Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The discussion contained herein is for the three and six months ended September 30, 2017 and September 30, 2016.  The following discussion should be read in conjunction with the financial statements of AeroGrow International, Inc. (the "Company," "AeroGrow," "we," "our," or "us") and the notes to the financial statements included elsewhere in this Quarterly Report on Form 10-Q for the period ended September 30, 2017 (this "Quarterly Report"). The following discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), including statements that include words such as "anticipates," "expects," "intends," "plans," "believes," "may," "will," or similar expressions that are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements include, but are not limited to, statements regarding our intent, belief, or current expectations regarding our strategies, plans, and objectives, our product release schedules, our ability to design, develop, manufacture, and market products, the ability of our products to achieve or maintain commercial acceptance, our ability to obtain financing and/or generate cash flow sufficient to fund our future operations, and our ability to continue as a going concern. Such statements are not guarantees of future performance and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Factors that could cause or contribute to the differences are discussed in this Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations and in Item 1A. "Risk Factors" of our Annual Report on Form 10-K for the year ended March 31, 2017.  Except as required by applicable law or regulation, we undertake no obligation to revise or update any forward-looking statements contained in this Quarterly Report. The information contained in this Quarterly Report is not a complete description of our business or the risks associated with an investment in our common stock. Each reader should carefully review and consider the various disclosures we made in this Quarterly Report and in our other filings with the U.S. Securities and Exchange Commission ("SEC").

Overview

AeroGrow International, Inc. was formed as a Nevada corporation on March 25, 2002. The Company's principal business is developing, marketing, and distributing advanced indoor aeroponic garden systems designed and priced to appeal to the consumer gardening, cooking and small indoor appliance markets worldwide.  The Company's principal activities from its formation through March 2006, consisted of product research and development, market research, business planning, and raising the capital necessary to fund these activities. In December 2005, the Company commenced initial production of its AeroGarden system and, in March 2006, began shipping these systems to retail and catalogue customers. The Company manufactures, distributes and markets nine different models of its AeroGarden systems in multiple colors, as well as over 40 varieties of seed pod kits and a full line of accessory products through multiple channels including retail distribution, catalogue and direct-to-consumer sales primarily in the United States and Canada, as well as selected countries in Europe.

In April 2013, we entered into a Securities Purchase Agreement and strategic alliance with a wholly owned subsidiary of The Scotts Miracle-Gro Company (collectively with its subsidiary, "Scotts Miracle-Gro"). Pursuant to the Securities Purchase Agreement, we issued (i) 2.6 million shares of Series B Convertible Preferred Stock, par value $0.001 per share (the "Series B Preferred Stock); and (ii) a warrant to purchase shares of our common stock for an aggregate purchase price of $4.0 million.  In addition, as part of the strategic alliance, we entered into several other agreements with Scotts Miracle-Gro, including: (i) an Intellectual Property Sale Agreement; (ii) a Technology Licensing Agreement; (iii) a Brand License Agreement; and (iv) a Supply Chain Management Agreement.

  

Pursuant to the Intellectual Property Agreement, we agreed to sell all intellectual property associated with our hydroponic products (the "Hydroponic IP"), other than the AeroGrow and AeroGarden trademarks, free and clear of all encumbrances, to Scotts Miracle-Gro for $500,000.  Scotts Miracle-Gro has the right to use the AeroGrow and AeroGarden trademarks in connection with the sale of products incorporating the Hydroponic IP.   In addition to the working capital infusion of approximately $4.5 million from the Securities Purchase Agreement and Intellectual Property Sale Agreement, as amended, the strategic alliance allows us to use the globally recognized and highly trusted Miracle-Gro brand name.  We believe that the strategic alliance also gives Scotts Miracle-Gro an entry into the burgeoning indoor gardening market, while providing AeroGrow a broad base of support in marketing, distribution, supply chain logistics, R&D, and sourcing.   We used our strategic alliance with Scotts Miracle-Gro to re-establish our presence in the retail and international sales channels.

On September 13, 2017, the Company entered into a Term Loan Agreement in the principal amount of up to $2.0 million with Scotts Miracle-Gro.  The proceeds will be made available as needed in increments of $500,000 not to exceed $2.0 million with a due date of March 30, 2018.  The Term Loan Agreement is secured by a lien on the assets of the Company.  Interest will be charged at the stated rate of 10% per annum and will be paid, in cash, quarterly in arrears at the end of each September, December and March. The funding provides general working capital and is being used for the purpose of acquiring inventory to support anticipated growth as the Company expands its retail and its direct-to-consumer sales channels.  See Note 3 "Notes Payable, Long Term Debt and Current Portion – Long Term Debt" to our condensed financial statements.

