Forward Looking Statements
You should read the following discussion of our financial condition and results
of operations together with our audited consolidated financial statements and
interim unaudited condensed consolidated financial statements and notes to such
financial statements included elsewhere in this 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 our industry,
business and future financial results. Our 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 Labs produces premium cannabis and cannabis related products in a rapidly
growing market. We currently offer more than 300 products that we group in the
following categories: flower; concentrates; distillates; and hardware. Our
product offerings will continue to grow as we develop new products to meet the
needs of the end-users. We make our products available to consumers through
licensed dispensaries in Arizona. In just over a year from our first product
delivery, Item 9 Labs' products are now carried in more than 40 dispensaries
throughout the state of Arizona.
We believe our past and future success is dependent upon our ongoing ability to
understand the needs and desires of the consumers; and we develop and offer
products that meet their needs.
The objective of Item 9 Labs is to leverage our assets (tangible and intangible)
to fuel the growth of our share of the Arizona cannabis market, as well as
expand the geographical reach of our 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 our shareholders.
We expanded our assets in November 2018 with the acquisition of the majority of
the assets of AZ DP Consulting LLC. The acquisition was treated as a business
combination for financial reporting purposes. The acquisition was valued at
$9,270,000, $1,500,000 in cash and $7,770,000 (3 million shares valued at
$2.59/share) of the Company's restricted common stock. As part of the
acquisition, the owner of AZ DP Consulting LLC, Sara Gullickson came aboard Item
9 Labs Corp. as CEO. We acquired numerous web domains, including
dispensarypermits.com and dispensarytemplates.com, amongst many others,
marijuana business templates, a workforce, tradenames and customer lists. The
consulting side of the business provides dispensary application services to its
clients, and through the acquisition, provides Item 9 Labs Corp. with
synergistic partnerships for growth into new markets. Through nine months of
operating the business, we concluded that the assets, as recorded at the
acquisition date were impaired. The impairment is included in the results of
operations, totaling $5,758,827. Subsequent to year end, in November 2019, Sara
Gullickson resigned as CEO. As part of her resignation, she and the Company
mutually agreed on an amendment to her employment agreement in which she would
cancel and return 2,300,000 shares of the common stock she obtained in the
acquisition in exchange for a reduction in the duration of her non-compete
agreement from 3 years to 4 months.
Our Arizona cannabis operations saw significant expansion as well, both in our
physical and geographic footprint. Our physical footprint expanded with the
addition of a 2nd 10,000 square foot facility, more than doubling our
cultivation and processing space for Arizona. Our geographic footprint grew as
we increased the number of dispensaries our products are offered in, from around
45 at the beginning of the year, to over 70 by the end of the year.
Item 9 Labs Corp. continued its expansion plans into other states during the
year as well as we broke ground in Nevada and spent over $3.5 million on our
20,000 square foot cultivation and processing facility.
We will expand into other markets through various methods, and will utilize
strategic partnerships as necessary to provide the synergies to assist in our
growth. As part of this expansion plan, we acquired land in Pahrump, Nevada to
build our second production facility. Through partnerships, we obtained
cultivation, production and distribution licenses in the state of Nevada.
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Results of Operations
Year Ended Year Ended
September 30, 2018 September 30, 2019
Revenues, net $ 1,401,858 $ 4,933,960
Cost of services 1,018,109 2,556,189
Gross profit 389,749 2,377,771
Operating expenses 1,037,567 12,518,810
Loss from operations (653,818 ) (10,141,039 )
Other income 32,643 192,401
Income from disc Ops 21,280 0
Income tax expense (88,826 ) 0
Net loss $ (710,001 ) $ (9,948,638 )
Revenues
Total Revenues for the year ended September 30, 2019 were $4,933,960 compared to
the revenue for the period ended September 30, 2018 of $1,401,858, an increase
of $3,532,102 or 252%. This increase was primarily due to an overall increase in
monthly sales as production and demand for our products grew. Management
anticipates revenues to continue to grow as the revenue trends are positive
month over month.
Costs of Services
Costs of services consist primarily of labor, materials, supplies and utilities.
Costs of services as a percentage of revenues was 52% for the year ended
September 30, 2019 compared to 73% for the period ended September 30, 2018,
consisting of certain costs, predominantly labor and materials increased at a
higher rate to ramp up production. Management believes these costs will increase
at a much lower rate than revenues and production in future periods, which will
lead to higher profit margins than these historical figures illustrate.
