As filed with the Securities and Exchange Commission on September 20, 2019

File No.                       

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10

 

 

 

GENERAL FORM FOR REGISTRATION OF SECURITIES

Pursuant to Section 12(b) or (g) of The Securities Exchange Act of 1934

 

 

DIRTT ENVIRONMENTAL SOLUTIONS LTD.

(Exact name of registrant as specified in its charter)

 

 

 

Alberta, Canada		N/A
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
7303 30th Street S.E. Calgary, Alberta, Canada		T2C 1N6
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (403) 723-5000

 

Copies to:
Joseph Zirkman Senior Vice President and General Counsel DIRTT Environmental Solutions Ltd. 7303 30th Street S.E. Calgary, Alberta, Canada T2C 1N6 (403) 723-5000		Robert L. Kimball Michael A. Saslaw Vinson & Elkins L.L.P. 2001 Ross Avenue Suite 3900 Dallas, TX 75201 (214) 220-7700

Securities to be registered pursuant to Section 12(b) of the Act:

 

Title of each class to be so registered		Name of each exchange on which each class is to be registered
Common Shares, without par value		The Nasdaq Stock Market LLC

Securities to be registered pursuant to Section 12(g) of the Act:

None

(Title of Class)

 

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act:

 

Large accelerated filer		☐		Accelerated filer		☐
Non-accelerated filer		☒		Smaller reporting company		☐
				Emerging growth company		☒

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒

 

 

 

TABLE OF CONTENTS

 

Cautionary Note Regarding Forward-Looking Statements					ii
Item 1.		Business			1
Item 1A.		Risk Factors			10
Item 2.		Financial Information			23
Item 3.		Properties			42
Item 4.		Security Ownership of Certain Beneficial Owners and Management			43
Item 5.		Directors and Executive Officers			45
Item 6.		Executive Compensation			52
Item 7.		Certain Relationships and Related Transactions, and Director Independence			62
Item 8.		Legal Proceedings			64
Item 9.		Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters			65
Item 10.		Recent Sales of Unregistered Securities			66
Item 11.		Description of Securities to be Registered			67
Item 12.		Indemnification of Directors and Officers			80
Item 13.		Financial Statements and Supplementary Data			82
Item 14.		Changes in and Disagreements with Accountants on Accounting and Financial Disclosures			82
Item 15.		Financial Statements and Exhibits			83

 

Explanatory Note

DIRTT Environmental Solutions Ltd. was incorporated under the Business Corporations Act (Alberta) (“ABCA”) on March 4, 2003. We completed our initial public offering in Canada in November 2013. Our common shares trade on the Toronto Stock Exchange (“TSX”) under the ticker symbol “DRT.” We are filing this General Form for Registration of Securities on Form 10 to register our common shares pursuant to Section 12(b) of the Securities and Exchange Act of 1934 (“Exchange Act”). We have applied to list our common shares on The Nasdaq Global Select Market (“Nasdaq”) under the ticker symbol “DRTT.”

Once this registration statement becomes effective, we will be subject to the requirements of Section 13(a) of the Exchange Act, including the rules and regulations promulgated thereunder, which will require us to file, among other things, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy or information statements with the Securities and Exchange Commission (“SEC”), in addition to requirements of the applicable securities laws of Canada.

The audited consolidated financial statements included elsewhere in this registration statement have been prepared in conformity with accounting principles generally accepted in the United States (“GAAP”) and the rules and regulations of the SEC.

Unless otherwise specified or the context otherwise requires, references to “we,” “us,” “our,” “its,” “the Company” or “DIRTT” mean DIRTT Environmental Solutions Ltd. and, where the context so requires, includes our subsidiaries.

Currency and Exchange Rate Information

Unless otherwise indicated, references herein to “$” or “dollars” are expressed in U.S. dollars (US$). References in this registration statement to Canadian dollars are noted as “C$.”

Our consolidated financial statements that are included in this registration statement are presented in U.S. dollars. Unless otherwise stated, all figures presented in Canadian dollars and translated into U.S. dollars were calculated using the daily average exchange rate as reported by the H.10 statistical release of the Board of Governors of the Federal Reserve System on September 13, 2019 of C$1.3268 = US$1.00.

Market and Industry Data

Certain market and industry data contained in this Form 10, including “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are based upon information from government or other third-party publications, reports and websites or based on estimates derived from such publications, reports and websites. Government and other third-party publications and reports do not guarantee the accuracy or completeness of their information. While management believes this data to be reliable, market and industry data are subject to variations and cannot be verified with complete certainty due to limits on the availability and reliability of raw data, the voluntary nature of the data-gathering process, and other limitations and uncertainties inherent in any statistical survey.

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements contained in this registration statement are “forward-looking statements” within the meaning of “safe harbor” provisions of the United States Private Securities Litigation Reform Act of 1995, and Section 21E of the Exchange Act and “forward-looking information” within the meaning of applicable Canadian securities laws. All statements, other than statements of historical fact included in this registration statement, regarding our strategy, future operations, financial position, estimated revenues and losses, projected costs, prospects, plans and objectives of management are forward-looking statements. When used in this registration statement, the words “anticipate,” “believe,” “expect,” “estimate,” “intend,” “plan,” “project,” “outlook,” “may,” “will,” “should,” “would,” “could,” “can,” the negatives thereof, variations thereon and other similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. Forward-looking statements are based on certain estimates, beliefs, expectations and assumptions made in light of management’s experience and perception of historical trends, current conditions and expected future developments, as well as other factors that may be appropriate.

Forward-looking statements necessarily involve unknown risks and uncertainties, which could cause actual results or outcomes to differ materially from those expressed or implied in such statements. Due to the risks, uncertainties and assumptions inherent in forward-looking information, you should not place undue reliance on forward-looking statements. Factors that could have a material adverse effect on our business, financial condition, results of operations and growth prospects can be found in Item 1A. “Risk Factors,” Item 2. “Financial Information – Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this registration statement. These factors include, but are not limited to, the following:

 

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competition in the interior construction industry;

 

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global economic, political and social conditions and financial markets;

 

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our reliance on our network of Distribution Partners (as defined herein) for sales, marketing and installation of our solutions;

 

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our ability to maintain and manage growth effectively;

 

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our ability to introduce new designs, solutions and technology and gain client and market acceptance;

 

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loss of our key executives;

 

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labor shortages and disruptions in our manufacturing facilities;

 

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product liability, product defects and warranty claims brought against us;

 

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defects in our designing and manufacturing software;

 

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infringement on our patents and other intellectual property;

 

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cyber-attacks and other security breaches of our information and technology systems;

 

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material fluctuations of commodity prices, including raw materials;

 

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shortages of supplies of certain key components and materials;

 

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our ability to achieve requisite capacity from our existing manufacturing facilities;

 

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our exposure to currency exchange rate, tax rate and other fluctuations that result from general economic conditions and changes in laws;

 

ii

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legal and regulatory proceedings brought against us;

 

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the availability of capital or financing on acceptable terms, which may impair our ability to make investments in the business; and

 

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other factors and risks described under Item 1A. “Risk Factors” and under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 2. “Financial Information.”

These risks are not exhaustive. Because of these risks and other uncertainties, our actual results, performance or achievement, or industry results, may be materially different from the anticipated or estimated results discussed in the forward-looking statements in this registration statement. New risk factors emerge from time to time, and it is not possible for our management to predict all risk factors nor can we assess the effects of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in, or implied by, any forward-looking statements. Our past results of operations are not necessarily indicative of our future results. You should not rely on any forward-looking statements, which represent our beliefs, assumptions and estimates only as of the dates on which they were made, as predictions of future events. We undertake no obligation to update these forward-looking statements, even though circumstances may change in the future, except as required under applicable securities laws. We qualify all of our forward-looking statements by these cautionary statements.

 

 

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ITEM 1.

BUSINESS

Overview

DIRTT is an innovative manufacturing company featuring a proprietary software and virtual reality visualization platform, coupled with vertically integrated manufacturing that designs, configures and manufactures prefabricated interior solutions used primarily in commercial spaces across a wide range of industries and businesses. We combine innovative product design with our industry-leading, proprietary ICE^® Software (“ICE” or “ICE Software”), and technology-driven, lean manufacturing practices and sustainable materials to provide end-to-end solutions for the traditionally inefficient and fragmented interior construction industry. We create customized interiors with the aesthetics of conventional construction but with greater schedule and cost certainty, shorter lead times, greater future flexibility, and better environmental sustainability than conventional construction.

Our ICE Software allows us to design, visualize (including 3D virtual reality modeling of interiors), configure, price, communicate, engineer, specify, order and manage projects, thereby reducing challenges associated with traditional construction, including cost overruns, change orders, inconsistent quality, delays and material waste. While other software programs and virtual reality tools are used in the architectural and construction industries, we believe our ICE Software is the only interior construction technology that provides end-to-end management, from design through engineering, manufacturing and installation. Our interior construction solutions include prefabricated, customized interior modular walls, ceilings, and floors; decorative and functional millwork; power infrastructure; network infrastructure; and pre-installed medical gas piping systems. We strive to incorporate environmentally sustainable materials into our solutions while creating flexible, functional and well-designed environments for the people who will use them.

We offer our interior construction solutions throughout the United States and Canada, as well as in select international markets, through a network of independent distribution partners (“Distribution Partners”) and an internal sales team. Our Distribution Partners use ICE to work with end users to envision and design their spaces, and orders are electronically sent through ICE to our manufacturing facilities for production, packing and shipping. Our Distribution Partners then coordinate the receipt and installations of our interior solutions at the end users’ locations.

Our name “DIRTT” stands for Doing It Right This Time. DIRTT was incorporated in Alberta, Canada, on March 4, 2003. Our headquarters are in Calgary, Alberta, Canada, and our manufacturing facilities are in Calgary, Alberta; Phoenix, Arizona; and Savannah, Georgia.

Our Solutions

We offer a wide array of interior construction solutions powered by technology that address the challenges inherent in traditional interior designing and building methods. Unlike traditional interior construction, including prefabricated products, our solutions are not predetermined in shape or size, so clients are free to design any shape, size or configuration. Our design and visualization technologies integrate with our manufacturing capabilities and enable short and precise manufacturing times. With a strong network of Distribution Partners, we are able to complete an interior construction project in as few as 30 days, from visualization and completion of design to installation and move-in. Because our solutions remain highly adaptable over time, clients are able to change and customize our solutions even after installation to maintain satisfaction with the functionality and aesthetics of their space as their needs change.

Sustainability practices are a core part of our business, from design and manufacturing to installation and beyond. Our solutions are form-fit, so the only waste produced at job sites is packing material, which is bio-degradable, recyclable or able to be returned to DIRTT for reuse.

 

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DIRTT Solutions

Our solutions typically encompass over 90% of an interior space. Walls, doors, cabinetry, access floor, ceilings, power solutions, data networks, heavy timber and medical gas components are all fabricated in our manufacturing facilities and shipped to the site for final assembly and installation. The following table provides a brief description of our primary solutions (together with related complementary offerings, “DIRTT Solutions”):

 

DIRTT Solution		Description
DIRTT Walls		Prefabricated, customized, modular solid or glass interior wall solutions that support new and legacy furniture, that include glass walls, doors or windows, and that support integrated technology for commercial, healthcare, education, hospitality and other industries and medical gas piping systems for healthcare.
DIRTT Millwork		Fully customized modular cabinetry that may be used in a variety of industries, including commercial, healthcare, education and hospitality.
DIRTT Floors		Low-profile floors that allow quick access to modular power and network infrastructure, facilitating future adaptation and reconfiguration in both existing facilities and new buildings.
DIRTT Ceilings		Prefabricated custom ceilings that increase sound privacy and reduce noise.
DIRTT Power		Quick-connect, pre-tested adaptable power solutions that are prefabricated to arrive on-site in correct lengths with factory components ready for installation and use, eliminating waste and providing future flexibility.
DIRTT Networks		Prefabricated, pre-tested and componentized passive optical networks utilizing single mode fiber cables instead of traditional copper cables. Similar to DIRTT Power, data infrastructure components arrive on the job site pre-cut to correct lengths and with components ready for quick-connect installation and use.
DIRTT Timber		Prefabricated timber construction for interior mezzanines, structural elements for low-rise buildings, and other architectural elements, including completely customized cross-laminated timber and glue-laminated (glulam) timber.