Results of Operations

Three Months Ended September 30, 2017 and September 30, 2016

Summary Overview

For the three months ended September 30, 2017, total revenue was $5.7 million, an increase of 156.1%, or $3.5 million, relative to the same period in the prior year.  The increase was primarily due to nearly $2.0 million of in-store retail channel sales with our newly acquired retail accounts, including Bed Bath and Beyond, Macy's and Kohl's.  Additionally, we also experienced increased sales at Amazon.ca and other online retailers.  This is consistent with our current strategy to build through online retailers while refocusing on in-store tests marketing primarily in the housewares channel that may lead to company-wide roll-outs.  We anticipate that quarterly sales results during the first six months of our fiscal year (April-September), may continue to be inconsistent as the Company tests various retail channel strategies in an effort to optimize sales and profitability throughout the year, as well as the impact of load-in timing before the holiday season.  Additionally, sales in our direct-to-consumer channel also increased 10.4%, or $86,000, primarily due to growing enthusiasm about new gardens, continued momentum from our general advertising and marketing campaign, and an increase in our user-base.  We believe that we benefit from more visibility from our increased presence on Amazon platforms and other select online retail distribution channels.  

 

For the three months ended September 30, 2017, total dollar sales of AeroGarden units increased by 302.8% from the prior year period due to earlier load-in of large AeroGarden orders to retailers in the current period, in advance of the peak holiday season.  Sales in the prior year period did not have comparable retail load-in sales for items that will be carried in-store during the holiday season. Seed pod kit and accessory sales increased by 67.3% over prior year period as our established base of AeroGardeners continues to grow.  AeroGarden sales net of allowances represented 78.1% of total revenue, as compared to 66.5% in the prior year period.  This percentage increase, on a product line basis, was attributable to sales to expanded and newly acquired retail accounts including many retail sales due to earlier load-in product sales prior to the holiday season.  Seed pod kit and accessory sales decreased as a percent of the total to 21.8% from 33.5% due to the increased sales of AeroGarden this quarter.  However, as noted above the total dollar sales increased $505,000.

The Company continues to spend advertising dollars in order to strategically build market awareness and enhance initiatives implemented in the prior year. For Fiscal 2018, we intend to expand consumer awareness of the AeroGrow brand and product line.  During the three months ended September 30, 2017, we spent $174,000 in advertising expenditures, a $24,000 or 15.8% year-over-year increase compared to the same period ended September 30, 2016. This was primarily due to an increase in our retail marketing campaigns and expanded email programs.  The advertising expenditures were divided as follows:

 

·

Direct-to-consumer advertising increased $14,000 from $36,000 to $50,000 during the three months ended September 30, 2017, primarily reflecting a reallocation of spending from pay-per-click and digital display advertising campaigns to retail spending.  Efficiency, as measured by dollars of direct-to-consumer sales generated per dollar of related advertising expense continued to be strong, although the ratio decreased 19.5% to $18.35 for the three months ended September 30, 2017, as compared to $22.81 for the same period in Fiscal 2017 as spending increased due to increases in pay-per-click programs.

·

Retail advertising increased $8,000 from $107,000 to $115,000 for the three months ended September 30, 2017 and September 30, 2016, respectively.  The Company continues to invest in driving product awareness through: (i) platforms made available by our retailers; (ii) various promotional programs to increase product awareness with our housewares channel of retail accounts, including catalogs and email campaigns; and (iii) web-based advertising programs (e.g. including retail catalogues, website banner ads, email blasts, targeted search campaigns, etc.).

Our gross profit for the three months ended September 30, 2017 was 28.9%, down from 30.8% in the prior year period due to increased sales into the retail channel, which requires much higher return allowances, particularly for load-in sales, and traditionally carries lower margins.

 

In aggregate, our total operating expenses increased 35.9% or $473,000 year-over-year, principally as a result of aligning our growth Company initiatives in support of anticipated future growth.  Gross spending fluctuated in the following areas:

 

·	A $248,000 increase in personnel expenses, due to a small increase in headcount and other changes to our compensation program to align with our growth initiatives;

·	A $78,000 increase in general market research, new product samples, public relations and new product programs such as illustration and language translations for international product distribution;

·	A $29,000 increase in travel as we conducted face-to-face meetings with potential domestic and European customers and manufacturers in China; and

·	A $24,000 increase in advertising expenditures described above including Amazon Prime Day deals;

 

As a result of efforts to prepare for growth and timing of load-in orders, our operating loss improved to $129,000 for the three months ended September 30, 2017, as compared to an operating loss of $627,000 in the prior year period.

