ITEM 9 LABS CORP. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included in this Quarterly Report on Form 10-Q and the audited financial statements and notes thereto as of and for the year endedSeptember 30, 2021 and the related Management's Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in the Company's Annual Report on Form 10-K for the year endedSeptember 30, 2021 , filed with theSecurities and Exchange Commission
(the "SEC") onJanuary 13, 2022 . Forward-Looking Statements
The information in this discussion contains forward-looking statements and information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the securities Exchange Act of 1934, as amended, (the "Exchange Act"), which are subject to the "safe harbor" created by those sections. The words "anticipated," "believes," "estimates," "expects," "intends," "may," "plans," "projects," "will," "should," "could," "predicts," "potential," "continue," "would," and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We may not actually achieve the plans, intentions, or expectations disclosed in our forward-looking statements that we make. The forward-looking statements are applicable only as of the date on which they are made, and we do not assume any obligation to update any forward-looking statements. All forward-looking statements in this Form 10-Q are made based on our current expectations, forecasts, estimates and assumptions, and involve risks, uncertainties and other factors that could cause results or events to differ materially from those expressed in the forward-looking statements. In evaluating these statements, you should specifically consider various factors, uncertainties and risks that could affect our future results or operations. These factors, uncertainties and risks may cause our actual results to differ materially from any forward-looking statement set forth in this quarterly report on Form 10-Q. You should carefully consider these risks and uncertainties described and other information contained in the reports we file with or furnish to theSEC before making any investment decision with respect to our securities. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by this cautionary statement. OverviewItem 9 Labs produces 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 inArizona .Item 9 Labs' products are now carried in more than 70 dispensaries throughout the state ofArizona . 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 theArizona cannabis market, as well as expand the geographical reach of its products into markets outside ofArizona , 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. InMarch 2020 , theWorld Health Organization categorized Coronavirus Disease 2019 ("COVID-19") as a pandemic, and the President ofthe United States declared 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. InMarch 2021 , the Company closed on the acquisition ofOCG, Inc. , dbaUnity Rd. , a cannabis dispensary franchisor. The transaction was structured as a reverse triangular merger, with the effect ofOCG, Inc. becoming a wholly owned subsidiary of the Company.Unity Rd has agreements with more than twenty (20) entrepreneurial groups to open more than thirty (30)Unity Rd retail dispensary locations in twelve (12) states. The majority of the locations are in the licensing process. We currently have one franchisee operating inBoulder, Colorado . One such franchise unit has been opened to date, inBoulder, Colorado .Unity Rd. will assist in providing distribution forItem 9 Labs products to be sold acrossthe United States and internationally to its franchisees for public resale, while keeping dispensaries locally owned and operated. AsUnity Rd. dispensaries expand in its market penetration,Item 9 Labs aims to offer its products in those locations by expanding the distribution footprint of its premium product offerings to new states. 25 The Company'sArizona cannabis 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 forArizona . 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. TheArizona expansion has continued in fiscal year 2022 and is expected to continue thereafter. The Company has tripled production sinceOctober 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 inNye County, Nevada which will be paired with theirNevada facility. In fiscal 2019, the Company broke ground on their 20,000 square foot cultivation and processing facility inNevada . The facility is now approximately 98% complete. Construction recommenced, after a pause due to Covid-19, inAugust 2021 . The Company aims to commence operations inNevada in fiscal year 2022. OnOctober 6, 2021 , the Company entered into an Asset Purchase Agreement ("APA") to acquire an existing dispensary license and storefront fromNebrina Adams County LLC , aColorado limited liability company ("Seller") inAdams County, CO. The total purchase price was$1,536,000 , as to which$1,000,000 was paid to an escrow account upon conditional approvals of the change of ownership from state and local licensing authorities concerning the transfer of ownership. At closing, that amount was released to the Seller along with an 18-month promissory note in the principal amount of$200,000 and the balance payable in 300,000 shares of Company common stock, valued at$336,000 . For additional terms of the APA, please see the Company's filing on Form 8-K filed with theSecurities and Exchange Commission onOctober 7, 2021 . The Company obtained financing to consummate this transaction. OnMarch 2, 2022 , the Company received the necessary regulatory approvals and completed this transaction. The existing dispensary license has never been operational. If completed, this will be the first corporate-owned shop