Our DIRTT Power and DIRTT Networks solutions may be integrated with DIRTT Walls, and DIRTT Networks may also be integrated with DIRTT Floors and DIRTT Ceilings. DIRTT Millwork solutions may be added to DIRTT Walls for decorative and functional purposes. Additionally, DIRTT Walls, DIRTT Floors, DIRTT Ceilings and DIRTT Timber may be integrated among each solution.

ICE^® Software

Our manufacturing approach is built on a foundation of technology, the center of which is our proprietary ICE Software. We use ICE to sell, design, visualize, configure, price, communicate, engineer, specify, order and manage projects. ICE was developed as a custom interior design and construction software solution to integrate into our interior offerings. ICE makes manufactured, fully custom interiors both feasible and profitable while addressing challenges associated with traditional construction, including cost overruns, inconsistent quality, delays and significant material waste. Simultaneously, it gives our clients full control over the look, cost and move-in schedule of their interior construction projects.

Clients typically engage an architect or designer and initially design their interior space and customize their solutions components, including material, color, finish and layout, in two-dimensional renderings. A DIRTT Distribution Partner imports this design into ICE and prices projects in real time. Any changes clients make after the design is imported into ICE will immediately be reflected in the price quote. Once the design is ready, clients can then explore and walk through their designed space in immersive and interactive 3D virtual reality or on-screen computer renderings so they can more readily conceptualize the design. This improves on the experience of reviewing only a two-dimensional blueprint or CAD drawing. We have four

 

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virtual reality walk-through centers, including one at our corporate headquarters, that allow clients to use virtual reality headsets to walk through a 3D virtual reality model of their design. We also integrated ICE with augmented (mixed) reality technology, including phones and tablets, to allow project stakeholders in different physical locations to visualize, interact and discuss their future spaces without having to visit one of our virtual reality walk-through centers.

Once the client is satisfied with the design in ICE, the specifications are transmitted to our manufacturing facilities, where the solutions are created to the exact design standards and specifications set forth in the design. ICE manages many aspects of the manufacturing process, including product inventory and cataloguing, price quotation, order submission, parts manufacturing, and production management, thereby facilitating the delivery of custom solutions with shorter production times. We allocate production among our manufacturing facilities based on proximity and capacity. ICE allows an entire project to be tracked and managed across the entire life of the project, from sales, production, delivery, and installation. The ICE file (containing all of a project’s engineering and manufacturing data) generated during the design and specification process is preserved and can be used for optimizing future reconfigurations, renovations, technology integration initiatives and changes to a client’s space at lower cost than traditional construction methods.

Our Business Strategy

Our goal is to help clients envision and design interior construction projects and then build and deliver those projects faster, cleaner, more efficiently and with a better overall client experience and satisfaction than traditional construction methods. The modular aspect of our DIRTT Solutions allows them to be easily reconfigured with a minimal amount of waste as client space needs change. Our innovative, technology-driven approach includes outstanding product design that is customized for each client application and delivered on time and on budget.

Our strategy is founded on the following priorities:

 

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The identification and pursuit of client segments that benefit most from DIRTT’s value proposition;

 

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Client-centric, continuous innovation in DIRTT Solutions and our technology to enhance product differentiation and drive market penetration and growth;

 

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Technology-enabled manufacturing processes that facilitate short lead times, a reliable client service platform, and outstanding quality on a cost-effective basis; and

 

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Ongoing development and support of our Distribution Partners to ensure flawless execution and a superior end client experience.

In combination with a focus on cost-disciplined control, a continuous improvement philosophy, and a focused approach to capital investment, we believe these strategic priorities will drive increased value creation for our employees, clients, Distribution Partners, and shareholders.

Our Competitive Strengths

We believe the following attributes provide us with competitive strengths in the interior solutions manufacturing industry.

 

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Leader in Integrated Design and Manufacturing Technology. We believe our ICE Software is the only interior construction technology that efficiently integrates the design, configuration, and virtual reality visualization processes with the manufacturing process. The use of 3D technology in a design environment, mimicking video game visuals, is proprietary to DIRTT.

 

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Easy and Intuitive Software Interface. Our ICE Software is a fast, powerful tool with an intuitive user interface. Our software’s ease of use enables rapid time-to-value for our clients and collaboration among all the stakeholders involved in the design, reconfiguration, budgeting and manufacturing processes. Our use of 3D virtual reality and augmented (mixed) reality technologies enables clients to visualize and modify their designs before manufacturing begins, thereby reducing cost and time to completion.

 

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Proprietary Solutions Components. The physical components that comprise our DIRTT Solutions have been designed to provide clients with numerous options and full modularity. As a result, we are able to create interior environments that are fully customizable and not limited by a pre-set product list. The modular nature of our components allows them to be reconfigured easily, with minimal disruption to the occupants of the space and with minimal job site waste.

 

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Strong Distribution Partner and Sales Network. Our strong network of Distribution Partners and DIRTT sales representatives allows us to maximize our geographic reach, helps build brand awareness in the interior construction market, and enhances our positioning in our target markets.

 

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Superior Results Compared to Traditional Design and Construction. We believe we produce superior client results as compared with traditional design and construction methods in sequencing, certainty, budget allocation, and outcome.

 

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Effective Sequencing. Conventional construction generally follows a rigid sequencing process. Typically, wall framing is constructed first, followed by floors and electrical and data networks. This process is then followed by drywall installation, painting, and flooring, and then installation or building of millwork and fixtures. These steps generate significant waste and create opportunities for delay, change orders, cost overruns and rework. In contrast, DIRTT Solutions design and integrate the walls, floors and ceiling, including the finish, electrical wiring and data networks. They are manufactured off-site and arrive on-site organized, labeled and ready to be installed. This enables the interior solutions to be produced concurrently with on-site construction work, thereby reducing on-site time and the overall construction schedule.

 

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Certainty. Our technology-based design and manufacturing solutions address changes in design, communications with clients, and material costs with more certainty than conventional construction methods, which often involve retrofitting electrical and data networks, change orders, uncertain timelines, and costly rework. Our controlled manufacturing environment reduces deficiencies and errors and produces more consistent solutions in predictable time frames.

 

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Budget. Because of our integrated design, visualization and manufacturing technologies, we can price the effect of design choices and changes immediately and deliver the fully designed, manufactured interior solutions ready to install. This provides budget certainty both in the cost of our DIRTT Solutions as well as in on-site labor for the installation process.

 

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Outcome. Our interior spaces look like the images our clients expect from the design drawings and virtual visualizations, because those same drawings and visualizations drive the manufacturing process. Plumbing, electrical, A/V and networks are integrated into the architecture of our DIRTT Solutions. For example, DIRTT Walls look and perform like permanent walls, but if an IT or facilities team needs to get inside the wall for any reason, they can use a tool to remove the surface of the wall to examine the wall cavity quickly, cleanly and quietly. This eliminates the need to knock down, and then patch and repaint, drywall or to reconfigure fixtures and cabinetry. Our modular designs offer flexibility and interconnectivity with any technology, furniture, millwork or DIRTT Solutions that were previously used or that will be used in the future, allowing clients to reconfigure and repurpose their space while reducing disruptive and time-consuming demolition and waste removal.

Distribution Partners and Sales Network

We primarily sell DIRTT Solutions through a network of independent Distribution Partners working in conjunction with local DIRTT sales representatives as well as internal DIRTT industry specialists, business development professionals and a dedicated Distribution Partner support team. Distribution Partners and local sales representatives are located in cities throughout the United States and Canada, as well as in select international markets. The use of a dispersed network of Distribution Partners greatly enhances our ability to drive awareness of the DIRTT brand throughout our markets.

 

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Including through our Distribution Partners, we operate 82 Green Learning Centers (“GLCs”) throughout North America, the Middle East and India, which are display areas that showcase DIRTT Solutions. As part of our distribution agreements, our Distribution Partners are typically required to invest in their own GLC so that they are better able to demonstrate DIRTT Solutions. As of June 30, 2019, there were 76 Distribution Partner-operated GLCs and six DIRTT-operated GLCs.

Our Distribution Partners operate under agreements that outline sales goals and marketing territories which are generally non-exclusive. We expect our Distribution Partners to build regional DIRTT-dedicated teams (sales, design and project management) and to use our ICE Software in the sales process. In addition to sales and marketing, our Distribution Partners provide value throughout the construction process. At the pre-construction stage, Distribution Partners provide design assistance services to the architect and designer; through the construction process, Distribution Partners act as a specialty subcontractor to the general contractor and provide installation and other construction services; and post-move in, Distribution Partners provide warranty work, ongoing maintenance and reconfiguring support. Local DIRTT sales representatives work closely with the Distribution Partners throughout the process to ensure successful project implementation and the highest client satisfaction. Distribution Partners generally place orders for DIRTT Solutions directly with us and pay us directly for such orders.

We have the ability to bring on new Distribution Partners in virtually any geographic area, which permits us to quickly establish a presence in new areas. Our Distribution Partners also scale our virtual reality technology, such as our phone- and tablet-based applications, to fit their capacity and needs.

At June 30, 2019, we had a total of 92 Distribution Partners and 84 sales representatives across North America, the United Kingdom, India and Singapore. We are not dependent on any one Distribution Partner or sales representative.

Manufacturing and Properties

Our DIRTT Solutions are manufactured at our facilities in Calgary, Alberta; Phoenix, Arizona; and Savannah, Georgia. Our wall surfaces (which we call tiles), millwork and timber solutions are manufactured in Calgary, while aluminum, glass and power components are manufactured at all three locations. Through distributed manufacturing we can shift production of some components among our manufacturing sites, reduce transportation times and costs, and meet targeted lead times. In 2019, we conducted an evaluation of our aluminum, tile and millwork capacities under various growth scenarios and concluded that the capacity of our aluminum manufacturing facilities is currently sufficient to support our anticipated growth. Given the longer lead time to acquire tile and millwork manufacturing equipment, combined with a lack of redundancy in those manufacturing facilities, we also concluded that we should commence construction of a new combined tile and millwork facility. We anticipate that this new manufacturing facility will be constructed in the southeastern United States. Should we experience additional growth, we may need to add or expand additional manufacturing facilities.

Suppliers and Raw Materials

Our inventory balances consist primarily of raw materials, which are kept on hand as components of our custom manufacturing process. Managing our raw material inventory is essential to our business, given our short lead times from order to shipment and our high level of order customization. Our key manufacturing materials are aluminum, hardware, wood and glass. For the six months ended June 30, 2019, aluminum accounted for approximately 32% of our purchased materials, while hardware, wood and glass accounted for approximately 14%, 14% and 8%, respectively. While we maintain multiple suppliers for key materials, for the six months ended June 30, 2019, two suppliers accounted for approximately 32% and 21% of our aluminum supply, and two suppliers accounted for approximately 43% and 38% of our wood supply.