Other income and expense for the three months ended September 30, 2017 totaled to a net other income of $8,000, as compared to net other expense of $502,000 in the prior year period.  In the prior year, net other expense is primarily attributable to non-cash expenses relating to the fair value revaluation of the warrant held by Scotts Miracle-Gro. 

 

The net loss for the three months ended September 30, 2017 decreased to $121,000, as compared to a $1.1 million net loss in the prior year.  The decline in net loss is due to higher overall sales, which are a result newly acquired retail accounts and earlier pre-holiday load-in sales to retailers, decreased operating expenses as a percentage of revenue and no fair value changes associated with the Scotts Miracle-Gro warrant liability as the warrant was fully exercised offset by decreases in margins. 

The following table sets forth, as a percentage of sales, our financial results for the three months ended September 30, 2017 and the three months ended September 30, 2016:

Direct-to-consumer sales for the three months ended September 30, 2017 totaled $911,000, up $86,000 or 10.4%, from the prior year period.  The increase in sales to direct-to-consumer channels was caused by increased visibility and continued momentum from our general advertising and marketing campaign, including our increased presence on select online retail distribution channels.

Sales to retailer customers for the three months ended September 30, 2017 totaled $4.7 million, up $3.4 million from the prior-year period, principally reflecting load-in sales to newly acquired brick-and-mortar stores in advance of the peak holiday season, as well as growth in the existing Amazon.ca account.  International sales totaled $84,000 in comparison to sales testing in Europe in the prior year of $36,000 as we continue to understand the trends that impact the international market and expand our international presence.  

Our products consist of AeroGardens, and seed pod kits and accessories.  A summary of the sales of these two product categories for the three months ended September 30, 2017 and September 30, 2016 is as follows:

 

 

AeroGarden sales increased $5.0 million, or 302.8%, from the prior year period, reflecting in: (i) increased retail channel sales as we sold into brick-and-mortar stores in advance of the peak holiday season and expanded upon tests that were successful in the prior year; and (ii) increased sales of AeroGardens in our Direct-to-Consumer channel as our advertising campaigns from the prior year continued to inform buyers about our products.  The increase in seed pod kit and accessory sales, from $750,000 to $1.3 million, principally reflects the overall increase in our established base of AeroGardens.  For the three months ended September 30, 2017, sales of seed pod kits and accessories represented 21.8% of total revenue, as compared to 33.5% in the prior year period, which is a result of the increase in AeroGarden retail sales to expanded accounts in the current year.  Other revenue, which is comprised primarily of grow club revenue, shipping revenue, accruals and deductions, decreased as a percent of the total to (37.2)% from (6.9)% in the prior year period due to lower shipping revenue as a percentage of sales and significantly higher deductions for sales allowances and future discounts for in-store retail accounts.

 

Cost of Revenue

Cost of revenue for the three months ended September 30, 2017 totaled $4.1 million, an increase of $2.5 million from the three months ended September 30, 2016, due to increased revenue.  Cost of revenue includes product costs for purchased and manufactured products, freight costs for inbound freight from manufacturers, costs related to warehousing and the shipping of products to customers, credit card processing fees for direct sales, and duties and customs applicable to imported products. As a percent of total revenue, cost of revenue represented 71.1% of revenue as compared to 69.2% for the quarter ended September 30, 2016.  The increase in costs as a percent of revenue reflected our change in customer mix to a higher percentage of retail sales at brick-and-mortar locations, which traditionally generate lower margins.

Gross Profit

Our gross profit varies based upon the factors affecting net revenue and cost of revenue (as discussed above), as well as the mix of our revenue that comes from the retail, direct-to-consumer, and international channels.  In a direct-to-consumer sale, we recognize as revenue the full consumer purchase price for the product.  In retail and international sales, by comparison, we recognize as revenue the wholesale price for the product which we charge to the retailer or international distributor.  Media costs associated with direct sales are included in sales and marketing expenses.  As a result, retail and international sales generally have lower gross margins than direct-to-consumer sales.  The gross profit for the quarter ended September 30, 2017 was 28.9% as compared to 30.8% for the quarter ended September 30, 2016.  The decrease in our gross profit is due primarily to changes in customer and product mix, particularly the introduction of AeroGarden products into new brick-and-mortar stores which carry higher return allowances.  Additionally, we experienced higher costs during the current quarter for, one-time fees related to establishing new retail customers and additional shipping costs for international and direct-to-consumer channels.