inColorado under its cannabis dispensary brand,Unity Rd. , and is anticipated to open in early to the middle of fiscal year 2022. This license acquisition is part of an overarching acquisition strategy that is intended to accelerate national expansion by creating turnkey investment opportunities forUnity Rd. franchisees. The Company plans to convert acquired dispensaries intoUnity Rd. shops, operate them internally and sell them to an existing or future franchise partner. This offers an expedited solution for entrepreneurs seeking immediate entry into cannabis. The Company is targeting numerous similar transactions in the next 12 months to gain a deeper market penetration in select markets. Subsequently and/or concurrently, the Company plans to introduce theItem 9 Labs suite of products to the same markets through the acquisition of cultivation and production licenses or through joint ventures with qualified local, licensed operators. OnMarch 11, 2022 , the Company entered into an Asset Purchase Agreement withThe Herbal Cure LLC , aColorado limited liability company, pursuant to which the Company is purchasing certain assets. Effective upon the completion of the sale, which as not occurred as of the date of this filing, the licenses, contracts and certain personal property to operate a licensed medicinal and recreational cannabis dispensary will be delivered to the Company. The total purchase price is$5,750,000 , as to which$250,000 is to be paid upon execution of the Asset Purchase Agreement,$3,700,000 payable at closing,$700,000 shall be financed by seller pursuant to a Secured Promissory Note and the remainder of the purchase prices shall be paid in shares of the Company's common stock on the closing date. The Secured Promissory Note shall accrue interest at 5% per annum and have a term of 18 months, commencing on the closing date, payable in even monthly installments until paid in full. The shares of the Company's common stock to be issued shall be in such an amount as is the quotient of$1,100,000 divided by the product of the 10-day volume weighted average price of the shares as of
the
closing date and 85%.
26
Results of Operations
Six months ended March 31,
2022 2021 $ Change % Change
Revenues, net $ 12,824,197 $ 9,150,195 $ 3,674,002 40 %
Cost of revenues 7,748,193 4,729,176 3,019,017 64 %
Gross profit 5,076,004 4,421,019 654,985 15 %
Operating expenses
Professional fees and outside
services 1,214,166 907,713 306,453 34 %
Payroll and employee related
expenses 5,205,950 2,422,146 2,783,804 115 %
Sales and marketing 1,053,338 127,346 925,992 727 %
Depreciation and amortization 881,612 248,442 633,170 255 % Other operating expenses 1,632,835 564,054 1,068,781 189 % Provision for bad debt (5,000 ) - (5,000 ) 100 % Total operating expenses 9,982,901 4,269,701 5,713,200 134 % Income (loss) from operations (4,906,897 ) 151,318 (5,058,215 ) -3343 % Other expense, net (2,307,445 ) (1,176,754 ) (1,130,691 ) 96 % Net loss, before income tax provision (benefit) (7,214,342 ) (1,025,436 ) (6,188,906 ) 604 %
Income tax provision (benefit) 3,324 - 3,324 0 % Net loss (7,217,666 ) (1,025,436 ) (6,192,230 ) 604 % Less: Net income attributable to non-controlling interests 5,426 - 5,426 100 % Net loss attributable to Item 9 Labs Corp.$ (7,223,092 ) $ (1,025,436 ) $ (6,197,656 ) 604 % Three months ended March 31, 2022 2021 $ Change % Change Revenues, net$ 6,638,186 $ 6,110,631 $ 527,555 9 % Cost of revenues 3,960,948 3,121,045 839,903 27 % Gross profit 2,677,238 2,989,586 (312,348 ) -10 % Operating expenses Professional fees and outside services 556,721 613,758 (57,037 ) -9 % Payroll and employee related expenses 3,055,244 1,318,842 1,736,402 132 % Sales and marketing 613,902 84,165 529,737 629 % Other operating expenses 786,167 349,517 436,650 125 % Provision for (recovery of) bad debt (5,000 ) - (5,000 ) 100 % Total operating expenses 5,449,511 2,472,179 2,977,332 120 % Income (loss) from operations (2,772,273 ) 517,407 (3,289,680 ) -636 % Other expense, net (1,097,055 ) (468,387 ) (628,668 ) 134 % Net income (loss), before income tax provision (benefit) (3,869,328 ) 49,020 (3,918,348 ) -7993 % Income tax provision (benefit) 3,324 - 3,324 0 % Net income (loss) (3,872,652 ) 49,020 (3,921,672 ) -8000 % Less: Net income attributable to non-controlling interests 5,426 - 5,426 100 % Net income (loss) attributable to Item 9 Labs Corp.$ (3,878,078 ) $ 49,020 $ (3,927,098 ) -8011 % Revenues
The increase in revenue was primarily due to a change in certain processes and procedures in the Company's lab during the year endedSeptember 30, 2021 . 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 purchases certain inventory materials from third party vendors that it had previously produced itself. This allows 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 allows the Company to deliver its products to the dispensaries more timely. Management anticipates revenues to continue to grow as the revenue trends are positive month over month. 27 Cost of Revenues Cost of revenues consist primarily of labor, materials, supplies and utilities. Cost of revenues as a percentage of revenues was 60% and 61% for the three and six months endedMarch 31, 2022 compared to 51% and 52% for the three and six months endedMarch 31, 2021 . 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 cost of revenues and cost of revenues will increase at a lower rate than revenues in future periods, which will lead to increased profit margins. Gross Profit
The decrease in gross profit as a percentage of revenue was due to increases in revenue offset by price reduction as competition rises and 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 increase going forward.