Materials are sourced domestically and, to a much lesser extent, overseas. Approximately 92% of our materials are manufactured and purchased in North America. Purchase decisions are made on the basis of cost, quality and ability to meet delivery requirements. We do not typically enter into long-term agreements with suppliers. In general, adequate supplies of raw materials are available to all of our operations, although aluminum purchase may be subject to market capacity constraints.

Technology and Development

We continue to focus on developing client-centric innovations and enhancements of both ICE Software and DIRTT Solutions with a primary focus on improving client experience, increasing market penetration and growing key markets. At June 30, 2019, we employed 103 employees within our technology and development groups and, including capitalized amounts, invested $5.8 million, $9.9 million and $12.4 million in the first half of 2019 and in 2018 and 2017, respectively, in innovation activities.

 

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Clients

DIRTT’s principal geographic markets are the United States, Canada, and, to a more limited extent, select international markets. Our revenue is derived almost entirely from projects in North America sold by our North American Distribution Partners.

Our revenue opportunities primarily come from commercial projects, including both new construction projects and renovations of existing buildings. Clients range from small owner-managed businesses to multinational Fortune 50 corporations across a variety of industries including healthcare, education, financial services, government and military, manufacturing, non-profit, energy, professional services, retail, technology and hospitality. We view DIRTT Solutions as industry agnostic, with applications in many different industries with minimal adjustments. We are not dependent on any one client or industry segment. In recent years, the percentage of our revenue attributable to the healthcare industry has been increasing, from 16.9% in 2017 to 22.0% in 2018. No single client represented more than 10% of our revenue for the years ended December 31, 2018 or 2017.

Competition

The overall market for interior construction is fragmented and highly competitive. The principal competitive factors in the interior construction industry include price (including cost certainty), speed, quality, customization and service. Our main competitors are comprised primarily of conventional construction firms, individual tradespeople (including framers, drywall installers, and interior product designers) and modular systems manufacturers. Additionally, conventional construction firms are beginning to develop customizable wall paneling and other interior construction solutions and may directly compete with our DIRTT Solutions. We also compete with commercial furniture manufacturers, such as Teknion Corporation, Haworth Inc. and Allsteel Inc., who offer a variety of prefabricated interior wall solutions. We expect competition to increase as new entrants or solutions enter the construction market.

Seasonality

The construction industry has also historically experienced seasonal slowdowns related to winter weather conditions and holiday schedules, which affect shipping and on-site installation dates, in the fourth and first quarters of each calendar year. Our business has generally followed this trend with a slight time lag, leading to stronger sales in the second half of the year versus the first half. During the fourth quarter of 2017, for example, the extreme weather conditions experienced in the United States adversely affected the timing of delivery of a number of our projects. Weather factors can influence third-party exterior construction schedules and site conditions, which may in turn affect timing of interior renovations.

Due to the fixed nature of certain of our manufacturing costs, such as our facilities leases and related indirect operating costs, periods of higher revenue volume tend to generate higher operating income. Quarters that contain consistent monthly manufacturing volumes tend to generate higher gross profit than those where manufacturing levels vary significantly from month to month.

Patent and Intellectual Property Rights

Our success depends, in part, upon our intellectual property rights relating to our products, production processes, our technology, including our ICE Software, and other operations. We rely on a combination of trade secret, nondisclosure and other contractual arrangements, as well as patent copyright and trademark laws, to protect our proprietary rights. We register our patents and trademarks as we deem appropriate and take measures to defend patents where we deem others are infringing on our patents. The following table presents the status as of June 30, 2019 of our issued and pending patents relating to various aspects of DIRTT Solutions and ICE Software:

 

Jurisdiction		Granted Patents				Applications Pending
Canada			61				38
United States			103				32
European Union			30				40
Singapore			13				15
Patent Cooperation Treaty			—				7
Other			25				2
Total			232				134

 

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Our issued patents expire between 2024 and 2039. We do not believe that the expiration of any individual patent will have a material adverse effect on our business, financial condition or results of operations. As we develop new innovations and technology, we expect to file additional and supplemental patents to protect our rights in those innovations and new technology.

Sustainability and Environmental Matters

Conventional construction generates substantial waste, with approximately 40% of solid waste in the United States in 2012 coming from construction and demolition, according to a 2014 briefing by the Environmental and Energy Study Institute. Imprecise calculations or last-minute design changes may result in excess materials on the job-site, such as wiring, drywall, wood, paint and flooring, that are sometimes unable to be reused or recycled. Measuring and cutting materials on-site leads to scrap waste that generally is sent to landfills. Sustainability is an integral component of our corporate brand identity and DIRTT Solutions. DIRTT Solutions are designed for disassembly, form-fit and allow for less materials waste throughout the manufacturing process. We integrate environmentally friendly elements into our business wherever possible, including utilizing solar energy at our factories to offset the cost of electricity and the environmental impact of our operations, and utilizing materials with high recycled content in our DIRTT Solutions. We also ship DIRTT Solutions with recyclable or reusable packing and shipping materials.

The adoption of environmentally responsible building codes and standards, such as the Leadership in Energy and Environmental Design (“LEED”) rating system established by the U.S. Green Building Council, also has the potential to increase demand for products, systems and services that contribute to building sustainable spaces. Many of our DIRTT Solutions can contribute to the award of LEED credits and other green building rating systems. We are continuing to develop new products, systems and services to address market demand for products that enable construction of buildings that require fewer natural resources to build, operate and maintain. Our Enzo^TM line of wall components received the Canadian Green Building Council’s Green Building Product of the Year Award in 2015 due to its ingenuity and application, particularly as a benefit to healthcare facilities. With the help of Climate Earth, in 2014 DIRTT was the first modular wall manufacturer to complete a full scope Life Cycle Assessment, resulting in 15 Environmental Product Declarations.

Government Regulations

The operation of our business is subject to stringent and complex laws and regulations pertaining to health, safety and the environment. As an owner or operator of various manufacturing facilities, we must comply with these laws and regulations at the federal, state, provincial and local levels in both the United States and Canada. Failure to comply with environmental laws and regulations may trigger a variety of administrative, civil or criminal enforcement actions, including the assessment of monetary penalties, the imposition of investigative or remedial requirements, or the issuance of orders limiting current or future operations. Certain environmental statutes impose strict, joint and several liability for costs required to clean up and restore sites where hazardous substances or industrial wastes have been mismanaged or otherwise released.

While we do not believe that compliance with federal, state, provincial or local environmental laws and regulations will have a material adverse effect on our business, financial position or results of operations, we cannot provide any assurances that future events, such as changes in existing laws or regulations, the promulgation of new laws or regulations, or the development or discovery of new facts or conditions related to our operations will not cause us to incur significant costs.

 

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Legal and Regulatory Proceedings

We may be involved from time to time in various lawsuits, claims, investigations and other legal matters that arise in the ordinary course of business, including matters involving our products, intellectual property, relationships with suppliers, relationships with Distribution Partners, relationships with competitors, employees and other matters. We may, for example, be a party to various litigation matters that involve product liability, tort liability and claims under other allegations including claims from our employees either individually or collectively. We do not believe that any current claims, individually or in the aggregate, will have a material adverse effect on our financial condition, liquidity or results of operations.

Implications of Being an Emerging Growth Company

We are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act (the “JOBS Act”) enacted in April 2012. Certain specified reduced reporting and other regulatory requirements are available to public companies that are emerging growth companies. These provisions include:

 

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an exemption from the auditor attestation requirement in the assessment of our internal controls over financial reporting required by Section 404 of the Sarbanes-Oxley Act of 2002;

 

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an exemption from the adoption of new or revised financial accounting standards until they would apply to private companies;

 

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an exemption from compliance with any new requirements adopted by the Public Company Accounting Oversight Board requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about our audit and our financial statements; and

 

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reduced disclosure about our executive compensation arrangements.

We will continue to be an emerging growth company until the earliest of:

 

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the last day of our fiscal year in which we have total annual gross revenues of $1.07 billion (as such amount is indexed for inflation every five years by the SEC to reflect the change in the Consumer Price Index for All Urban Consumers published by the Bureau of Labor Statistics, setting the threshold to the nearest $1 million) or more;

 

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the last day of our fiscal year following the fifth anniversary of the date of our first sale of common equity securities pursuant to an effective registration statement under the Securities Act of 1933 (“Securities Act”);

 

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the date on which we have, during the prior three-year period, issued more than $1 billion in non-convertible debt; or

 

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the date on which we are deemed to be a “large accelerated filer” under the rules of the SEC, which means the market value of our common shares that is held by non-affiliates (or public float) exceeds $700 million as of the last day of our second fiscal quarter in our prior fiscal year.

We have elected to take advantage of certain of the reduced disclosure obligations in this registration statement and may elect to take advantage of other reduced reporting requirements in future filings. As a result, the information that we provide to our shareholders may be different than what you might receive from other public reporting companies in which you hold equity interests. However, we have irrevocably elected not to avail ourselves of the extended transition period for complying with new or revised accounting standards and, therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies.

 

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Employees

As of June 30, 2019, we had 1,150 full-time employees consisting of 784 employees in production, 116 employees in sales and marketing, 103 employees in technology and development, 81 employees in operations support, and 66 general and administrative employees. None of our employees are covered by collective bargaining agreements. We have never experienced labor-related work stoppages or strikes, and we believe we have established a positive relationship with our employees.

General Corporate Information

Our principal executive offices are located at 7303 30th Street S.E., Calgary, Alberta, and our telephone number at that address is (403) 723-5000. Additional information can be found on our website: www.dirtt.net. Information on our website or any other website is not incorporated by reference herein and does not constitute a part of this registration statement.

 

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ITEM 1A.

RISK FACTORS

Investing in our common shares involves a high degree of risk. You should carefully consider the risks described in these “Risk Factors” as well as the other information in this registration statement, including our consolidated financial statements and the related notes and Item 2. “Financial Information – Management’s Discussion and Analysis of Financial Condition and Results of Operations,” before deciding whether to invest in our common shares. The occurrence of any of the events or developments described could harm our business, financial condition, results of operations and growth prospects. In such an event, the market price of our common shares could decline, and you may lose all or part of your investment. Although we have discussed known material risks, the risks described are not the only ones that we may face. Additional risks and uncertainties not currently known to us or that we currently deem immaterial may also impair our business operations.

Risks Related to Our Industry

Our industry is highly competitive, and our success depends on our ability to continue to persuade clients to utilize our innovative and unique approach to interior construction rather than traditional interior construction methods. Our failure to compete effectively by not offering compelling products and services or by not pricing our solutions competitively could materially and adversely affect our market share, financial condition and results of operations.

We operate in a highly competitive industry that is constantly developing and changing. We compete on the basis of, among other things, price, predictability of timing and cost, speed, quality, customization, and product design. Our main competitors primarily consist of conventional construction firms, individual tradespeople (including framers, drywall installers, and interior product designers) and modular systems manufacturers. In addition, conventional construction firms are beginning to develop customizable wall paneling and other modular interior construction solutions. We also compete with commercial furniture manufacturers, such as Teknion Corporation, Haworth Inc. and Allsteel Inc., who offer a variety of prefabricated interior wall solutions. Our competitors may have greater financial, technical, sales, production and marketing resources, and they may develop products that achieve greater market acceptance, hire key personnel, or introduce competing or disruptive technology, all of which may reduce demand for DIRTT Solutions. In addition, we face pricing pressure on large construction projects from our competitors who take on projects at reduced prices or at a loss to ensure continuity of work. If we are unable to provide competitive pricing terms for DIRTT Solutions, our sales may be reduced. If we reduce our pricing to compete in these situations, our revenues and operating margins may decrease.