 

Research and Development

Research and development costs for the quarter ended September 30, 2017 totaled $141,000, an increase of $27,000 from the quarter ended September 30, 2016.  The increase reflects approximately $40,000 for increases in employee salaries and wages for newly hired employees assisting in new product development and bonus accruals partially offset by $8,000 of consulting fee reimbursements and decreases in new product certification and testing.

 

Advertising expense is principally comprised of the costs of development, production, printing, and postage for our catalogue mailing and web media costs for search and affiliate web marketing programs, and developing and employing other forms of advertising.  Each of these are key components of our integrated marketing strategy because they help build awareness of, and consumer demand for, our products, in addition to generating direct-to-consumer sales.  Advertising expense totaled $174,000 for the quarter ended September 30, 2017, a year-over-year increase of 15.8%, or $24,000, due to our increase in participation in various promotional programs and our general marketing and advertising campaigns along with our web-based advertising programs.

Sales and marketing personnel costs include salaries, payroll taxes, employee benefits and other payroll costs for our sales, operations, customer service, graphics and marketing departments.  For the three months ended September 30, 2017, personnel costs for sales and marketing were $548,000, up $78,000 or 16.5% from the three months ended September 30, 2016.  The increase reflected an increase in headcount necessary to support our sales to retailers.  Personnel expenses include all related payroll including departmental incentive programs, including salaries, bonuses and employee benefits.

Other marketing expenses increased year-over-year principally because of additional travel, social media, market research programs, retailer marketing programs, third party sales tax software and new products that were initiated during the current year quarter.

General and Administrative

General and administrative costs for the three months ended September 30, 2017 totaled $638,000, as compared to $475,000 for the three months ended September 30, 2016, an increase of 34.2%, or $163,000.  The increase is attributable to increases in: (i) payroll-related expenses, including departmental incentive programs, salaries, bonuses and employee benefits; (ii) web hosting, electronic data processing, network consulting fees for software troubleshooting; and (iii) estimates for the allowance for bad debt.

Operating Loss

Our operating loss for the three months ended September 30, 2017 was $129,000, an improvement of $497,000 from the operating loss of $627,000 for the three months ended September 30, 2016.  The decreased loss reflected higher sales in both our retail and direct-to-consumer channels, as well as an overall proportional decrease in operating expenses (as a percentage of revenue), as discussed in greater detail above.

Net Loss

For the three months ended September 30, 2017, we recorded a net loss of $121,000 as compared to a net loss of $1.1 million for the three months ended September 30, 2016.

Segment Results

We report our segment information in the same way that management assesses the business and makes decision regarding the allocations of resources in accordance with the Segment Reporting Topic of the Financial Accounting Standards Board Accounting Standards Codification (ASC). We have two reportable segments. Retail and Direct-to-Consumer. Factors considered in determining our Reportable Segments include the nature of the business activities, the reports provided to the Company's chief operating decision maker (CODM) for operating and administrative activities, available information and information that is presented to our Board of Directors.

The Company's CODM has been identified as the Chief Executive Officer because he has final authority over the performance assessment and resource allocation decisions. The CODM regularly receives discrete financial information about each Reportable Segment. The CODM uses all such information for performance assessment and resource allocation decisions. The CODM evaluates the performance of and allocates resources based upon the contribution margins of each segment.

As a result, we divide our business into two reportable segments: Direct-to-Consumer and Retail. This division of reportable segments is consistent with how the segments report to and are managed by the chief operating decision maker of the Company.  The Company evaluates performance based on the primary financial measure of contribution margin ("segment profit"). Segment profit reflects the income or loss from operations before corporate expenses, non-operating income, net interest expense, and income taxes.

 

(1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A.

(1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A.

