SECTION 9 LABS CORP. Management report and analysis of the financial situation and operating results. (Form 10-K)
You should read the following discussion of the Company's financial condition and results of operations together with its audited consolidated financial statements and notes to such financial statements included elsewhere in this Form 10-K. The following discussion contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about the Company's industry, business and future financial results. The Company's actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed under "Item 1A. Risk Factors" and other
sections in this 10-K. Overview
Item 9 Labsproduces premium cannabis and cannabis related products in a rapidly growing market. The Company currently offers over seventy-five (75) active cannabis strains and more than one hundred fifty (150) differentiated cannabis vape products as well as premium concentrates and Orion vape technologies. The Company's product offerings will continue to grow as they develop new products to meet the needs of the end users. The Company makes its products available to consumers through licensed dispensaries in Arizona. Item 9 Labs'products are now carried in more than 70 dispensaries throughout the state of Arizona. The Company believes its past and future success is dependent upon its ongoing ability to understand the needs and desires of the consumers, and the Company develops and offers products that meet those needs. The Company's objective is to leverage its assets (tangible and intangible) to fuel the growth of its share of the Arizonacannabis market, as well as expand the geographical reach of its products into markets outside of Arizona, with the ultimate goal of providing comfortable cannabis health solutions to a larger population in a manner that will create value for the Company's shareholders. In March 2020, the World Health Organizationcategorized Coronavirus Disease 2019 ("COVID-19") as a pandemic, and the President of the United Statesdeclared the COVID-19 outbreak a national emergency. The extent of the impact of the COVID-19 outbreak on the Company's operational and financial performance will depend on certain developments, including the duration and spread of the outbreak, its impact on its customers and vendors, and the range of governmental and community reactions to the pandemic, which are uncertain and cannot be fully predicted at this time. In March 2021, the Company closed on the acquisition of OCG, Inc., dba Unity Rd., a cannabis dispensary franchisor. The transaction was structured as a reverse triangular merger, with the effect of OCG, Inc.becoming a wholly owned subsidiary of the Company. Unity Rd.has agreements with more than twenty (20) partners for such partners to open more than thirty-five (35) Unity Rd.retail dispensary locations in fourteen(14) states. The majority of the locations are in the licensing process. One such franchise unit has been opened to date, in Boulder, Colorado. Unity Rd.will assist in providing distribution for Item 9 Labsproducts to be sold across the United Statesand internationally to its franchisees for public resale, while keeping dispensaries locally owned and operated. As Unity Rd.dispensaries expand in its market penetration, Item 9 Labsaims to offer its products in those locations by expanding the distribution footprint of its premium product offerings to new states. The Company's Arizonacannabis operations have expanded in recent years, with the addition of a 2nd nearly 10,000 square foot facility in the 4th quarter of fiscal year 2019, more than doubling the Company's cultivation and processing space for Arizona. As the Company methodically expanded its operational capacity by more than 100% in fiscal year 2020, it was also able to significantly increase efficiencies within the cultivation and processing operations. 30
Arizonaexpansion has continued in fiscal year 2021 and is expected to continue thereafter. The Company has tripled production since October 1, 2020, while beginning construction on phase 1 of its construction plan to build additional cultivation space. Phase 1 plans total over 60,000 square feet of additional cultivation and processing space, and the planned remaining five phases would add over 560,000 square feet of cultivation and processing space. By the conclusion of their master site development, the Company anticipates a total of more than 640,000 square feet of cultivation and processing space; there is no assurance the Company can complete these construction projects as planned. Item 9 Labs Corp.has continued its expansion plans into other states as well as the Company acquired (pending regulatory approval) cultivation and processing licenses in Nye County, Nevadawhich will be paired with their Nevadafacility. In fiscal 2019, the Company broke ground on their 20,000 square foot cultivation and processing facility in Nevada. The facility is now approximately 70% complete. Construction recommenced after a pause due to Covid-19 in August 2021. The Company aims to commence operations in Nevadain fiscal year 2022. Results of Operations Years Ended September 30, 2021 2020 $ Change % Change Revenues, net $ 21,937,227 $ 8,121,733 $ 13,815,494170 % Cost of revenues 13,324,284 4,825,959 8,498,325 176 % Gross profit 8,612,943 3,295,774 5,317,169 161 % Operating expenses Professional fees and outside services 3,241,820 1,389,183 1,852,637 133 % Payroll and employee related expenses 6,649,097 4,131,948 2,517,149 61 % Sales and marketing 1,170,982 265,028 905,954 342 % Depreciation and amortization 1,085,847 907,556