Gross Profit
Gross profit for the year ended September 30, 2019 was $2,377,771 compared to
$383,749 for the year ended September 30, 2018. The increase was due to the ramp
up in operations and continued improvement in the operating capacity of the
Company's cultivation and processing facilities.
Operating Expenses
Total operating expenses for the year ended September 30, 2019 were $12,518,810
compared to $1,037,567 for the year ending September 30, 2018, an increase of
$11,481,243. Operating expenses as a percentage of gross profit increased from
270% to 526% for the periods compared. Management believes this ratio will
decrease going forward as the expectation is that revenues will continue to grow
at a much higher rate than operating expenses. $5,758,827 of the Company's
operating expenses for the year ended September 30, 2019 are a loss on
impairment of goodwill and other intangible assets, and $376,430 is a provision
for bad debt, both items that management does not believe to be indicative of
future results. Additionally, $1,067,617 of the Company's operating expenses in
2019 were paid through the issuance of shares of common stock of the Company
compared to $103,774 in 2018. The loss on impairment was determined by comparing
the fair value of the acquired assets as of September 30, 2019 to the carrying
amounts recorded on the consolidated financial statements. The Company utilized
the projected future cash flows of the acquired assets and a weighted average
cost of capital of 11.4% to calculate the estimated fair value of the assets.
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FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Liquidity and Capital Resources
Our primary need for liquidity is to fund working capital requirements of our
business, capital expenditures, acquisitions, debt service, and for general
corporate purposes. Our primary source of liquidity is funds generated by
financing activities and from private placements. Our ability to fund our
operations, to make planned capital expenditures, to make planned acquisitions,
to make scheduled debt payments, and to repay or refinance indebtedness depends
on our future operating performance and cash flows, which are subject to
prevailing economic conditions and financial, business and other factors, some
of which are beyond our control.
The accompanying consolidated financial statements have been prepared in
conformity with accounting principles generally accepted in the United States,
which contemplate 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. As a result, the Company's
independent registered public accounting firm included an emphasis-of-matter
paragraph with respect to the accompanying consolidated financial statements,
expressing uncertainty regarding the Company's assumption that it will 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 of
Arizona. The Company's revenues have increased significantly since its inception
in May 2017, and continue to grow as of the date of these consolidated financial
statements. Management will continue its plans to increase revenues in the
Arizona market by providing superior products. Additionally, as capital
resources become available, the Company will expand into additional markets
outside of Arizona, with construction of a cultivation and processing facility
well underway in Nevada.
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 grow significantly, 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 significant 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, 2019, the Company had $574,943 of cash and restricted cash
and working capital of $(4,174,962) (current assets minus current liabilities),
compared with $1,674,266 of cash and $2,054,260 of working capital as of
September 30, 2018. The decrease of $6,229,222 in our working capital and
$1,099,323 in cash was primarily due to investing in construction projects in
Arizona and Nevada totaling $6,006,764, acquisition outlays of $1,500,000 and
increase in deferred costs of $1,317,816. This was offset by stock sales
totaling $5,885,003 and the issuance of debt of $3,251,714. 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 will
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.
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Cash Flows
The following table summarizes the sources and uses of cash for each of the
periods presented:
Year Ended Year Ended
September 30, September 30,
2018 2019
Net cash used in operating activities $ (972,263 ) $ (2,393,428 )
Net cash used in investing activities (362,881 ) (7,842,612 )
Net cash provided by financing activities 2,995,550 9,136,717
Net increase (decrease) in cash and cash equivalents $ 1,660,406 $ (1,099,323 )
Operating Activities
During the year ended September 30, 2019, operating activities used $2,393,428
of cash, primarily resulting from a net loss of $9,948,638 and net cash used in
operating assets and liabilities of $260,815. There was significant non-cash
activity that contributed to the net loss totaling $7,816,025 including a loss
on impairment of $5,578,827, depreciation and amortization of $676,134,
provision for bad debt of $376,430 and compensation paid in the form of stock of
$1,067,617. Cash used by changes in operating assets and liabilities was
primarily due to an increase in deferred costs of $1,317,816, and accounts
receivable of $339,644, offset by an increase in accounts payable of $351,036,
accrued interest of $663,827 and accrued expenses of $298,609.