Six Months Ended September 30, 2017 and September 30, 2016

Summary Overview

For the six months ended September 30, 2017, total revenue of $8.2 million was up 86.5%, or $3.8 million, relative to the same period in the prior year.  The increase was primarily due to growth of sales at all Amazon accounts and other online retailers, nearly $2.0 million of in-store retail channel sales to new customers, continued sales into the retail housewares channel and growing interest in our new AeroGardens that were first introduced in the prior year.   The increase is the result of our strategy to use our platform with online retailers to generate focused and successful in-store tests, primarily in the housewares channel.  We anticipate that quarterly sales results during the first six months of our fiscal year (April-September), may be variable as we test various retail channel strategies in an effort to optimize sales and profitability throughout the year, particularly due to retailers purchasing load-in products in advance of the peak holiday season.  Sales in our direct-to-consumer channels increased, by 18.8%, or $369,000, primarily due to more visibility and continued momentum from our general advertising and marketing campaign, increased user-base including our increased presence on Amazon accounts and other select online retail distribution channels.  Sales to international distributors increased by 43.8% to $146,000 in the six months ended September 30, 2017, relative to the same period in the prior year, primarily due to our expanded distribution in certain international markets such as Amazon.uk, France, Germany, Spain and Italy.

For the six months ended September 30, 2017, total dollar sales of AeroGarden units increased by 176.7% from the prior year period and seed pod kit and accessory sales increased by 36.2% over prior year period.  AeroGarden sales net of allowances represented 74.6% of total revenue, as compared to 65.2% in the prior year period.  This percentage increase, on a product line basis, was attributable to existing and new customers purchasing AeroGardens and expansion and introduction of AeroGardens into newly acquired retail accounts including significantly earlier load-in retail sales prior to the holiday season.  Seed pod kit and accessory sales decreased as a percent of the total to 25.4% from 34.8% in the prior year period as a result of as a result of the higher AeroGarden sales as we approach our peak selling season.  However, as noted above, the total dollar sales increased by $553,000.

During the six months ended September 30, 2017, we spent $441,000 in advertising expenditures, a year-over-year increase of $9,000, or 2.0%, compared to the same period ended September 30, 2016. This increase was to support our retail sales channels.  These expenditures were divided as follows:

 

·

Direct-to-consumer advertising increased $5,000 to $121,000 during the six months ended September 30, 2017, primarily reflecting reallocation of specific pay-per-click advertising geared toward the direct-to-consumer customer base and direct advertising campaigns.  Efficiency, as measured by dollars of direct-to-consumer sales per dollar of related advertising expense increased to $19.40 for the six months ended September 30, 2017, as compared to $17.05 for the same period in Fiscal 2017.

·

Retail advertising decreased to $301,000 from $302,000 for the six months ended September 30, 2017 and September 30, 2016, respectively, as we invested in: (i) platforms made available by our retailers; (ii) various promotional programs to increase product awareness with our retail housewares channel, including catalogues and email campaigns; and (iii) web-based advertising programs (e.g. inclusion in retail catalogues, website banner ads, email blasts, targeted search campaigns, etc.).

 

Our gross profit for the six months ended September 30, 2017, was 30.3%, down from 34.9% in the prior year period.  The decrease in the gross profit percentage is due to increased sales, which traditionally have lower margins and are impacted by allowances for estimated returns, particularly on higher product load-in sales in advance of the peak selling season.

In aggregate, our total operating expenses increased 18.7%, or $527,000, year-over-year, principally to support new product introductions and anticipated growth.  Gross spending fluctuated in the following areas:

 

·	A $311,000 increase in personnel expenses, due to a small increase in headcount and other changes to our compensation program to align with our growth initiatives;

·	A $115,000 increase in general market research, new product samples, public relations and new product programs such as illustration and language translations for international product distribution; and

·	A $25,000 increase in travel to manufacturers in China and potential domestic and European customers.

 

Our operating loss was $858,000 for the six months ended September 30, 2017, as compared to an operating loss of $1.3 million in the prior year period, primarily due to earlier load-in product sales to retailers prior to the holiday season.

 

Our operating loss decreased $422,000 to $858,000 for the six months ended September 30, 2017, from $1.3 million in the prior year period, primarily as a result of increased product load-in sales to new retail accounts, partially offset by lower margins on these accounts and increases in general spending for new products and market expansion.  The first six months of the year are our seasonally slowest sales period.

Other income and expense for the six months ended September 30, 2017 totaled to a net other income of $47,000, as compared to net other expense of $975,000 in the prior year period.   The current year other income is attributable to interest income, other income from consulting related revenue, and foreign exchange gains.  In the prior year, net other expense was primarily attributable to non-cash expenses relating to the fair value revaluation of the warrant held by Scotts Miracle-Gro.  