Our products are unique and offer an alternative to traditional construction techniques. Market acceptance of offsite construction methods is growing, but this still represents only a fraction of all construction methods and the overall construction market. Our ability to grow and increase market share depends, in part, on our success in continuing to increase demand for modular construction methods and products as an alternative to more traditional construction methods. While we intend to follow a strategy of continuing product development to enhance our position to the extent practicable, we cannot assure you that we will be able to maintain our current position in the industry or continue to compete successfully against current and future sources of competition. There is no guarantee that we, together with our Distribution Partners, can increase our client base or that our solutions will attain a degree of market acceptance sufficient for sustained profitable operations. Failure to compete effectively by, among other things, meeting consumer preferences, developing and marketing innovative solutions, maintaining strong client service and distribution relationships, growing market share, and expanding our solutions capabilities could have a material adverse effect on our liquidity, financial condition, or results of operations.

Additionally, the competition for highly skilled technical, research and development, management, sales and other employees is high in our industry. There can be no assurance that we will be able to attract qualified personnel or retain our current personnel. If we are unable to attract and retain appropriate executives and employees, our business, results of operations and liquidity could be materially and adversely affected.

 

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Risks Related to Our Business

Global economic, political and social conditions and financial markets may impact our ability to do business and adversely affect our sales, costs, results of operations and cash flows.

Our industry is cyclical and highly sensitive to macroeconomic conditions. We are subject to global economic, political and social conditions that may cause an overall decline or reduction in construction and renovation due to economic downturns, difficulties in the financial services sector and credit markets, geopolitical uncertainties and other macroeconomic factors. We face risks that may arise from financial difficulties experienced by our suppliers, Distribution Partners or clients. For example, our Distribution Partners and their clients may face financial difficulties or may become insolvent, which could result in the delay or cancellation of their plans to purchase DIRTT Solutions or lead to our inability to obtain payment of accounts receivable that they may owe. Such clients or potential clients may also be unable to obtain financing for their construction projects, including purchases of DIRTT Solutions. Our suppliers of raw materials, finished products or components may face financial difficulties or may become insolvent, which could lead to disruption in our manufacturing processes. Any general economic, political or social conditions that may contribute to financial difficulties experienced by us, our suppliers, Distribution Partners or clients may adversely affect our liquidity, financial condition and results of operations.

We depend heavily on our network of Distribution Partners for distribution and sales, and the loss or inattention of our Distribution Partners could materially and adversely affect our sales and results of operations.

We currently do not engage in many direct sales projects and rely almost exclusively on our network of Distribution Partners to promote brand awareness, sell and market DIRTT Solutions, and provide design, installation, distribution and other services to clients on each project. While we are not dependent on any single Distribution Partner, sales generated by approximately 10% of our Distribution Partners comprised approximately 60% of our total revenues for 2018. The loss of any top performing Distribution Partners, or their failure to adequately penetrate local markets, may negatively affect our sales, financial condition or results of operations. The loss of a Distribution Partner could also impair our ability to maintain a presence in a particular geographic region while we establish another Distribution Partner relationship in that region, which would require significant time and resources.

Our arrangements with our Distribution Partners are generally not exclusive, meaning that our Distribution Partners may market and sell both DIRTT Solutions and the products of our competitors. We may have multiple Distribution Partners in a geographic region depending on the size of the region. We offer our DIRTT Solutions at the same prices to our Distribution Partners, and, while we make recommendations on pricing terms to clients, our Distribution Partners may implement different pricing models that may be in excess of what clients in their territory would be willing to pay for DIRTT Solutions or that may be detrimental to other Distribution Partners who may offer different pricing terms.

We provide training and education to our Distribution Partners covering DIRTT Solutions and installation, sales, client service and experience, and maintenance of client relationships. However, our Distribution Partners may not be able to successfully sell our DIRTT Solutions or manage client experiences and relationships. Additionally, Distribution Partners may not successfully transport, deliver or install DIRTT Solutions, which could damage their relationships with clients and harm our reputation. Our ability to generate revenue in the future will depend in part on our success in maintaining effective working relationships with our Distribution Partners, choosing quality Distribution Partners, assisting our Distribution Partners to independently sell and to correctly install our DIRTT Solutions, and training our Distribution Partners to develop and maintain successful client relationships. If we are unable to maintain successful relationships with our Distribution Partners, or if our Distribution Partners are unable to maintain successful relationships with clients, our business, financial condition and results of operations could be adversely affected.

We may encounter difficulties in managing our growth and expanding our operations successfully.

Our success will depend in part on our ability to maintain and manage growth effectively. We have experienced, and may continue to experience, growth in our headcount and operations, which has placed, and may continue to place, significant demands on our management and operational and financial resources. Additionally, we expect to scale our business for sustainable, profitable growth as part of our overall business strategy. Managing growth of our operations and personnel requires continuous improvement of our internal controls and reporting systems and procedures. Failure to effectively manage growth could result in difficulty in providing current DIRTT Solutions and introducing future solutions, difficulty in securing clients and Distribution Partners, declines in quality or client satisfaction, increases in costs or other operational difficulties. Any of these difficulties could lead to loss of investor confidence and adversely affect our business performance, financial condition and results of operations.

 

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We may be unsuccessful in designing, introducing or selling new, innovative solutions, solution features or software.

Our future success depends in part on our continuing ability to promote and demonstrate the value proposition of DIRTT Solutions, as well as our ability to develop new, innovative solutions or solution features that differentiate our solutions and achieve market acceptance in a timely and cost-effective manner. We incur significant costs associated with the investment in our research and development in furtherance of our strategy that may not result in increased revenue or demand for DIRTT Solutions and that could negatively affect our results of operations. Rapidly changing technology, evolving regulatory and industry standards, and changing consumer trends, demands and requirements require us to continuously innovate high-quality, new solutions and features. Additionally, such rapid technological changes, standards and preferences could render the complex and proprietary technology of our software and solutions obsolete. We may also be unable to successfully address these developments on a timely basis, or at all. New solutions, solution features or software may also be less successful than we anticipated, and such offerings may fail to achieve market acceptance. If we fail to respond quickly and cost-effectively to a changing market and changing consumer preferences, our competitive position, financial condition and results of operations could be materially and adversely affected.

We have experienced, and may experience in the future, quarterly fluctuations in results of operations and financial condition.

Our results of operations and financial condition may continue to fluctuate from one quarter or year to another due to a number of factors, some of which are outside of our control. Furthermore, our actual or projected results of operations may fail to match our past performance. These events could in turn cause the market price of our common shares to fluctuate. In particular, if our results of operations do not meet the expectations of securities analysts or investors, who may derive their expectations by extrapolating data from recent historical results of operations, the market price of our common shares will likely decline. Due to our high fixed manufacturing costs, quarterly volatility in sales volumes could result in periods of low operating cash flow and negatively affect our liquidity.

The construction industry has also historically experienced seasonal slowdowns related to winter weather conditions and holiday schedules in the first and fourth quarters of each calendar year. Our business has generally followed this trend with a slight time lag, leading to stronger sales in the second half of the year versus the first half. Weather conditions, such as unseasonably warm, cold or wet weather, which affect, and sometimes delay or accelerate, delivery and installation of some of our products, may significantly affect our results of operations. For example, during the fourth quarter of 2017, the extreme weather conditions experienced in the United States negatively affected the delivery of projects and our financial condition. Sales that we anticipate in one quarter may occur in another quarter, affecting both quarters’ results and potentially the trading price of our common shares. In addition, we typically ship orders within two weeks of when we receive them and maintain inventory levels to allow us to operate with little backlog. The efficiency of our inventory system, and our ability to avoid backlogs and potential loss of clients, is closely tied to our ability to accurately predict seasonal and quarterly variances. Our planned expenditures are also based primarily on sales forecasts. Our sales cycle is generally long, making our sales forecasts more uncertain than in businesses with short sales cycles. When sales do not meet our expectations, our results of operations will be reduced for the relevant quarters, as we will have already incurred expenses based on those expectations. Due to these risk factors, quarter-to-quarter or year-to-year comparisons of our results of operations may not be an indicator of future performance.

Turnover of our key executives, and difficulty of recruiting and retaining key employees, could have a material adverse effect on our business.

The performance of key personnel is essential to our business. Our success will depend in part on our ability to attract, develop and retain qualified key personnel as needed. We have experienced executive-level changes since 2017, which could negatively affect our ability to retain other key executives and employees. Since January 2018, two of our co-founders and our former Chief Operating Officer have left the Company. Our business has a long sales cycle, and we believe the distraction from significant management changes since 2017 has adversely affected our project bidding efforts during 2018, and therefore our 2019 sales, to a greater extent than we anticipated. While we believe that these management changes will ultimately position the Company for growth, we cannot provide any assurance that we will effectively manage these or any other management transitions. Failure to effectively manage these transitions may affect our ability to retain our new or remaining key executives and employees and could harm our business and results of operations.

 

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Labor shortages and disruptions in our manufacturing facilities may delay or impede production and could have a material adverse effect on our financial condition, liquidity or results of operations.

Our manufacturing processes and technology development largely depend on human labor, although certain parts are automated or integrated with technology. Our distributed manufacturing approach allows us to shift production among our manufacturing facilities, although not all production can be moved. As a custom manufacturer, we do not carry finished goods inventory that can withstand a labor shortage or disruption for an extended period of time. We may therefore be affected by labor shortages or disruptions, particularly in the United States. Both our profitability and our ability to scale could be adversely affected if we encounter difficulty in attracting and retaining qualified personnel. If we are unable to continue to attract and retain qualified personnel, or if we experience any labor shortages or disruptions, we could incur higher recruiting expenses or a loss of manufacturing capabilities, all of which would adversely affect our business and financial condition.

We may be exposed to product liability and warranty claims on DIRTT Solutions, which if successfully asserted, could have a material adverse effect on our financial condition, liquidity or results of operations.

Our DIRTT Solutions are generally backed by warranties, some of which are up to ten years. We may, from time to time, be involved in product liability and product warranty claims relating to DIRTT Solutions that could adversely affect our financial condition, results of operations, and cash flows. For example, we incurred increased manufacturing costs in 2018 in the amount of $3.5 million due to rework and increases to provisions required in connection with deficiencies in certain of our tile solutions. Although we maintain warranty reserves in an amount based primarily on production, historical and anticipated warranty claims, future warranty claims may exceed this amount resulting in a need to increase the reserve. An increase in the rate of warranty claims or the occurrence of unexpected warranty claims could also result in clients rejecting our products and damage to our reputation, all of which could materially and adversely affect our financial condition, results of operations and cash flows.

We have also on occasion found flaws and deficiencies in the design, manufacturing, assembling, labeling, product formulations or testing of DIRTT Solutions. DIRTT Timber is occasionally integrated as structural components in projects. Some flaws and deficiencies have not been apparent until after the solutions were installed. If any flaws or deficiencies exist in our products and if such flaws or deficiencies are not discovered and corrected before DIRTT Solutions are installed or otherwise incorporated into the structures, damages could result, including collapse, fire, personal injury or death.