During the year ended September 30, 2018, operating activities used $972,263 of
cash, primarily resulting from a net loss of $688,721 and net cash used in
operating assets and liabilities of $402,870. Cash used by changes in operating
assets and liabilities was primarily due to an increase in accounts payable of
$57,660, accrued payroll of $36,733, and accrued income tax of $88,826, offset
by an increase in deferred costs of $577,681.
Investing Activities
During the year ended September 30, 2019, investing activities used $7,842,612
of cash, consisting primarily of payments totaling $6,006,764 in purchases of
property and equipment, $400,000 in deposits made on a land acquisition, and
$1,500,000 in acquisition outlays offset by $115,000 in cash received on
short-term notes receivable.
During the year ended September 30, 2018, investing activities used $362,881 of
cash, consisting primarily of payments totaling $340,244 in purchases of
property and equipment, $200,000 in deposits made on a land acquisition, and
$210,000 in extending notes receivable offset by $300,000 in cash received on
the sale of Airware assets.
Financing Activities
During the year ended September 30, 2019, financing activities provided
$9,136,717, which included proceeds from the sale of common stock of $5,885,003
and cash proceeds from notes payable of $3,251,714.
During the year ended September 30, 2018, financing activities provided
$2,995,550, which included proceeds from the sale of common stock of $1,495,550
and cash proceeds from a note payable of $1,500,000.
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Anticipated Capital Requirements
We estimate that our capital requirements to implement our expansion plan over
the next 18 months will be approximately $15,000,000 as described in the table
below. These estimates may change significantly depending on the nature of our
future business activities, expansion rollout, identification of suitable
acquisition targets, and our ability to raise capital necessary to conduct the
aforementioned activities. We further anticipate incurring additional costs and
expenses for accounting, legal, and other miscellaneous fees relating to
compliance with SEC requirements.
Estimated
Description Expenses
Legal, Accounting & Other Registration Expenses $ 350,000
Costs Associated with Being a Public Company
240,000
Trade Shows and Travel 50,000
Website Development 40,000
Rent 170,000
Advertising and Marketing 600,000
Staffing 2,750,000
General Working Capital 400,000
Cash Reserves 1,500,000
Business Acquisitions and Construction 7,000,000
License Applications 1,900,000
Total $ 15,000,000Given 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.
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 currently do not have any
other arrangements in place to complete any private placement financings and
there is no assurance that we will be successful in completing any such
financings on terms that will be acceptable to us.
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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
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 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. 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.
Principles of Consolidation - The consolidated financial statements include the
accounts of the Company, its wholly-owned subsidiaries and variable interest
entities in which the Company is the primary beneficiary. Intercompany balances
and transactions have been eliminated.
Use of Estimates - The preparation of financial statements in conformity with
Generally Accepted Accounting Principles ("GAAP") in the United States of
America requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenue and expenses during the reporting period. Actual results could
materially differ from those estimates. Significant estimates of the Company
include but are not limited to accounting for depreciation and amortization,
current and deferred income taxes, deferred costs, accruals and contingencies,
carrying value of goodwill and intangible assets, collectability of notes
receivable, the fair value of common stock and the estimated fair value of stock
options and warrants. Due to the uncertainties in the formation of accounting
estimates, and the significance of these items, it is reasonably possible that
these estimates could be materially changed in the near term.
Fair Value of Financial Instruments - The carrying value of the Company's
financial instruments, consisting of cash and cash equivalents, accounts
receivable, accounts payable, and accrued expenses approximate fair value due to
their short term to maturity. The Company's long-term receivable resulting from
the sale of Airware, notes receivable and notes payable were discounted to its
estimated fair value.
Revenue - The majority of the Company's revenue is associated with a customer
contract that represents an obligation to perform services that are delivered at
a single point in time. Any costs incurred prior to the period in which the
services are performed to completion are deferred and recognized as cost of
services in the period in which the performance obligations are completed. Since
the majority of the Company's revenue is generated from one customer contract,
the Company does not have material contract assets or liabilities that fall
under ASC 606. For the year ended September 30, 2019, 90% of the Company's
revenue was generated for performance obligations completed in the State of
Arizona and in 2018, 100% of the Company's revenues was generated for
performance obligations completed in the State of Arizona.