The net loss for the six months ended September 30, 2017 was $811,000, as compared to the $2.3 million loss in the prior year.   The decreased net loss is due to no fair value changes associated with the Scotts Miracle-Gro warrant liability as the warrant was fully exercised and higher overall sales, which includes several sales to newly acquired retail accounts in advance of the peak holiday season, partially offset by sales into the lower margin retail channel and an increase in salaries and wages.

The following table sets forth, as a percentage of sales, our financial results for the six months ended September 30, 2017, and the six months ended September 30, 2016:

 

 

Direct-to-consumer sales for the six months ended September 30, 2017, totaled $2.3 million, up $369,000 or 18.8%, from the prior year period. The increase in sales to direct-to-consumer channels was caused by pricing strategies to drive direct-to-consumer sales during our non-peak season, and continued cumulative momentum from our general brand awareness campaigns.  

Sales to retailer customers for the six months ended September 30, 2017, totaled $5.7 million, up $3.4 million, or 145.7%, from the prior-year period, principally reflecting earlier load-in sales to newly acquired and expanded retail accounts, including more brick-and-mortar retailers, in our housewares outlets, and increased online sales to the existing Amazon accounts.  We also tested our products in several retail stores during the period in anticipation of the continued retail expansion throughout the year.

 

International sales for the six months ended September 30, 2017, totaled $146,000, an increase of $44,000, primarily due to expansion of sales testing in Europe and as we continue to understand the trends that impact the international market.

Our products consist of AeroGardens, and seed pod kits and accessories.  A summary of the sales of these two product categories for the six months ended September 30, 2017 and September 30, 2016 is as follows:

 

AeroGarden sales increased $5.3 million, or 176.7%, from the prior year period, reflecting increased retail channel sales and increased sales of AeroGardens in our direct-to-consumer channel.  The increase in seed pod kit and accessory sales, which increased by $553,000, or 36.2%, principally reflects the increase in our established base of AeroGardens.  For the six months ended September 30, 2017, sales of seed pod kits and accessories represented 25.4% of total revenue, as compared to 34.8% in the prior year period.  The percentage decrease is due to increased sales of AeroGardens.  Other revenue, which is comprised primarily of grow club revenue, shipping revenue, accruals and deductions, increased as a percent of the total to (26.3)% from (2.8)% in the prior year period due to higher deductions and accruals for sales allowances and future discounts for in-store new retail accounts and lower shipping revenue as a percentage of sales.

Cost of Revenue

Cost of revenue for the six months ended September 30, 2017 totaled $5.7 million, an increase of $2.9 million, from the six months ended September 30, 2016, due to increased revenues.  Cost of revenue includes product costs for purchased and manufactured products, freight costs for inbound freight from manufacturers, costs related to warehousing and the shipping of products to customers, credit card processing fees for direct sales, and duties and customs applicable to imported products. As a percent of total revenue, cost of revenue represented 69.7% of revenue as compared to 65.1% for the prior year period.  

 

Gross Profit

Our gross profit varies based upon the factors affecting net revenue and cost of revenue as discussed above, as well as the mix of our revenue that comes from the retail, direct-to-consumer, and international channels.  In a direct-to-consumer sale, we recognize as revenue the full consumer purchase price for the product.  In retail and international sales, by comparison, we recognize as revenue the wholesale price for the product which we charge to the retailer or international distributor.  Media costs associated with direct sales are included in sales and marketing expenses.  As a result, retail and international sales generally have lower gross profits than direct-to-consumer sales.  The gross profit for the six months ended September 30, 2017, was 30.3% as compared to 34.9% for the six months ended September 30, 2016.  The decrease in our gross profit percentage was primarily attributable to the increased percentage of sales to new brick-and-mortar retail accounts with lower margins, changes in customer and product mix and increased pricing pressure in our direct-to-consumer channel.

  

Research and Development

Research and development costs for the six months ended September 30, 2017, totaled $233,000, an increase of 8.4%, or $18,000, from the six months ended September 30, 2016.  The increase reflects increases in Research and Development employee headcount and prototype development and shipping expenses, offset by decreases in new product certification and testing and $60,000 of consulting fee reimbursements.

 

Advertising expense totaled $441,000 for the six months ended September 30, 2017, a year-over-year increase of 2.0%, or $9,000, primarily due to conservative spending on promotional programs within our retail channel, while maintaining catalogues, email campaigns, and web-based advertising programs for our houseware customers.