178,291 20 % Other operating expenses 1,828,954 1,477,991 350,963 24 % Loss on impairment - 100,000 (100,000 ) -100 % Provision for bad debt 237,506 450,018 (212,512 ) -47 % Total operating expenses 14,214,206 8,721,724 5,492,482 63 % Loss from operations (5,601,263 ) (5,425,950 ) (175,313 ) 3 % Other expense, net (5,304,509 ) (6,959,691 ) 1,655,182 -24 % Net loss, before income tax provision (benefit) (10,905,772 ) (12,385,641 ) 1,479,869 -12 %
Income tax provision (benefit) - (85,984 )
85,984 -100 % Net loss
$ (10,905,772 ) $ (12,299,657 ) $ 1,393,885-11 % Revenues, net
The increase in revenue was primarily due to a change in certain processes and procedures in the Company's lab. That is, during fiscal year 2021, the Company purchased equipment to automate certain manual processes. The purchase of this equipment made certain processes, such as the filling of cartridges, more efficient, which allowed for increased output. In order to support this increased output, the Company began to purchase certain inventory materials from third party vendors that it had previously produced itself. This allowed the Company to avoid interruptions in production due to a lack of material. Further, during fiscal year 2021, the Company added and reorganized post-production space to more efficiently package its products for sale. This allowed the Company to deliver its products to the dispensaries more timely. The demand for the Company's products is greater than the supply it is able to produce and the changes in process and procedures in the Company's lab allowed the Company to increase production more than 100% during the year ended
September 30, 2021. Management anticipates revenues to continue to grow as the revenue trends are positive month over month. Cost of revenues Cost of revenues consist primarily of labor, materials, supplies and utilities. Costs of revenues as a percentage of revenues was 61% for the year ended September 30, 2021compared to 59% for the period ended September 30, 2020. The Company was able to increase operational efficiency throughout fiscal year 2021. However, the cost of the purchased inventory materials discussed above and increases in other costs, such as product testing, primarily negated these efficiency gains. Management will remain focused on reducing costs through bulk purchasing, implementing additional efficiencies in production and making additional investments in property and equipment. The Company believes that it will continue reducing the overall costs of revenues and costs of revenues will increase at a lower rate than revenues in future periods, which will lead to increased profit margins. 31 Gross Profit The increase in gross profit was due to increases in revenue offset by increases in purchased inventory materials and other costs. With the Company's continued efforts to increase capacity and focus on efficiencies and reducing costs, management expects gross profit to continue to grow going forward. Operating Expenses
Professional fees and outside services increased primarily due to increase legal and accounting fees related to the
OCG Inc.acquisition and increased spending for corporate advisory services and investor relations services. The increase in payroll expenses was primarily due to the increase in stock options granted during fiscal year 2021 and the scheduled amortization of stock options granted in the prior year. Further, payroll expenses increased due to an increase in employee headcount during fiscal year 2021. Sales and marketing expenses increased due to increased spending on marketing and branding initiatives during fiscal year 2021. The increase in depreciation and amortization is due to the amortization of intangible assets acquired in the OCG Inc.acquisition. Other operating expenses increased primarily due to increases in insurance expenses, travel related expenses and additional IT support for the increase in employees. The decrease in loss on impairment was due to no impairment needing to be recorded in fiscal year 2021. Finally, the provision for bad debt decreased due to a lesser reserve needed on the outstanding notes receivable at year-end. Total operating expenses as a percentage of gross profit decreased from 265% to 164% for the years compared. Management believes this ratio will continue to decrease going forward as the expectation is that revenues will continue to grow at a higher rate than operating expenses.