Operating Expenses Professional fees and outside services increased for the six months endedMarch 31, 2022 compared to the six months endedMarch 31, 2021 primarily due to the amortization of prepaid consulting agreements that were entered into subsequent toMarch 31, 2021 and additional expenses incurred for corporate advisory services, and investor and public relations services. Professional fees and outside services decreased for the three months endedMarch 31, 2022 compared to the three months endedMarch 31, 2021 as professional fees were higher than usual during the three months endedMarch 31, 2021 primarily due to fees incurred as part of theOCG, Inc. acquisition. The increase in payroll expenses was primarily due to the amortization of stock-based compensation expense for stock options granted subsequent toMarch 31, 2021 . Further, payroll expenses increased due to an increase in employee headcount during fiscal year 2021 and the six months endedMarch 31, 2022 , as a result of increased hiring of employees and the hiring ofOCG, Inc. employees as part of the merger.
Sales and marketing expenses increased due to increased spending on marketing
and branding initiatives during the three and six months ended
The increase in depreciation and amortization is due primarily to the scheduled amortization of intangible assets acquired in theOCG Inc. acquisition inMarch 2021 .
Other operating expenses increased primarily due to increases in insurance expenses, travel related expenses and additional IT support for the increase in employees.
Total operating expenses as a percentage of gross profit increased from 83% and 97% for the three and six months endedMarch 31, 2021 , respectively, to 193% and 191% for the three and six months endedMarch 31, 2022 , respectively. Management believes this ratio will decrease for the Cultivation segment going forward as the expectation is that revenues will continue to grow at a higher rate than operating expenses, however, management believes that operating expenses will outpace revenues for the Franchising and Corporate segments as the Franchising and Corporate segments continue to perform on growth initiatives. Other Expense, net Other expenses consist primarily of interest expense of$1,097,373 and$2,307,763 for the three and six months endedMarch 31, 2022 , respectively, and$468,387 and$1,176,754 for the three and six months endedMarch 31, 2021 , respectively. The increase in interest expense was primarily the result of the continued interest and amortization of debt discounts for debt outstanding atMarch 31, 2021 and the additional interest and amortization of debt discounts for debt incurred subsequent toMarch 31, 2021 . This increase in interest expense was offset by debt and amortization of debt discounts that were capitalized to construction in progress related to the Company's capital projects. 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 inthe United States , or "US
GAAP." 28
The following table reflects the reconciliation of net income (loss) to Adjusted
EBITDA for the three and six months ended
Three months ended March 31, Six months ended March 31,
2022 2021 2022 2021
Net income (loss) $ (3,872,652 ) $ 49,020 $ (7,217,666 ) $ (1,025,436 )
Depreciation and amortization 442,477 105,897 881,612 248,442
Interest expense 1,097,373 468,387 2,307,763 1,176,754
Income tax expense 3,324 - 3,324 -
Stock-based expense 1,363,485 304,672 1,870,779 772,580
Acquisition related costs 23,676 87,060
23,676 266,738
Adjusted EBITDA $ (942,317 ) $ 1,015,036 $ (2,130,512 ) $ 1,439,078
The approximately $1.9 million change from prior year is due to the addition of
the franchise business, as well as significant investments in human capital and
infrastructure to prepare for anticipated growth.
