So that's kind of the overall arching strategy, and I'll let Franklin cover the specifics of the deal.

Thanks, Tony. Yes, sir, Mr. Cleveland, happy to answer that question. The first thing I would just kind of echo what Tony was saying is our evaluation of this particular vehicle was across several other opportunities, and one of the main thoughts that we looked at was where our price is today versus where we believe it should be. And we truly believe it's lower than what our real valuation is today. So that's a big part of it. This particular structure allows us to help perform and show our company performance, increase our stock price and then if we choose transact at future stock prices. But to answer the specific question, it's a 2-note structure, one that we've executed and one that has a condition precedent that you probably read about. They both have 7% coupons. They both had an original issue discount of around 6%. And they're both 18-month notes with nothing that transpires, no redemptions for the first 6 months. After 6 months, the noteholder can redeem up to certain amounts per month, and we can decide how we redeem that. If we want to redeem it in cash, we will. If we want to redeem it in stock, we can. If we do it in stock, there will be a 15% discount on that future stock price, or we can do a combination of both. And as you know, we still have our ATM product in place today, so that gives us a little bit more flexibility.

Okay. So you have a choice. From your side, you could either pay it off or would be in line with the market at a 15% discount. So I think that's where the confusion comes in. So the discount is only 15% off the market at that time.

Yes, sir. That's correct. We will announce channel partners in association with significant sales they generate. I prefer not to flood the media with announcements that lack importance. The company previously shared information about signing several channel partners, but some were less active than others and did not produce revenue for us. Therefore, I want to avoid making announcements about channel partners that aren't meaningful. However, when significant deals occur, we will make those public. Additionally, we are in discussions with some strategic partners, including OEMs and large technology companies, and we will announce any material developments with those partners as well.

Two unrelated questions. Since you are still selling and marketing a product based on a box, you have 18 people evaluating the product at this point you said, could you give us some sense as to the range in broad terms as to the size of those 18? They range from 50 seats to 1,000 seats potentially. Obviously, someone may layer into the product, 50 seats to 5,000. Just some sense as to the types of how big the businesses are that are evaluating this.

It's a broad range, and we need to consider the context. Some of the proof of concepts involve organizations that currently have one appliance, but their actual deployment may require one, ten, or twenty-five units depending on their bandwidth needs. Once we introduce the cloud product in the second half of the year, the installation model and bandwidth capabilities will change. Currently, with the appliance, we are somewhat limited in the bandwidth we can support, making it difficult to describe the actual deployment in each case. What they are really interested in is understanding what is happening in their network that they are unaware of, and both the cloud and appliance products provide that insight, showcasing value to the customer. Some of these ongoing proof of concepts may lead organizations to prefer the cloud option, while others may find the current implementation valuable enough to stick with it. It's still too early for us to quantify either preference.

At this point, you're still marketing under the original plan, which involves a monthly charge per seat for the 18 you mentioned. The cloud may be marketed differently, but that's the model for now. Please continue; I apologize for interrupting.

I was going to mention that we have previously announced a high reliability failover, high-throughput hardware solution, and many customers are also showing interest in that. As I have stated before, I don't believe hardware will completely disappear in the future. Based on my own experience, there are diverse needs for those with large and expansive networks. I see some customers likely preferring a mix of hardware and cloud solutions, as they operate in a hybrid technology environment. Therefore, we will not be abandoning hardware but will offer customers the choice to use hardware, cloud solutions, or both depending on what fits their specific environment best. Sure. It's a great question and one that I get asked pretty often these days. So here's the situation. I have a portfolio that's a bit locked up at the moment. I'm doing some things to unlock that, and I will make an investment at a point in the future as soon as I get some flexibility in what I can do with my personal portfolio. And I'm excited about doing that, and you'll see an announcement when that happens. But I'll also point out, I'm personally subsidizing my existence at Intrusion as well. So every month, I'm making a contribution so that I can be here and do the things that we're anticipating doing, and I'm happy to continue doing that as well so we can get this rocket ship really launched.

When I listen to you describe the financing, it strikes me as it makes sense if you believe that you are within 6 months to a year of a major revenue ramp that's going to push you to where you actually become a free cash flow generating business. Is that a safe assumption to make?

It should be understood in the context of annual recurring revenue serving as a significant driver for the stock price. We believe that the current stock price significantly undervalues the company, and we expect to show that in the second half of the year through our annual recurring revenue and its implications for the future. Regarding actual cash flows, it's premature to make definitive predictions. If our products succeed, we might increase our R&D expenses, consider acquisitions, or explore various options, all of which would affect cash flow. It’s too early to forecast that right now, but we plan to manage our resources responsibly and focus on enhancing enterprise value for our shareholders.

Now do you foresee any of the channel or strategic partners that you're looking at working with and who are looking at utilizing Shield providing capital upfront in any way?

That could be a scenario with the big strategic partners. To make this successful, there's always going to need to be some investment on their part and some investment on our part to bring this solution to market jointly, and part of that formula could be a capital investment. We're not requiring that at this particular point, but we’re not ruling it out either, and it's been a part of the discussion. I agree. Yes. I wish I could comment on this, but I would get myself into trouble. Well, I'd like to just conclude the call today by saying that I really appreciate the support that I feel from our investors, and many of you have called and offered your insight and sharing your thoughts on the company and things that we could do going forward. And I'm grateful for that. As I said in my remarks, I think the team is energized, and we're ready to scale to new heights. So we're looking forward to what we can do together as a team in the next few months, and show the world what we’ve been working on. So I appreciate all the support. Keep the cards and letters coming, as they used to say, and I look forward to talking to you in the near future. Thanks so much.

This concludes today's conference call. Thank you for joining. You may now disconnect.