Other expenses, net
Other expenses consist primarily of interest expense of
$5,295,349and $6,959,705for the years ended September 30, 2021and 2020, respectively. The decrease in interest expense was primarily the result of a decrease in amortization of debt discounts and a decrease in overall interest expense due to a decrease in stated interest rates. Adjusted EBITDA Management uses the non-GAAP measurement of earnings before interest, taxes, depreciation, amortization, stock-related compensation expense, acquisition-related costs, and other adjustments, or "Adjusted EBITDA," to evaluate the Company's performance. Adjusted EBITDA is a non-GAAP measure that is also frequently used by analysts, investors and other interested parties to evaluate the market value of companies considered to be in similar businesses. The Company suggests that Adjusted EBITDA be viewed in conjunction with its reported financial results or other financial information prepared in accordance with accounting principles generally accepted in the United States, or "GAAP."
The following table reflects the reconciliation of net loss and adjusted EBITDA for the years ended
Years Ended September 30, 2021 2020 Net loss
$ (10,905,772 ) $ (12,299,657 )Depreciation and amortization 1,220,847 907,556 Interest expense 5,295,349 6,959,705 Stock-based expense 2,404,671 1,729,910 Acquisition related costs 273,432 243,755 Income tax benefit - (85,984 ) Adjusted EBITDA $ (1,711,473 ) $ (2,544,715 )
Financial position, liquidity and capital resources
Cash and capital resources
The Company's primary need for liquidity is to fund working capital requirements of its business, capital expenditures, acquisitions, debt service, and for general corporate purposes. The Company's primary source of liquidity is funds generated revenues, financing activities and from private placements. The Company's ability to fund its operations, to make planned capital expenditures, to make planned acquisitions, to make scheduled debt payments, and to repay or refinance indebtedness depends on its future operating performance and cash flows, which are subject to prevailing economic conditions and financial, business and other factors, some of which are beyond the Company's control.
32 The accompanying consolidated financial statements have been prepared in conformity with US GAAP, which contemplates continuation of the Company as a going concern. The Company has not yet established an ongoing source of revenue sufficient to cover its operating costs and has incurred net losses since its inception. These losses, with the associated substantial accumulated deficit, are a direct result of the Company's planned ramp up period as it is pursuing market acceptance and geographic expansion. In view of these matters, realization of a major portion of the assets in the accompanying consolidated balance sheets is dependent upon continued operations of the Company which in turn is dependent upon the Company's ability to meet its financing requirements, and the success of its future operations. The Company operates in a new, developing industry with a variety of competitors. These factors raise substantial doubt about the Company's ability to continue as a going concern.
In order to continue its operations, the Company will have to generate additional revenues and obtain additional capital to finance its operating losses and to service its debt. Management’s plans regarding these matters are described as follows:
Sales and Marketing. Historically, the Company has generated the majority of its revenues by providing its products to dispensaries throughout the state of
Arizona. The Company's revenues have increased significantly since its inception in May 2017. Management will continue its plans to increase revenues in the Arizonamarket by providing superior products. Additionally, as capital resources become available, the Company plans to expand into additional markets outside of Arizona, with construction of a cultivation and processing facility nearing completion in Nevada. The Company believes that it will continue reducing the overall costs of revenues and costs of revenues will increase at a lower rate than revenues in future periods, which will lead to increased profit margins.