Sales and marketing personnel costs include salaries, payroll taxes, employee benefits and other payroll costs for our sales, operations, customer service, graphics and marketing departments.  For the six months ended September 30, 2017, personnel costs for sales and marketing were $977,000, up from $866,000 for the six months ended September 30, 2016, an increase of 12.8%.  The increase reflected increased headcount necessary to drive what we anticipate will be increased sales to retailers and through our direct-to-consumer channel beginning in the fall of 2017.  Personnel expenses include all related payroll including departmental incentive programs, including salaries, bonuses and employee benefits.

Other marketing expenses increased year-over-year because of increases in a variety of spending categories, including additional travel, social media, market research programs, retailer marketing programs, third party sales tax software and new products that were initiated during the current year quarter.

General and Administrative

General and administrative costs for the six months ended September 30, 2017, totaled $1.3 million, as compared to $1.1 million for the six months ended September 30, 2016, an increase of 21.7%, or $225,000.  The increase is attributable to increase in: (i) payroll-related expenses, including departmental incentive programs, salaries, bonuses and employee benefits; (ii) web hosting, electronic data processing, network consulting fees for software troubleshooting; and (iii) estimates for the allowance for bad debt.

Operating Loss

Our operating loss for the six months ended September 30, 2017, was $858,000, a decrease of $422,000 from the operating loss of $1.3 million for the six months ended September 30, 2016.  The decreased operating loss was attributable to increased sales in both the retail distribution and direct-to consumer channels.

Net Loss

The net loss for the six months ended September 30, 2017 was $811,000, as compared to $2.2 million net loss in the prior–year period as discussed above.

Segment Results

We report our segment information in the same way that management assesses the business and makes decision regarding the allocations of resources in accordance with the Segment Reporting Topic of the Financial Accounting Standards Board Accounting Standards Codification (ASC). We have two reportable segments. Retail and Direct-to-Consumer. Factors considered in determining our Reportable Segments include the nature of the business activities, the reports provided to the Company's chief operating decision maker (CODM) for operating and administrative activities, available information and information that is presented to our Board of Directors.

The Company's CODM has been identified as the Chief Executive Officer because he has final authority over the performance assessment and resource allocation decisions. The CODM regularly receives discrete financial information about each Reportable Segment. The CODM uses all such information for performance assessment and resource allocation decisions. The CODM evaluates the performance of and allocates resources based upon the contribution margins of each segment.

As a result, we divide our business into two reportable segments: Direct-to-Consumer and Retail. This division of reportable segments is consistent with how the segments report to and are managed by the chief operating decision maker of the Company.  The Company evaluates performance based on the primary financial measure of contribution margin ("segment profit"). Segment profit reflects the income or loss from operations before corporate expenses, non-operating income, net interest expense, and income taxes.

 

(1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section.

 

(1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section.

Liquidity and Capital Resources

After adjusting the net loss for non-cash items and changes in operating assets and liabilities, the net cash used by operating activities totaled $7.3 million for the six months ended September 30, 2017, as compared to cash used of $2.7 million in the prior year period.

Non-cash items, comprising depreciation, amortization, bad debt (recoveries) allowances, change in fair value of the Scotts Miracle-Gro warrant liability and non-cash compensation expense, totaled to a net gain of $142,000 for the six months ended September 30, 2017, as compared to a net gain of $1.4 million in the prior year period.  The decrease principally reflected non-cash charges arising from the change in fair value on the warrant liability in the prior year, depreciation and non-cash compensation expenses.

Changes in current assets used net cash of $9.6 million during the six months ended September 30, 2017, principally from increases in inventory and in accounts receivable as timing of load-in orders increased and as we ramp up for our peak sales season, which historically begins in the third fiscal quarter.

As of September 30, 2017, the total inventory balance was $8.4 million, representing approximately 171 days of sales activity, and 189 days of sales activity, at the average daily rate of product cost expensed during the twelve months and three months ended September 30, 2017, respectively.  The days in inventory calculation based on the three months of sales activity can vary greatly due to the seasonality of our sales, which are at their highest level during our quarter ended December 31.  The twelve months' days in inventory calculation is based on the twelve months of sales activity and is less impacted by the seasonality of our sales.

Current operating liabilities increased $3.0 million during the six months ended September 30, 2017, principally because of an increase in accounts payable.  Accounts payable as of September 30, 2017, totaled $3.0 million, representing approximately 39 days of daily expense activity, and 46 days of daily expense activity, at the average daily rate of expenses incurred during the twelve months and three months ended September 30, 2017, respectively.