In addition, we may be exposed to potential claims arising from the conduct of general contractors and their sub-contractors. Errors in the installation of DIRTT Solutions, even if the products are free of flaws and deficiencies, could also cause personal injury or death. To the extent that such damage or injury is not covered by our product liability insurance and we are held to be liable, we could be required to correct such damage and to compensate persons who might have suffered injury or death, and our reputation, business and financial condition could be materially and adversely affected. Additionally, we may incur additional costs to refund clients or repair or recall DIRTT Solutions, including costs to remedy the affected structures. Any such claims, if asserted, could require us to expend material time and efforts defending or resolving the claim and may materially and adversely affect our business, results of operations and financial condition. We may not be able to maintain insurance on acceptable terms that provide adequate protection against potential liabilities. Product liability claims can be expensive to defend, could divert the attention of management and other personnel for significant periods, regardless of the ultimate outcome, and could result in negative publicity. Increased costs to address product warranty claims or to defend against product liability claims may result in increased expenses and adversely affect our financial condition and results of operations.

 

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Our software and products may have design defects, deficiencies, or risks, and we may incur additional costs to fix any defects, deficiencies or risks.

Our software and solutions are complex and must meet the technical requirements of our clients. Our solutions may contain undetected errors or design and manufacturing defects, and our software may experience quality or reliability problems, or contain bugs or other defects. Software defects may also cause errors in our manufacturing or miscalculations in ordering pricing and could lead us to incur losses. Product or software defects could cause us to incur warranty costs, product liability costs, and repair and remediation costs. Although we maintain commercial general liability and errors and omissions liability insurance, such insurance coverage may not be sufficient to protect us against substantial claims.

Our former co-founders may engage in competitive behavior against us.

On September 10, 2018, our co-founder and former Executive Chairman and Chief Executive Officer, Mogens Smed, left the Company. In connection with his departure, Mr. Smed entered into a settlement agreement (the “Settlement Agreement”) with the Company that provided, among other things, for the continued adherence to the non-compete and non-solicit obligations of his employment agreement. We believe that Mr. Smed has started, or has otherwise acquired an ownership interest in, an offsite construction and manufacturing company. We also believe that some of our former employees have departed to join this new company, including our former Vice President of Software Development. Mr. Smed has in-depth knowledge about our business, such as our customers, employees, Distribution Partners, consultants, products, policies, practices and prospects, and we may be adversely affected by increased competition with any business in which he becomes involved. Mr. Smed may solicit our current and former employees, Distribution Partners and customers or otherwise engage in competitive behavior. On May 9, 2019, we filed a lawsuit in the Court of Queen’s Bench of Alberta against Mr. Smed and our former Vice President of Software Development, Barrie Loberg, to enforce the terms of the Settlement Agreement and their respective obligations, including non-compete and non-solicit provisions, and they have denied liability and counterclaimed asserting rights to further compensation and damages for defamation. There can be no assurance that we will be successful on our claims or on our defense of their claims, although we believe their claims, if successful, are not material to the Company. If Mr. Smed should engage in a competitive business against us or if we are not successful in enforcing the Settlement Agreement, our business, financial condition and results of operations may be adversely affected.

We may be unable to protect our intellectual property adequately from infringement by third parties, and we may also be subject to claims that we infringe on intellectual property rights of others.

We expend considerable efforts to protect our intellectual property and to operate without infringing on the intellectual property rights of others. We rely on a combination of contract, copyright, patent, trademark and trade secret laws, confidentiality procedures and other measures to protect our proprietary information. There can be no assurance that our various patents, copyrights or trademarks will offer sufficient protection and prevent misappropriation of our proprietary rights. Additionally, our software copyright and other protections might not be adequate to protect our software and application code. We also may not be granted patents, copyrights or trademarks on our pending or proposed applications, and granted applications may be challenged, invalidated or circumvented in the future.

We will not be able to protect our intellectual property, trade secrets, or other proprietary information if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Additionally, we may be required to spend significant resources to monitor and protect our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy our applications and use information that we regard as proprietary to create products or services that compete with ours. We enforce our intellectual property rights where appropriate, but the cost of doing so may be substantial and could outweigh the potential benefits, and we may be unsuccessful in our enforcement efforts. Failure to protect or maintain the proprietary nature of our intellectual property could adversely affect our ability to sell original products and materially and adversely affect our business, financial condition and results of operations.

Additionally, our competitors, as well as a number of other entities and individuals, may own or claim to own intellectual property in technology areas relating to our technology, including ICE Software, manufacturing processes, and DIRTT Solutions. Although we do not believe that our software or DIRTT Solutions infringe on the proprietary rights of any third parties, claims are bound to arise regarding infringement or invalidity claims (or claims for indemnification resulting from infringement claims). Such assertions or prosecutions, regardless of their merit, may subject us to significant liabilities, require us to enter into royalty and licensing arrangements on unfavorable terms, prevent us from assembling or licensing certain of our products, subject us to injunctions restricting our sale of products, cause severe disruptions to our operations or the marketplaces in which we compete, or require us to satisfy indemnification commitments with our clients, including contractual provisions under various license arrangements. A damages award against us could include an award of royalties or lost profits and, if the court finds willful infringement, treble damages and attorneys’ fees. This may cause us to expend significant costs and resources, and could adversely affect our business, financial condition or results of operations.

If we are unable to protect our information systems against data corruption, cyber-based attacks or network security breaches, our operations could be disrupted and our reputation and profitability could be negatively affected.

In the ordinary course of our business, we generate, collect and store confidential and proprietary information, including intellectual property and business information. While we do not generally collect information from clients and Distribution Partners, we may obtain certain of their information from time to time during the ordinary course of business. The secure storage, maintenance, and transmission of and access to this information is important to our operations and reputation. Various third parties, including computer hackers, who are continually becoming more aggressive and sophisticated, may attempt to penetrate our network security and, if successful, misappropriate

 

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confidential client, Distribution Partner, employee or supplier information. In addition, one of our Distribution Partners, employees, or other third parties with whom we do business may attempt to circumvent our security measures in order to obtain such information or may inadvertently cause a breach involving such information. There is no guarantee that our security systems, processes or procedures are adequate to safeguard against all data security breaches, misuse of data, cyber-attacks, acts of vandalism, computer viruses, misplaced or lost data, programming or human errors or other similar events. Any security breach involving the misappropriation, loss or other unauthorized disclosure of confidential information of a client, Distribution Partner, employee, supplier or Company information could result in financial losses, exposure to litigation risks and liability (including regulatory liability), damages to our reputation, and disruptions in our operations, all of which would have a material adverse effect on our business, financial condition and results of operations.

The regulatory environment related to information security, data collection and use, and privacy is increasingly rigorous, with new and frequently changing requirements, and compliance with those requirements could result in additional costs. These costs associated with information security, such as increased investment in technology, the costs of compliance with privacy laws, and costs incurred to prevent or remediate information security breaches, could be substantial and adversely affect our business. A significant compromise of sensitive employee, Distribution Partner, client or supplier data in our possession could result in legal damages and regulatory penalties. In addition, the costs of defending such actions or remediating breaches could be material.

Damage to our information technology and software systems could impair our ability to effectively provide DIRTT Solutions, harm our reputation, and adversely affect our business.

Our information technology and software networks and systems, which include the processing, transmission and storage of information, are integrated with our manufacturing processes and essential to our business operations. These systems are vulnerable to, among other things, damage or interruption from power outages, network failures or natural disasters, loss or corruption of data, human error, employee misconduct and difficulties associated with upgrades, installations of major software or hardware, and integration with new systems. While we maintain retention backups to geo-diverse digital and physical locations and have a recovery data center, the data center and other protective measures we take could prove to be inadequate. Any disruption in our systems or unauthorized disclosure of information could result in delayed manufacturing and delivery of our DIRTT Solutions, legal claims, a loss of intellectual property and a disruption in operations, all of which could adversely affect our reputation, relationships with clients, financial condition and results of operations.

We are subject to fluctuations in the prices of our commodities, including raw materials, which could adversely affect our financial condition and results of operations.

We experience fluctuations in the cost of our raw materials, including aluminum, glass and wood. A variety of factors over which we have no control, such as global demand for aluminum, fluctuations in transportation costs, speculation in commodities futures, changes in laws or regulations, and the creation of new materials or products based on new technologies may affect the purchase and transportation costs and availability of raw materials that we use to manufacture DIRTT Solutions. These factors may also magnify the effect of economic cycles on our business. In addition, we do not typically enter into long-term agreements with vendors and may be exposed to short-term and long-term price fluctuations as a result.

Aluminum represents the largest component of our raw materials consumption. Substantial, prolonged upward trends in aluminum prices could significantly increase the cost of our aluminum needs and have an adverse effect on our financial condition and results of operations. We have experienced fluctuations in the price of aluminum and anticipate that these fluctuations will continue in the future. In 2018, the U.S. government imposed tariffs on steel and aluminum and limited the amounts of steel and aluminum coming into the United States based on the countries of origin of those imports. In 2018, we sourced the majority of our aluminum from North America and sourced under 10% of our raw materials from outside North America. Nonetheless, tariffs and import limitations may increase the prices we pay for aluminum. Increases in the price that we pay for our commodities, including raw materials, could adversely affect our liquidity, operating margins, and financial condition.

 

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We rely on a limited number of outside suppliers for certain key components and materials, and failure or delay in obtaining the necessary components or materials could delay or prevent the manufacturing or distribution of our DIRTT Solutions.

We rely on certain key suppliers for raw materials and components, including aluminum, glass and wood. We maintain multiple suppliers for key materials, although two suppliers accounted for approximately 32% and 21% of our aluminum supply for the six months ended June 30, 2019. While we believe there are other vendors for most of our key requirements, certain materials meeting our quality standards are available only through a limited number of vendors. If we are required to obtain another source for these materials or components, we may not be able to obtain pricing on as favorable terms or on terms comparable to our competitors. Any failure or delay in obtaining the necessary raw materials in the quantities and quality required may result in increased costs and delays in manufacturing or distributing our products, which could have a material adverse effect on our liquidity, financial condition, or results of operations. A vendor may also choose, subject to existing contracts, to modify its relationship with us due to general economic concerns or specific concerns relating to that vendor or us, at any time. These modifications might include additional requirements from our suppliers that we provide them additional security in the form of prepayments or with letters of credit. Any significant change in the terms that we have with our key suppliers could materially and adversely affect our liquidity, financial condition, or results of operations.

Our current manufacturing facilities may reach capacity, and we may have difficulty procuring adequate manufacturing space to meet our needs.

We have manufacturing facilities in Calgary, Alberta; Phoenix, Arizona; and Savannah, Georgia. Our wall tiles, millwork and timber solutions are manufactured in Calgary, while aluminum, glass and power components are manufactured in all three locations. We may be constrained by physical capacity in our facilities. While we may address increased short-term demands through the addition of production shifts in our manufacturing facilities, we will need to expand our current manufacturing capabilities and add or expand facilities within the next two to three years. For example, we are in the process of identifying a site for construction of a new tile and millwork manufacturing facility in order to further support our anticipated growth. If we are unable to timely meet increased demands, we could experience delays in production and shipments of product due to both the loss of inventory and materials storage and production capacity, which would materially and adversely affect our financial condition and results of operations.

We may incur significant costs complying with environmental, health and safety laws and related claims, and failure to comply with these laws and regulations could expose us to significant liabilities, which could materially adversely affect our results of operations.