Financing. To date, the Company has financed its operations primarily with loans from shareholders, private placement financings and sales revenue. Management believes that with continued production efficiencies, production growth, and continued marketing efforts, sales revenue will continue to grow, thus enabling the Company to reverse its negative cash flow from operations and raise additional capital as needed. However, there is no assurance that the Company's overall efforts will be successful. If the Company is unable to generate additional sales growth in the near term and raise additional capital, there is a risk that the Company could default on additional obligations, and could be required to discontinue or significantly reduce the scope of its operations if no other means of financing operations are available. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities or any other adjustment that might be necessary should the Company be unable to continue as a going concern. As of
September 30, 2021, the Company had $1,454,460of cash and cash equivalents and negative working capital of ( $4,393,385) (current assets minus current liabilities), compared with $84,677of cash and cash equivalents and negative working capital of ( $7,396,258) as of September 30, 2020. The improvement of $3,002,873in the Company's working capital was primarily due to increases in accounts receivable, inventory and prepaid expenses and other current assets. These increases in current assets were offset by increases in accounts payable, accrued payroll, accrued interest and accrued expenses, deferred revenue and current portions of debt. The $1,369,783improvement in cash and cash equivalents was primarily due to proceeds from the issuance of debt. The Company is an early-stage growth company. It is generating cash from sales and is investing its capital reserves in current operations and new acquisitions that are expected to generate additional earnings in the long term. The Company expects that its cash on hand and cash flows from operations, along with private and/or public financing, will be adequate to meet its capital requirements and operational needs for the next 12 months, although no assurance can be given that private and/or public financing can be obtained on terms acceptable to the Company, or at all. Cash Flows The following table summarizes the sources and uses of cash for each of the periods presented: Years Ended September 30, 2021 2020 Net cash used in operating activities $ (5,989,581 ) $ (1,141,416 )Net cash used in investing activities (3,917,969 ) (886,854 ) Net cash provided by financing activities 11,277,333
Net increase (decrease) in cash and cash equivalents
Operating Activities During the year ended
September 30, 2021, operating activities used $5,989,581of cash and cash equivalents, primarily resulting from a net loss of $10,905,772and net cash used by operating assets and liabilities of $2,877,911, comprised of increases in accounts receivable of $1,085,400and inventory of $4,244,241, offset by increases in accounts payable and accrued expenses of $2,397,416. These uses of cash were further offset by non-cash operating expenses of $7,794,102, primarily comprised of depreciation and amortization of fixed and intangible assets and the right of use asset in the amount of $1,260,665, amortization of debt discounts in the amount of $3,891,260, stock-based compensation totaling $2,404,671and the provision for bad debt in the amount of $237,506. 33 During the year ended September 30, 2020, operating activities used $1,141,416of cash and cash equivalents, primarily resulting from a net loss of $12,299,657offset by net cash provided by operating assets and liabilities of $3,096,439. There was significant non-cash activity that contributed to the net loss totaling $8,061,802including depreciation and amortization of $979,158, provision for bad debt of $450,018, amortization of debt discounts of $2,240,617, amortization of beneficial conversion of $2,562,099, and compensation paid in the form of stock and stock options of $1,729,910. Cash provided by changes in operating assets and liabilities was primarily due to an increase in accrued interest of $1,371,606, $900,661in accounts payable, and accrued expenses of $1,428,847, offset by a decrease in inventory of $210,576, and prepaid expenses and other current assets of $293,496. Investing Activities During the year ended September 30, 2021, investing activities used $3,917,969of cash and cash equivalents, consisting primarily of deposits on acquisitions of $1,775,348and purchases of property, equipment and construction in process of $2,242,217. During the year ended September 30, 2020, investing activities used $886,854of cash and cash equivalents, consisting primarily of payments totaling $167,152in purchases of property and equipment, $555,738paid for acquisitions, and $238,964in license fees offset by $75,000in cash received on notes receivable. Financing Activities During the year ended September 30, 2021, financing activities provided $11,277,333of cash and cash equivalents, which includes cash proceeds from the sale of common stock of $13,299,808and cash proceeds from the issuance of debt of $2,580,000. These proceeds were offset by payments on existing debt of $4,583,469.