Intangible Assets Subject to Amortization - Intangible assets include trade
name, customer relationships, website, and intellectual property obtained
through a business acquisition. Intangible assets acquired in a business
combination are recognized at fair value using generally accepted valuation
methods deemed appropriate for the type of intangible assets acquired.
Intangible assets with finite lives are amortized over their estimated useful
life and are reported net of accumulated amortization, separately from goodwill.
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Goodwill - Goodwill represents the excess of the purchase price paid for the
acquisition of a business over the fair value of the net tangible and intangible
assets acquired. Goodwill is not subject to amortization and is tested annually
for impairment, or more frequently if events or changes in circumstances
indicate that the carrying value of goodwill may not be recoverable.
Income Taxes - The Company accounts for income taxes under FASB ASC 740, Income
Taxes. Deferred income tax assets and liabilities are determined based upon
differences between financial reporting and tax bases of assets and liabilities,
and are measured using the enacted tax rates and laws that will be in effect
when the differences are expected to reverse. The Company has net operating loss
carryforwards in excess of $27,000,000, though a portion of those losses will
likely be disallowed due to the merger with BSSD Group, LLC and none of the
carryforwards can be utilized until the Company is profitable. Due to these
facts, the Company has decided to reserve for 100% of any deferred tax asset it
may be entitled to.
The Company files income tax returns in the U.S. federal jurisdiction and the
State of Arizona. The Company is subject to U.S. federal, state, and local
income tax examinations by tax authorities. All periods beginning on or after
January 1, 2014 are open to examination by taxing authorities. The Company
believes it has no tax positions for which the ultimate deductibility is highly
uncertain.
Stock-Based Compensation - The Company follows the guidelines in FASB
Codification Topic ASC 718-10 "Compensation-Stock Compensation", which requires
the measurement and recognition of compensation expense for all share-based
payment awards made to employees and directors including employee stock options
and employee stock purchases related to an Employee Stock Purchase Plan based on
the estimated fair values.
Earnings (Loss) Per Share - Basic earnings per share does not include dilution
and is computed by dividing loss available to common stockholders by the
weighted average number of common shares outstanding for the period. Diluted
earnings per share reflects the potential dilution of securities that could
share in the earnings of an entity. Dilutive securities are not included in the
weighted average number of shares when inclusion would be anti-dilutive.
At September 30, 2019, there were 656,112 shares underlying convertible notes
payable, warrants and options.
Recently Issued Accounting Pronouncements
Adopted
In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other
(Topic 350). The update simplifies the process for assessing goodwill for
impairment. The amended guidance removes the second step that was previously
required. ASU 2017-04 is effective for us for the fiscal year ending September
30, 2021, with early adoption permitted for periods beginning after January 1,
2017. The Company adopted ASU 2017-04 on October 1, 2018.
Pending Adoption
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The update
improves financial reporting about leasing transactions by requiring a lessee to
record on the balance sheet the assets and liabilities for the rights and
obligations created by lease terms of more than 12 months. We will adopt ASU
2016-02 in the first quarter of 2019 and are in the process of aggregating and
evaluating lease arrangements and implementing new processes. Although we are
still in the process of evaluating the impact of adoption of the ASU on our
consolidated financial statements, we currently believe that the most
significant change will be related to the recognition of a right-of-use asset
and lease liability on our balance sheet for our real estate operating lease.
The impact on our results of operations and cash flows is not expected to be
material.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses
(Topic 326), which provides guidance on measuring credit losses on financial
instruments. The amended guidance replaces current incurred loss impairment
methodology of recognizing credit losses when a loss is probable with a
methodology that reflects expected credit losses and requires a broader range of
reasonable and supportable information to assess credit loss estimates. ASU
2016-13 is effective for us on January 1, 2020, with early adoption permitted on
January 1, 2019. We are assessing the provisions of this amended guidance;
however, the adoption of the standard is not expected to have a material effect
on our consolidated financial statements.
There have been no other recent accounting pronouncements or changes in
accounting pronouncements that have been issued but not yet adopted that are of
significance, or potential significance, to us.
Seasonality
We do not expect our sales to be impacted by seasonal demands for our products
and services. Also, due to the fact we use indoor grow space, seasonality should
not have any impact on our cultivation operations.
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