 

Net investment activity used $97,000 of cash in the current year period, principally because of the purchases of equipment as we change our supply manufacturers and introduce new products.

Net financing activity used net cash of $4,000 during the six months ended September 30, 2017, principally due the payments on the capital lease.

Cash

As of September 30, 2017, we had a cash balance of $1.4 million, of which $15,000 was restricted as collateral for various corporate obligations.  This compares to a cash balance of $8.8 million as of March 31, 2017, of which $15,000 was restricted.  The decrease in cash is primarily attributable to the purchase of inventory in the current quarter to meet peak season sales demand, in particular to satisfy the current period load-in sales with new and expanded brick-and-mortar retail customers.

Borrowing Agreements

As of September 30, 2017 and March 31, 2017, we have no outstanding long-term debt, however, we have entered into a Term Loan Agreement in the principal amount of up to $2.0 million with Scotts Miracle-Gro.

Cash Requirements

We generally require cash to:

 

·	fund our operations and working capital requirements,

·	develop and execute our product development and market introduction plans,

·	execute our sales and marketing plans,

·	fund research and development efforts, and

·	pay debt obligations as they come due.

 

At this time, we do not expect to enter into additional capital leases to finance major purchases.  In addition, we do not currently have any binding commitments with third parties to obtain any material amount of equity or debt financing other than the financing arrangements described in this report.

Assessment of Future Liquidity and Results of Operations

Liquidity

To assess our ability to fund ongoing operating requirements, we developed assumptions regarding operating cash flow.  Critical sources of funding, and key assumptions and areas of uncertainty include:

 

·	our cash of $1.4 million ($15,000 of which is restricted as collateral for our various corporate obligations) as of September 30, 2017;

·	our cash of $2.1 million ($15,000 of which is restricted as collateral for our various corporate obligations) as of November 8, 2017;

·	continued support of, and extensions of credit by, our suppliers and lenders, including, but not limited to, the Term Loan of up to $2.0 million from Scotts Miracle-Gro, of which we had borrowed zero and $1.0 million in principal amount as of September 30, 2017 and November 6, 2017, respectively;

·	our historical pattern of increased sales between September and March, and lower sales volume from April through August;

·	the level of spending necessary to support our planned initiatives; and

·	our sales to consumers, retailers, and international distributors, and the resulting cash flow from operations, which will depend in great measure on the success of our direct-to-consumer sales initiatives, and the acceptance of the product at our various retail distribution customers.

 

On September 13, 2017, the Company entered into a Term Loan Agreement in the principal amount of up to $2.0 million with Scotts Miracle-Gro.  The proceeds will be made available as needed in increments of $500,000 not to exceed $2.0 million with a due date of March 30, 2018.  The Term Loan Agreement is secured by a lien on the assets of the Company and interest is charged at the stated rate of 10% per annum to be paid quarterly in arrears in cash, at the end of each September, December and March.  The funding will provide general working capital and is being used for the purpose of acquiring inventory to support anticipated growth as the Company expands its retail and its direct-to-consumer sales channels.  We have borrowed $1.0 million as of November 6, 2017 and will continue to borrow against the $2.0 million loan in order to purchase inventory during our peak selling season.  See Note 3 "Notes Payable, Long Term Debt and Current Portion – Long Term Debt" to our condensed financial statements.

Based on these facts and assumptions, we believe our existing cash and cash equivalents, along with the Term Loan Agreement and the cash generated by our anticipated results from operations, will be sufficient to meet our needs for the next twelve months.  

Results of Operations

There are several factors that could affect our future results of operations.  These factors include, but are not limited to, the following:

 

·	the effectiveness of our consumer marketing efforts in generating both direct-to-consumer sales, and sales to consumers by our retailer customers,

·	uncertainty regarding the impact of macroeconomic conditions on consumer spending,

·	uncertainty regarding the capital markets and our access to sufficient capital to support our current and projected scale of operations,

·	the seasonality of our business, in which we have historically experienced higher sales volume during the fall and winter months (September through March),

·	a continued, uninterrupted supply of product from our third-party manufacturing suppliers in China, and

·	the success of the Scotts Miracle-Gro relationship.

 

Off-Balance Sheet Arrangements

Other than our headquarter facility lease commitment incurred in the normal course of business, we do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interest in transferred assets, and have not entered into any contracts for financial derivative such as futures, swaps, and options.