We are subject to laws, regulations, and other requirements with respect to workers’ health and safety and environmental matters in the United States, Canada and other countries in which we operate. The costs of compliance with such laws and regulations could adversely affect our liquidity, financial condition, or results of operations. Environmental laws and regulations impose, among other things, restrictions, liabilities and obligations in connection with the production, processing, preparation, handling, storage, transportation, disposal and management of wastes and other substances, and the prevention and remediation of environmental effects. More stringent laws and regulations relating to climate change and emission of greenhouse gases may be adopted in the future and could impact our facilities, raw material suppliers, the transportation and distribution of our solutions, and our clients, which could reduce demand for our solutions or cause us to incur additional operating costs. Health and safety laws and regulations impose, among other things, requirements designed to ensure the protection of workers. In addition, we are required to obtain numerous governmental permits in order to operate our facilities and in connection with the design, development, manufacture and transport of our products and the storage, use, handling and disposal of hazardous substances, including environmental, health and safety laws, regulations and permits governing air emissions. If we fail to comply with these requirements, we could be subject to civil or criminal liability, damages and fines, and our operations could be curtailed, suspended or shutdown and our reputation, ability to attract employees, and success of our operations could be adversely affected. In addition, certain foreign laws and regulations may affect our ability to export products outside of or import into the United States or Canada. Although we handle minimal quantities of hazardous substances, existing environmental, health and safety laws and regulations apply to our operations, new laws and regulations could be adopted or become applicable to us or our products, and future changes in environmental, health and safety laws and regulations could occur. These factors may materially increase the amount we must invest to bring our processes into compliance with legal requirements and impose additional expenses on our operations.

 

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Private lawsuits, including claims for remediation of contamination, personal injury or property damage, or actions by regional, national, state and local regulatory agencies, including enforcement or cost-recovery actions, may materially increase our costs. Certain environmental laws make us potentially liable on a joint and several basis for the remediation of contamination at or emanating from properties or facilities that we currently or formerly owned or operated or properties to which we arranged for the disposal of hazardous substances. Such liability may require us to pay more than our proportionate share based on our contribution to the amount or type of waste we dispose, and could require us to address contamination caused by others. Any changes in these laws or regulations or changes in our manufacturing processes may require us to request changes to our existing permits or obtain new permits. Any requests to change our existing permits or obtain new permits may be delayed or denied and may require us to modify our manufacturing processes, which could be costly and time consuming and could adversely affect our business and results of operations.

We may not be able to obtain or maintain, from time to time, all required environmental regulatory approvals. A delay in obtaining any required environmental regulatory approvals or failure to obtain and comply with them could materially adversely affect our business and results of operations.

We are exposed to currency exchange, tax rate and other fluctuations that may result from general economic conditions and changes in laws.

Our revenues and expenses are collected and paid in different currencies, including the U.S. dollar and Canadian dollar. Fluctuations in the value of any such currency expose us to foreign exchange risk and could have a material and adverse effect on our cash flows, revenues and results of operations. We also have currency exchange exposure to the extent of a mismatch between foreign-currency denominated revenues and expenditures – in particular, where U.S. dollar revenues do not equal U.S. dollar expenditures. We are not currently using exchange rate derivatives to manage currency exchange rate risks. There are currently no significant restrictions on the repatriation of capital and distribution of earnings to foreign entities from any of the jurisdictions in which we operate. There can be no assurance that such restrictions will not be imposed in the future.

Compliance with new or amended tax laws and regulations could have a material adverse effect on our business. We operate in multiple tax jurisdictions, including the United States and Canada, and may therefore be subject to the tax laws and regulations of such jurisdiction. For instance, the U.S. 2017 Tax Cuts and Jobs Act was enacted on December 22, 2017, and significantly affected U.S. tax law; it also affected our business and financial condition because approximately 85% of our revenue is derived from U.S. projects. We base our tax position, including allocation of income to various jurisdictions, upon our understanding of the tax laws of and the applicable tax treaties in the various countries in which we have assets or conduct business activities. However, our tax positions are subject to review and possible challenges by taxing authorities, including review of our allocation of income as between entities, transfer pricing and other complex issues. This includes adverse changes to the manner in which Canada, the United States and other countries tax local and foreign corporations and interpret or change their tax laws and applicable tax treaties. We cannot determine in advance the extent to which such jurisdictions may assess additional taxes or interest and penalties on such taxes. In addition, our effective tax rate may be increased by changes in the valuation of deferred tax assets and liabilities, our cash management strategies, local tax rates, or interpretations of tax laws.

We may be subject to legal and regulatory proceedings for a variety of claims, which could subject us to significant costs and judgments and divert management’s attention from our business.

From time to time we may become involved in litigation for a variety of claims relating to our operations, solutions, contracts, relationships or other circumstances, or may become involved in regulatory proceedings. We may also be subject to claims arising from personal injuries or workers’ compensation occurring on our properties, including our manufacturing facilities. We are not currently party to any material litigation or regulatory proceedings against us. The defense of litigation, including fees of legal counsel, expert witnesses and related costs, is expensive and difficult to forecast accurately. In general, such costs are unrecoverable even if we ultimately prevail in litigation and could represent a significant use of our capital resources. To defend lawsuits, it is also necessary for us to divert the attention and resources of officers and other employees from their normal business functions to gather evidence, give testimony and otherwise support litigation efforts.

 

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The outcome of any litigation, regardless of its merits, is inherently uncertain. Given the inherent uncertainties in evaluating certain exposures, actual costs to be incurred in future periods may vary from our estimates for such contingent liabilities. There can be no assurance that we will be able to continue to successfully avoid, manage and defend such matters. If we are unsuccessful in defending any litigation or claims, we could face material judgments or awards against us, which could adversely affect our reputation, business, financial condition, and results of operations.

We may be subject to increased counterparty credit risk resulting from, among other things, an increase in the number of Distribution Partners and clients.

Continued growth of our Distribution Partner network and client base increases our exposure to credit risk related to amounts due from our Distribution Partners and their clients. Our Distribution Partners purchase DIRTT Solutions from us directly. We routinely monitor the financial condition of our Distribution Partners and their clients, and review the credit history of our new Distribution Partners and their clients, to establish credit limits. While we establish an allowance for doubtful accounts that corresponds to our estimate of the credit risk of our Distribution Partners and their clients based on historical trends and economic circumstances, there can be no assurances that our estimates and assumptions regarding allowance for doubtful accounts will prove to be accurate. We could realize additional losses if Distribution Partners or their clients default on their outstanding balance beyond our allowance for doubtful accounts, which would adversely affect our liquidity, financial condition and results of operation.

We may have future capital needs and may not be able to obtain additional capital or financing on acceptable terms.

We plan to continually invest in business growth and may require additional funds to respond to business opportunities. Such investments may relate to expanding sales and marketing activities; developing our Distribution Partner network; developing new software, products or features; enhancing our operating infrastructure; acquiring complementary businesses and technologies; expanding our manufacturing capacity; or investing in innovation and operational capacity ahead of anticipated growth, including commencing factory automation. To the extent that our existing capital is insufficient to meet our requirements, we may need to undertake equity or debt financings to secure additional funds. Further issuances of equity or convertible debt securities may result in significant share dilution. Additional new equity securities issued could have rights, preferences and privileges superior to those of currently issued and outstanding common shares.

Additional debt financings may involve restrictive covenants relating to our capital-raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities. We cannot provide any assurance that sufficient debt or equity financing will be available for necessary or desirable expenditures or acquisitions, or to cover losses, and accordingly, our ability to continue to support our business growth and to respond to business challenges could be significantly limited, and our liquidity could be materially and adversely affected.

The agreements that govern our indebtedness contain a number of covenants that impose significant operating and financial restrictions, including restrictions on our ability to engage in activities that may be in our best long-term interests.

On October 21, 2013, we entered into an Amended and Restated Loan Agreement (as amended, the “Comerica Credit Facility”) with Comerica Bank, as subsequently amended, pursuant to which we had access to a $18.0 million revolving operating facility. The Comerica Credit Facility included customary covenants, and as of June 30, 2019, we were in compliance with all covenants. The Comerica Credit Facility expired on June 30, 2019, and we had no borrowings outstanding at that time.

On July 19, 2019, we entered into a C$50 million senior secured revolving credit facility with the Royal Bank of Canada (the “RBC Credit Facility”). The RBC Credit Facility includes covenants that, among other things, impose significant operating and financial restrictions, including restrictions on our ability to engage in activities that may be in our best long-term interests. These covenants may restrict our ability to (i) make certain acquisitions or dispose of our property; (ii) consolidate, amalgamate, merge, or otherwise permit a material change in our corporate or capital structure; (iii) incur additional debt, other than permitted debt; (iv) permit encumbrances on certain assets to secure debt; and (v) pay dividends on or make other distributions in respect of our common shares or redeem, repurchase or retire our common shares or subordinated debt or make certain other restricted payments.

 

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We are also required to maintain specified financial ratios. Our ability to meet these ratios could be affected by events beyond our control, and we cannot assure you that we will meet them. A breach of any of the restrictive covenants or ratios may result in an event of default, or may limit our ability to borrow, under the RBC Credit Facility. If any such default occurs, the lender under the RBC Credit Facility may be able to elect to declare all outstanding borrowings, together with accrued and unpaid interest and other fees, to be immediately due and payable, or enforce their security interest. The lender may also have the right in these circumstances to terminate commitments to provide further borrowings.

We have experienced a history of losses, and despite certain periods of profitability in recent years, we may not be able to generate sufficient revenue to achieve and sustain profitability.

We have incurred significant losses since commencing business, but have been profitable in four of the past five years. Recently, we incurred net losses of $7.7 million for the year ended December 31, 2017. At June 30, 2019, we had an accumulated deficit of $44.2 million. These losses and accumulated deficits were due in part to the substantial investments made to grow our business and acquire clients, to further develop our service offerings through product and software development, and to ensure that we have sufficient production capacity and capability to deliver on our commitment of rapid delivery times. Our revenue growth and recent profitability may not be indicative of our future performance and there can be no assurance that we will generate net income in the future.

We may not have insurance adequate in amount or coverage to protect us from all claims that may arise in connection with our business and operations.

While we currently maintain insurance of the types and amounts we consider consistent with industry practice, including directors and officers, errors and omissions, property, and general liability insurance, we may not be fully insured against all risks incident to our business. There can be no assurance that insurance coverage will be available in the future on commercially reasonable terms or at commercially reasonable rates. There can also be no assurance that the amounts for which we are insured, or the proceeds of such insurance, will fully compensate us for any losses. In addition, the insurance coverage obtained with respect to our business and facilities will be subject to limits and exclusions or limitations on coverage that are considered by management to be reasonable, given the cost of procuring insurance and current operating conditions. If a significant event occurs that is not fully insured, it could adversely affect our financial condition and results of operations.

We may engage in future mergers, acquisitions, agreements, consolidations or other corporate transactions that could disrupt and harm our business, financial condition, and results of operations.

While we have no specific plans to acquire any businesses, we may, in the future, seek to expand our business and capabilities through acquiring compatible technology, products or businesses. Additionally, we may explore other corporate transactions, including mergers, agreements, consolidations, or joint ventures, that we believe may be beneficial to our business or further specific business goals. Acquisitions involve certain risks and uncertainties, including, among other things, (i) difficulty integrating the newly acquired businesses and operations in an efficient and cost-effective manner; (ii) inability to maintain relationships with key clients, vendors and other business partners of the acquired businesses; (iii) potential loss of key employees of the acquired businesses; and (iv) exposure to litigation or other claims in connection with our assumption of certain claims and liabilities of the acquired businesses. The occurrence of any of these risks could adversely affect our business, results of operations, and financial condition.