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Liquidity 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 from 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. The accompanying condensed consolidated financial statements have been prepared assuming the 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 condensed 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 as a going concern, the Company will need to generate additional revenue and obtain additional capital to fund its operating losses and service its debt. Management's plans in regard to 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 ofArizona . The Company's revenues have increased significantly since its inception inMay 2017 . Management will continue its plans to increase revenues in theArizona market by providing superior products. Additionally, as capital resources become available, the Company plans to expand into additional markets outside ofArizona , with construction of a cultivation and processing facility nearing completion inNevada . The Company believes that it will continue reducing the overall cost of revenues and cost 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 condensed 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. 29
As ofMarch 31, 2022 , the Company had$105,128 of cash and cash equivalents and negative working capital of ($28,715,140 ) (current assets minus current liabilities), compared with$1,454,460 of cash and cash equivalents and negative working capital of ($4,893,385 ) as ofSeptember 30, 2021 . The decrease of$23,821,755 in the Company's working capital is primarily due to increases in the amount of the Company's debt maturing within the next 12 months. The decrease is also due to decreases in the Company's cash, inventory and prepaid balances and increases in the Company's accounts payable and other operating liabilities and the current portion of operating lease liabilities. The$1,349,332 decrease in cash and cash equivalents was primarily due to the purchases of property, equipment and construction in progress related to the Company's capital projects, and the Company's acquisition of a dispensary license inColorado . 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: Six months ended March 31, 2022 2021 $ Change % Change Net cash provided by (used in) operating activities$ 373,812 $ (4,479,607 ) $ 4,853,419 -108 % Net cash used in investing activities (4,012,703 ) (2,328,122 ) (1,684,581 ) 72 % Net cash provided by financing activities 2,289,559 11,030,929 (8,741,370 ) -79 % Net increase (decrease) in cash and cash equivalents$ (1,349,332 ) $ 4,223,200 $ (5,572,532 ) -132 % Operating Activities
During the six months ended
During the six months endedMarch 31, 2021 , operating activities used$4,479,607 of cash, primarily resulting from a net loss of$1,025,436 which was extended by net cash used in operating assets and liabilities of$3,454,171 . There was significant non-cash activity that contributed to the net loss totaling$1,321,358 including depreciation and amortization of$276,419 , amortization of debt discount of$272,359 , and compensation paid in the form of stock of$772,580 . With the increase in revenues, the Company's receivables increased$2,213,229 , deferred costs increased$3,622,372 and prepaid expenses increased$1,024,680 , offset by an increase in current liabilities of$2,084,752 . Investing Activities During the six months endedMarch 31, 2022 , investing activities used$4,012,703 of cash and cash equivalents, consisting primarily of$3,235,125 in purchases of property, equipment and construction in progress, the purchase of a dispensary license in the amount of$1,130,872 and cash paid to acquisition escrow accounts of$381,932 , offset by$794,807 of cash received from the escrow deposit accounts. During the six months endedMarch 31, 2021 , investing activities used$2,328,122 of cash, consisting primarily of$739,560 in purchase of property and equipment and$1,685,368 of deposits paid on an acquisition. Financing Activities
During the six months ended
During the six months endedMarch 31, 2021 , financing activities provided$11,030,929 , consisting of$12,959,808 in proceeds from the issuance of stock and proceeds from the issuance of convertible debt of$1,355,000 and offset by$3,283,879 in debt payments made. Given that our cash needs are strongly driven by our growth requirements, we also intend to maintain a cash reserve for other risk contingencies that may arise. 30
We intend to meet our cash requirements for the next 12 months through the use of the cash we have on hand and through business operations, future equity financing, debt financing, or other sources, which may result in further dilution in the equity ownership of our shares. We have filed an offering document on Form 1-A with theSecurities and Exchange Commission in order to sell units comprising of one share of common stock and one-half of one warrant. We are also in discussions with various potential capital partners to provide additional debt capital for accretive acquisitions. We do not have any other arrangements in place to complete any private placement financings of debt and equity. There is no assurance that we will be successful in completing the offering on Form 1-A, or in finding a capital partner to provide additional debt capital or any other such financings on terms that will be acceptable to us.
Off-Balance Sheet Arrangements
We are not currently a party to, or otherwise involved with, any off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with US GAAP. The preparation of our condensed consolidated financial statements requires us to make estimates and judgements that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to areas that require a significant level of judgment or are otherwise subject to an inherent degree of uncertainty. Critical accounting policies and estimates in these condensed consolidated financial statements are those related to revenue recognition, valuation of options, warrants and debt discounts, carrying value of intangible assets subject to amortization, infinite life intangible assets and goodwill, stock-based compensation, and income taxes. We base our estimates on historical experience, our observance of trends in particular areas, and information or valuations and various other assumptions that we believe to be reasonable under the circumstances and which form the basis for making judgments about the carrying value of assets and liabilities that may not be readily apparent from other sources. Actual amounts could differ significantly from amounts previously estimated. For a discussion of our critical accounting policies, refer to Part I, item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our annual report on Form 10-K for the year endedSeptember 30, 2021 . Management believes that there have been no material changes in our critical accounting policies during the three months endedMarch 31, 2022 .
Recently Issued Accounting Pronouncements
See Note 1 to our condensed consolidated financial statements, included in Part I, Item 1, Financial Information for this quarterly report on Form 10-Q.
Contractual Obligations We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and are not required to provide the information under this item.
© Edgar Online, source