During the year ended
Off-balance sheet arrangements
The Company is not currently party to any off-balance sheet arrangement that has or is reasonably likely to have a material current or future effect on its financial position, changes in its financial position, its income or expenses, results of operations, cash, capital expenditure or capital resources.
Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with
U.S.Generally Accepted Accounting Principles ("GAAP") and the Company's discussion and analysis of its financial condition and operating results require the Company's management to make judgments, assumptions and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1, "Description of Business and Summary of Significant Accounting Policies," of the Notes to Consolidated Financial Statements included in this Form 10-K, describes the significant accounting policies and methods used in the preparation of the Company's consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates, and such differences may be material. Management believes the Company's critical accounting policies and estimates are those related to revenue recognition, valuation of warrants and debt discounts, carrying value of intangible assets subject to amortization, infinite life intangible assets and goodwill, stock-based compensation, business combinations and income taxes. Management considers these policies critical because they are both important to the portrayal of the Company's financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company's management has reviewed these critical accounting policies and related disclosures with the Audit Committee of the Company's Board of Directors. Revenue Recognition
The Company’s revenues are primarily associated with a customer contract that represents an obligation to supply cannabis products that are delivered at a given time. All costs incurred prior to the period in which the products are delivered are recorded in inventory and recognized as cost of products in the period in which the performance obligations are fulfilled.
The Company calculates the cost of equity awards based on the grant date fair value of the awards using the Black-Scholes-Merton option pricing model, which incorporates various assumptions, including volatility, expected duration and risk-free interest rates.
34 The expected term of the options is the estimated period of time until exercise and was determined using the
SEC'ssafe harbor rules, using an average of vesting and contractual terms, as the Company did not have sufficient historical experience of similar awards. Expected stock price volatility is based on historical volatility of the Company's stock since March 20, 2018, the day of the merger between BSSD Group LLCand Airware Labs Corp.The risk-free interest rate is based on the implied yield available on United States Treasury zero-coupon issues with an equivalent remaining term. The estimated fair value of stock-based compensation awards is amortized on a straight-line basis over the relevant vesting period and forfeitures at the time the occur.
In accordance with ASC Topic 350, Intangibles -
Goodwilland Other, the Company performs goodwill and indefinite life intangible asset impairment testing at least annually during the fourth quarter, unless indicators of impairment exist in interim periods. The Company's test of goodwill impairment included assessing qualitative factors and the use of judgment in evaluating economic conditions, industry and market conditions, cost factors, and entity-specific events, as well as overall financial performance. The impairment test for goodwill compares the estimated fair value of a reporting unit with goodwill to its carrying value. If the carrying amount of a reporting unit's goodwill exceeds the fair value of its goodwill, the Company recognizes an impairment loss equal to the excess, not to exceed the total amount of recorded goodwill. The Company also review the recoverability of its net intangible assets with finite lives when an indicator of impairment exists. Based on the Company's qualitative analysis of impairment indicators and estimated undiscounted future cash flows expected to result from the use of these net intangibles with finite lives, if needed, the Company determines if it will recover their carrying values as of the test date. If not recoverable, the Company records an impairment charge. The Company performed its most recent goodwill impairment analysis in the third quarter of 2020, utilizing an income approach with no impairment recorded. The Company believes that the discounted cash flow method best captures the significant value-creating activities it is undertaking. The primary assumptions in its income approach included estimating cash flows and projections. The Company determined that the fair value of its goodwill exceeded our carrying value, and consequently, no impairment was deemed to have occurred. However, a prolonged period of declining gross margins or a significant decrease in its anticipated revenue growth could result in the write-off of a portion or all of its goodwill and other intangible assets in future periods. Business Combinations The Company accounts for acquisitions in accordance with ASC Topic 805, Business Combinations. In purchase accounting, consideration paid, identifiable assets acquired and liabilities assumed are recognized at their estimated fair values at the acquisition date, and any remaining purchase price is recorded as goodwill. In determining the fair values of the consideration paid, assets acquired and liabilities assumed, the Company makes significant estimates and assumptions, particularly with respect to equity paid in the acquisition, and long-lived tangible and intangible assets. Critical estimates used in valuing tangible and intangible assets include, but are not limited to, future expected cash flows, discount rates, market prices and asset lives. Critical assumptions used in valuing the equity paid includes, but is not limited to, the stock price of the Company's stock on the date of acquisition and assumptions used in valuing the warrants paid, such as the stock price volatility, risk free interest rate and expected term. The Company's consolidated financial statements include the results of operations of the acquired company from the date of
The Company expensed all acquisition-related costs as incurred in selling, general and administrative expenses in the consolidated statements of earnings.