To the extent we are successful in identifying suitable companies or products for acquisition, we may deem it necessary or advisable to finance such acquisitions through issuing common shares, securities convertible into common shares, debt financing, or a combination thereof. In such cases, issuing common shares or convertible securities could result in dilution to our shareholders at the time of such issuance or conversion. We may also pursue issuing debt to finance acquisitions, which may result in, among other things, the encumbrance of certain of our assets, impediment of our ability to obtain bank financing, and a decrease in our liquidity.

 

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Risks Related to Our Common Shares

Our share price has been and may continue to be volatile, which could cause the value of your investment to decline.

Our common shares are currently listed on the TSX and have been quoted on the OTC Markets Group’s Pink tier under the symbol “DRTTF.” Upon effectiveness of this registration statement, our common shares will also be traded on Nasdaq. The price of our common shares has in the past fluctuated significantly, and may fluctuate significantly in the future, depending upon a number of factors, many of which are beyond our control and may adversely affect the market price of our common shares. These factors include: (i) variations in quarterly results of operations; (ii) deviations in our earnings from publicly disclosed forward-looking guidance; (iii) changes in earnings estimates by analysts; (iv) our announcements of significant contracts, acquisitions, strategic partnerships or joint ventures; (v) general conditions in the offsite construction and manufacturing industries; (vi) sales of our common shares by our significant shareholders; (vii) fluctuations in stock market price and volume; and (viii) other general economic conditions.

In the past, following periods of volatility in the trading price of a company’s securities, securities class action litigation may be brought against that company. If our share price is volatile, we may become the target of securities litigation in both the United States and Canada. Securities litigation could result in substantial costs and divert our management’s attention and resources from our business. This could have an adverse effect on our business, financial condition and results of operations.

The requirements of being a public company in the United States and Canada and maintaining a dual listing on both Nasdaq and the TSX, including compliance with the reporting requirements of the Exchange Act, the requirements of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) and applicable securities laws of Canada, may strain our resources, increase our costs, and distract management.

As a public company in the United States, we will need to comply with new laws, regulations and requirements, certain corporate governance provisions of Sarbanes-Oxley, related regulations of the SEC and the requirements of Nasdaq, with which we are not required to comply as a public company in Canada listed on the TSX. Specifically, we may incur significant additional accounting, legal, reporting and other expenses in order to maintain a dual listing on both Nasdaq and the TSX, including the costs of listing on two exchanges. Complying with these statutes, regulations and requirements, as well as any applicable securities laws of Canada, will occupy a significant amount of time of our Board of Directors (the “Board”) and management and will significantly increase our costs and expenses. Among other things, we will need to institute a more comprehensive compliance function, comply with rules promulgated by Nasdaq, establish or revise internal policies, and involve and retain outside counsel and accountants to a greater degree. We will also need to prepare and distribute periodic public reports in compliance with our obligations under the U.S. federal securities laws, in addition to applicable securities laws of Canada.

Shareholder activism, the current political environment and the current high level of government intervention and regulatory reform may lead to substantial new regulations and disclosure obligations, which could then result in additional compliance costs and affect the manner in which we operate our business. Moreover, any new regulations or disclosure obligations may increase our legal and financial compliance costs and may make some activities more time-consuming and costly.

Furthermore, while we generally must comply with Section 404 of Sarbanes-Oxley for our fiscal year ending December 31, 2019, we are not required to have our independent registered public accounting firm attest to the effectiveness of our internal controls until our first annual report subsequent to our ceasing to be an “emerging growth company” within the meaning of the Exchange Act. Once it is required to do so, our independent registered public accounting firm may issue a report that is adverse in the event it is not satisfied with the level at which our controls are documented, designed, operated or reviewed. Compliance with these requirements may strain our resources, increase our costs and distract management, and we may be unable to comply with these requirements in a timely or cost-effective manner.

 

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In addition, we expect that being a public company in the United States subject to these rules and regulations may make it more difficult and more expensive for us to obtain or maintain additional director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain or maintain the same or similar coverage. As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our Board or as executive officers. We cannot predict or estimate the amount of additional costs we may incur in the future or the timing of such costs in order to maintain the same or similar coverage.

For as long as we are an “emerging growth company,” we will not be required to comply with certain reporting requirements that apply to some other public companies, and such reduced disclosures requirement may make our Common Shares less attractive.

As an “emerging growth company” as defined in the JOBS Act, we are permitted to, and intend to, rely on exemptions from certain disclosure requirements. We are an emerging growth company until the earliest of (i) the last day of the fiscal year during which we have total annual gross revenues of $1.07 billion or more; (ii) the last day of the fiscal year following the fifth anniversary of the first sale of common equity securities pursuant to an effective registration statement under the Securities Act; (iii) the date on which we have, during the previous three-year period, issued more than $1 billion in non-convertible debt; or (iv) the date on which we are deemed a “large accelerated filer” under the rules of the SEC.

For so long as we remain an “emerging growth company,” we will not be required to, among other things:

 

•

have an auditor report on our internal control over financial reporting pursuant to Sarbanes-Oxley;

 

•

comply with any new requirements adopted by the Public Company Accounting Oversight Board requiring mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about our audit and our financial statements; and

 

•

include detailed compensation discussion and analysis in our filings under the Exchange Act and instead may provide a reduced level of disclosure concerning executive compensation.

Because of these exemptions, some investors may find our common shares less attractive, which may result in a less active trading market for our common shares, and our share price may be more volatile.

We historically have not paid dividends on our common shares.

We have not declared or paid any dividends on common shares to date. The declaration and payment of dividends is at the discretion of the Board, taking into account our earnings, capital requirements and financial condition, restrictions on our ability to pay dividends under our credit facilities, and such other factors as the Board considers relevant. Our RBC Credit Facility generally limits our ability to pay any dividends or make any other distribution on our outstanding capital shares. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Credit Facility” for more information.

We are governed by the corporate laws of Alberta, Canada which in some cases have a different effect on shareholders than the corporate laws of the United States.

Immediately prior to the completion of this registration, we will be governed by the ABCA and other relevant laws, which may affect the rights of shareholders differently than those of a company governed by the laws of a U.S. jurisdiction, and may, together with our charter documents, have the effect of delaying, deferring or discouraging another party from acquiring control of our company by means of a tender offer, a proxy contest or otherwise, or may affect the price an acquiring party would be willing to offer in such an instance. The material differences between the ABCA and Delaware General Corporation Law (the “DGCL”), that may have the greatest such effect include, but are not limited to, the following: (i) for certain extraordinary corporate transactions (such as amalgamations or amendments to our articles) the ABCA generally requires the voting threshold to be a special resolution passed by a majority of not less than two-thirds of the votes cast by the shareholders who voted in respect of the resolution whereas DGCL generally only requires a majority vote; and (ii) under the ABCA, registered holders or beneficial owners (as defined in the ABCA) of not less than 5% of our common shares in aggregate can requisition our directors to call a special meeting of shareholders, whereas such right does not exist under the DGCL. We cannot predict whether investors will find our company and our common shares less attractive because we are governed by foreign laws. For additional information, please see Item 11. “Description of Securities to be Registered.”

Because we are a corporation incorporated in Alberta and some of our directors and officers are resident in Canada, it may be difficult for investors in the United States to enforce civil liabilities against us based solely upon the federal securities laws of the United States. Similarly, it may be difficult for Canadian investors to enforce civil liabilities against our directors and officers residing outside of Canada.

We are a corporation amalgamated and existing under the laws of Alberta with our principal place of business in Calgary, Alberta, Canada. Some of our directors and officers are residents of Canada and a substantial portion of our assets and those of such persons are located outside the United States. Consequently, it may be difficult for U.S. investors to effect service of process within the United States upon us or our directors or officers who are not residents of the United States, or to realize in the United States upon judgments of courts of the United States predicated upon civil liabilities under the Securities Act. Investors should not assume that Canadian courts: (1) would enforce judgments of U.S. courts obtained in actions against us or such persons predicated upon the civil liability provisions of the U.S. federal securities laws or the securities or blue sky laws of any state within the United States or (2) would enforce, in original actions, liabilities against us or such persons predicated upon the U.S. federal securities laws or any such state securities or blue sky laws.

Similarly, some of our directors and officers are residents of countries other than Canada and all or a substantial portion of the assets of such persons are located outside Canada. As a result, it may be difficult for Canadian investors to initiate a lawsuit within Canada against these non-Canadian residents. In addition, it may not be possible for Canadian investors to collect from these non-Canadian residents judgments obtained in courts in Canada predicated on the civil liability provisions of securities legislation of certain of the provinces and territories of Canada. It may also be difficult for Canadian investors to succeed in a lawsuit in the United States, based solely on violations of federal, provincial or territorial securities laws.

If securities or industry analysts do not publish research or publish inaccurate or unfavorable research about our business, our share price and trading volume could decline.

The trading market for our common shares will depend on the research and reports that securities or industry analysts publish about us, our business, our market or our competitors. We do not have any control over these analysts. We cannot assure you that analysts will cover us or provide favorable coverage. If one or more of the analysts who cover us downgrade our stock or change their opinion of our common shares, our share price would likely decline. If one or more of these analysts cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which could cause our share price or trading volume to decline.

We could be treated as a “passive foreign investment company” for U.S. federal income tax purposes under certain circumstances, which would have adverse U.S. federal income tax consequences to U.S. Holders of our common shares.

A non-U.S. entity treated as a corporation for U.S. federal income tax purposes will be treated as a “passive foreign investment company” (a “PFIC”) for U.S. federal income tax purposes if 75% or more of its gross income for any taxable year consists of passive income or 50% or more of the average value of its assets produce, or are held for the production of, passive income. For purposes of these tests, passive income generally includes dividends, interest, gains from the sale or exchange of investment property, and rents and royalties other than rents and royalties that are received from unrelated parties in connection with the active conduct of a trade or business. We do not believe that we are currently a PFIC, and we do not anticipate becoming a PFIC in the foreseeable future. However, because there are uncertainties in the application of the relevant rules and PFIC status is a factual determination made annually after the close of each taxable year, there can be no assurance that we will not be a PFIC for the current taxable year or any future taxable year.

 

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If we are or have been a PFIC in any taxable year, a U.S. Holder (as defined in “Certain United States Federal Income Tax Considerations for U.S. Holders—U.S. Holder Defined”) may incur significantly increased U.S. federal income tax on gain recognized on the sale or other disposition of our common shares and on the receipt of distributions on our common shares to the extent such gain or distribution is treated as an “excess distribution” under the U.S. federal income tax rules, and such holder may be subject to burdensome reporting requirements. Further, if we are a PFIC for any year during which a U.S. Holder holds our common shares, we generally will continue to be treated as a PFIC for all succeeding years during which such U.S. Holder holds our common shares. Please see “Certain United States Federal Income Tax Considerations for U.S. Holders—Passive Foreign Investment Company Considerations” for a more detailed discussion of the U.S. federal income tax consequences to U.S. Holders if we are treated as a PFIC.

 

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ITEM 2.

FINANCIAL INFORMATION

Selected Financial Data

The following table sets forth selected historical consolidated financial information for each of the periods indicated. This information should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with the accompanying consolidated financial statements and related notes included in this registration statement. The selected historical financial information indicated for the years ended December 31, 2018, 2017, and 2016 and as of December 31, 2018 and 2017 have been derived from our audited consolidated financial statements prepared in conformity with GAAP included elsewhere in this registration statement. The selected historical financial information indicated for the three and six months ended June 30, 2019 and 2018 and as of June 30, 2019 have been derived from our unaudited interim condensed consolidated financial statements prepared in conformity with GAAP included elsewhere in this registration statement. Historical results set forth in the following table and elsewhere in this registration statement are not necessarily indicative of future performance.