Income Taxes The Company uses significant judgment in determining the provision for income taxes, deferred tax assets and liabilities, and any valuation allowance recorded against net deferred tax assets. In preparing its financial statements, the Company is required to estimate income taxes in each of the jurisdictions in which it operates. This process involves estimating the actual current tax liability together with assessing temporary differences resulting from differing treatment of items, such as depreciation and amortization of property and equipment, benefits of net operating loss tax carryforwards. These differences result in deferred tax assets, which include tax loss carryforwards, and liabilities. The Company then assesses the likelihood that deferred tax assets will be recovered from future taxable income, and to the extent that recovery is not likely or there is insufficient operating history, it establishes a valuation allowance. In evaluating its ability to recover its deferred tax assets within the jurisdiction from which they arise, the Company considers all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and results of recent operations. In projecting future taxable income, the Company begins with historical results and incorporate assumptions about the amount of future state and federal pretax operating income adjusted for items that do not have tax consequences. The assumptions about future taxable income require significant judgment and are consistent with the plans and estimates the Company is using to manage the underlying business. To the extent the Company establishes or changes a valuation allowance in a period, it includes an adjustment within the tax provision of its statements of operations. 35 Deferred tax assets reflect current statutory income tax rates in effect for the period in which the deferred tax assets are expected to be realized. As changes in tax laws or statutory tax rates are enacted, deferred tax assets and liabilities are adjusted through the provision of income taxes. The calculation of the Company's tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in a multitude of jurisdictions across its global operations. A tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, on the basis of the technical merits. The Company (1) records unrecognized tax benefits as liabilities in accordance with ASC 740 and (2) adjusts these liabilities when their judgment changes as a result of the evaluation of new information not previously available. Because of the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from its current estimate of the unrecognized tax benefit liabilities. These differences will be reflected as increases or decreases to income tax expense in the period in which new information is available.
Warrants, Common Stock and Debt Discounts
The Company bifurcates the value of warrants and common stock issued with debt. This bifurcation results in the establishment of a debt discount, based on the relative fair values of the warrants, common stock and debt, with a corresponding charge to equity unless the terms of the warrant require it to be classified as a liability. The warrants are initially valued using the Black-Scholes valuation model. This model uses estimates of volatility, risk free interest rate and the expected term of the warrants, along with the current market price of the Company's stock, to estimate the value of the outstanding warrants. The Company estimates the expected term using an average of the contractual term and vesting period of the award. The expected volatility is measured using the average historical daily changes in the market price of the Company's common stock over the expected term of the award and the risk-free interest rate is equivalent to the implied yield on zero-coupon
U.S. Treasurybonds with a remaining maturity equal to the expected term of the awards. The establishment of a debt discount on convertible debt recorded at the relative fair values may result in a beneficial conversion feature based on an effective conversion price. This beneficial conversion feature is recorded as an additional debt discount. The total debt discount is limited by the total proceeds received and is amortized over the term of the debt.
Recent accounting pronouncements
See Note 1 to the Company’s financial statements, included in Section 8. Financial Statements and Supplementary Data of this Annual Report on Form 10-K.
Seasonality The Company does not expect its sales to be impacted by seasonal demands for its products and services. Also, due to the fact the Company uses indoor grow space, seasonality should not have any impact on its cultivation operations.
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