 

		Three Months Ended June 30,								Six Months Ended June 30,								Year Ended December 31,
		2019				2018				2019				2018				2018				2017				2016
		($ in thousands, except per share data)
Revenue
Product Revenue		$	61,273			$	60,552			$	125,113			$	121,658			$	266,434			$	216,216			$	196,482
Service Revenue			2,818				1,928				4,039				4,670				8,247				10,323				4,882
Total Revenue			64,091				62,480				129,152				126,328				274,681				226,539				201,364
Cost of Sales
Product Cost of Sales			37,102				37,809				77,170				73,739				161,844				131,326				117,600
Service Cost of Sales			2,568				1,340				3,957				3,284				5,828				9,724				4,620
Total Cost of Sales			39,670				39,149				81,127				77,023				167,672				141,050				122,220
Gross Profit			24,421				23,331				48,025				49,305				107,009				85,489				79,144
Total Operating Expenses(1)(2)			19,660				22,151				48,029				44,263				101,315				91,990				72,114
Operating Income (Loss)			4,761				1,180				(4	)			5,042				5,694				(6,501	)			7,030
Foreign Exchange (Gain) Loss			441				(469	)			960				(1,205	)			(3,214	)			665				433
Interest Income			(38	)			(112	)			(92	)			(226	)			(425	)			(399	)			(457	)
Interest Expense			25				99				74				203				503				500				213
Net Income (Loss) Before Tax			4,333				1,662				(946	)			6,270				8,830				(7,267	)			6,841
Income Taxes			1,722				892				1,708				2,430				3,280				458				2,942
Net Income (Loss)		$	2,611			$	770			$	(2,654	)		$	3,840			$	5,550			$	(7,725	)		$	3,899
Income (Loss) Per Share
Basic		$	0.03			$	0.01			$	(0.03	)		$	0.05			$	0.07			$	(0.09	)		$	0.05
Diluted		$	0.03			$	0.01			$	(0.03	)		$	0.05			$	0.07			$	(0.09	)		$	0.05

 

(1)

In 2018 and 2017, we incurred $7.4 million and $1.1 million in reorganization expenses, respectively. In the second quarter of 2019 and 2018, we recorded a $1.7 million recovery of stock-based compensation, and a $0.6 million stock-based compensation expense, respectively. In the first quarter of 2019 and 2018, we incurred $6.4 million and $0.6 million of stock-based compensation expenses, respectively, and $2.6 million and $1.6 million in reorganization expenses, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations” for more information.

(2)	In 2018, we incurred $8.7 million in impairment expenses. See “Management’s Discussion and Analysis of Financial Condition and Result of Operations – Results of Operations” for more information.

 

		As of June 30,				As of December 31,
		2019				2018				2017
		($ in thousands)
Balance Sheet
Cash and Cash Equivalents		$	58,736			$	53,412			$	63,484
Total Assets		$	185,229			$	175,911			$	174,438
Total Liabilities		$	61,410			$	52,397			$	47,919

 

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion is intended to assist in the understanding of trends and significant changes in our results of operations and financial condition for the periods presented. This section should be read in conjunction with our consolidated financial statements and related notes for the years ended December 31, 2018, 2017 and 2016 and our unaudited interim condensed consolidated financial statements and related notes for the three and six months ended June 30, 2019 and 2018 included in this registration statement.

Operating Highlights

 

•

Revenue increased by 3% to $64.1 million for the three months ended June 30, 2019 compared to $62.5 million for the three months ended June 30, 2018. Revenue increased by 2% to $129.2 million for the six months ended June 30, 2019, compared to $126.3 million for the six months ended June 30, 2018. Revenue increased due to higher product and associated transportation sales, and an increase in installation activity in the second quarter of 2019. Additionally, the first quarter of 2018 included an estimated $4.0 million to $7.0 million of revenue (3% to 6% of year-to-date 2018 revenue) related to projects that were delayed by hurricanes in the fourth quarter of 2017 and delivered in the first quarter of 2018.

 

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Gross profit margin increased to 38.1% for the three months ended June 30, 2019 compared to 37.3% for the three months ended June 30, 2018. Gross profit margin decreased to 37.2% for the six months ended June 30, 2019, compared to 39.0% for the six months ended June 30, 2018. Costs related to the tile warping issue, as discussed below, headcount additions added throughout 2018 in anticipation of higher production volumes, and decreased margins on installation services were partially offset by improvements in product and transportation gross margins due to sales mix and the realization of operational efficiencies. We have identified and are implementing what we believe is a permanent solution for the tile warping issue; see “—Outlook” for more information.

 

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Operating expenses decreased 11% to $19.7 million for the three months ended June 30, 2019 compared to $22.1 million for the three months ended June 30, 2018, in part due to a $1.7 million recovery of stock-based compensation expense and a $0.8 million decrease in reorganization costs. These and other cost decreases were partially offset by $1.3 million of consulting costs incurred for our sales and marketing evaluation (the “Sales & Marketing Plan”), and $0.4 million of costs associated with the intended listing of our common shares on the Nasdaq stock exchange (the “U.S. Listing”).

 

•

Operating expenses increased by $3.8 million or 9% to $48.0 million for the six months ended June 30, 2019, from $44.3 million for the six months ended June 30, 2018. This increase was due to a $3.7 million increase in stock-based compensation expense, $1.3 million of costs incurred for the Sales & Marketing Plan, a $1.1 million reduction in capitalization of internally generated intangible assets, $1.1 million of costs associated with the U.S. Listing, and a $0.2 million increase in reorganization costs. These items were partially offset by reductions in non-revenue generating expenditures.

 

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Net income increased to $2.6 million ($0.03 per share) for the three months ended June 30, 2019 from $0.8 million ($0.01 per share) for the three months ended June 30, 2018. Net loss was $2.7 million ($0.03 loss per share) for the six months ended June 30, 2019, compared to net income of $3.8 million ($0.05 per share) for the six months ended June 30, 2018. Net income (loss) for both periods was affected primarily by the increases in gross profit, higher operating expenses, and the impacts of a $1.7 million recovery of stock based compensation expense and a $6.4 million expense recorded to account for the fair value of stock-based compensation for the three and six months ended June 30, 2019, respectively.

 

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Adjusted EBITDA decreased 15% to $5.6 million (8.7% of revenue) for the three months ended June 30, 2019 from $6.6 million (10.6% of revenue) for the three months ended June 30, 2018. Adjusted EBITDA decreased 26% to $12.6 million (9.7% of revenue) for the six months ended June 30, 2019 from $17.0 million (13.5% of revenue) for the six months ended June 30, 2018. Adjusted EBITDA decreased due to the inclusion of costs of the U.S. Listing and Sales & Marketing Plan in operating expenses and foreign exchange losses.

 

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Working capital decreased to $66.5 million at June 30, 2019, from $69.8 million at December 31, 2018, as a result of the repayment in the first quarter of $5.6 million of long-term debt (of which the long-term portion was $3.1 million), $3.4 million payment for stock options surrendered for cash in addition to a $2.8 million increase in the current liability for cash-settled stock options, and the addition of $4.7 million of current portion of lease liabilities;

 

•

Cash and cash equivalents increased to $58.7 million at June 30, 2019 from $53.4 million at December 31, 2018. Cash increases reflect $13.9 million of cash generated by operating activities, offset by $5.2 million of capital expenditures and $5.5 million used in financing activities, which includes the $5.6 million repayment of long-term debt. With current cash on hand, expected ongoing cashflow from operations, and available borrowings, we believe we have the financial capacity to support anticipated future growth.

 

24

Outlook

We continued to execute our plan to transform the Company into a scalable growth platform that will drive market penetration and improve project delivery and related profitability. Since we have a robust and proven product suite already in place, including our ICE Software platform, our plan focuses on three major initiatives, all of which are underway and ongoing:

 

•

developing and implementing an efficient and effective sales and marketing approach to drive profitable growth in market segments where our value proposition resonates;

 

•

increasing operational effectiveness within our manufacturing facilities, with a focus on improved safety, quality control, capacity management, metric-based process improvements, and strategic sourcing; and

 

•

enhancing ongoing corporate cost control measures, accountabilities and processes including department level budgeting, monthly management reporting and forecasting, and talent development initiatives.

In April 2019, we engaged an internationally recognized consulting firm to evaluate our current sales and marketing approach and assist in the development of a Sales & Marketing Plan to increase profitability and accelerate future growth. Evaluation of the Sales & Marketing Plan and related implementation steps are currently underway and will be synthesized into an overall strategic plan that is expected to be presented to the investment community during the fourth quarter of 2019. At June 30, 2019, we had incurred $1.3 million of the total estimated $2.0 million cost of this engagement.

 

We concluded our search for a Chief Commercial Officer, a role that was created for the purpose of leading the sales and marketing transformation to drive aggressive growth. Our new Chief Commercial Officer, Jennifer Warawa, started in this role effective September 16, 2019. In addition, we have appointed a national account director, promoted internally, to improve our approach to selling to clients with national footprints. We are currently enhancing and expanding our Green Learning Center (“GLC”) in New York City, expected to be completed in the fourth quarter of 2019 and designing a GLC in Seattle, with openings expected to be open in the fourth quarter of 2019 and the first quarter of 2020, respectively. In addition to these sales and marketing additions and enhancements, we have promoted Mark Greffen to Chief Technology Officer in recognition of his responsibilities to continue driving innovation and development of ICE Software and related digital platforms.

Our operational effectiveness improvements are driven by the fundamental goals of achieving 99% on time delivery with zero deficiencies, in a safe and cost-effective manner. During the second quarter of 2019, the Company continued to implement lean manufacturing practices in its facilities, including the adoption of standard measures and reporting through its Safety, Quality, Delivery, Inventory & Productivity boards, the introduction of process monitoring and alert systems, and the establishment of root cause analysis methodologies. Realization of the benefits of these improvements commenced in the second quarter and are expected to continue through the remainder of 2019 and beyond.

In the second half of 2018, we experienced warping in a small portion of our medium density fiberboard (“MDF”) tiles, primarily in locations that experience high humidity or significant variability in humidity and temperature. We conducted a root cause analysis and believe we have identified a permanent solution to the issue. The solution is being implemented in two phases and involves applying a primer coating on both sides of the MDF, which results in significantly less moisture absorption than unprimed MDF. We will initially source the primed MDF from a third party while we acquire and install the necessary equipment to apply the primer to the MDF in our factories. We expect to incur approximately $2.0 million in total equipment and installation costs to implement the solution, with anticipated commissioning of the new equipment in the first quarter of 2020. For the remainder of 2019 and until commissioning of this equipment, we expect that the cost for MDF will be commensurate with that incurred in the first two quarters. Upon commissioning, we expect cost reductions of between $0.7 million and $1.5 million per annum, relative to 2019 costs and based on 2019 volumes. Costs associated with controlling tile warping, mainly due to higher material costs, were $0.5 million and $2.0 million in the second quarter and year-to-date periods of 2019, respectively.

In the second quarter of 2019, we concluded an evaluation of our aluminum, tile and millwork capacities under various growth scenarios, including lead times for development of new facilities and a risk assessment of the effect of the loss of one of our facilities. We concluded that while sufficient capacity and redundancy exists within our aluminum frame plants to support future growth, the longer lead time to acquire tile and millwork manufacturing equipment combined with the lack of redundancy in our tile and millwork facilities result in the need to commence construction of a new combined tile and millwork facility (the “Facility”). Management has identified two potential sites in the southeastern United States and is currently in negotiations to select the ultimate site, with the selection process anticipated to be completed by the end of 2019. We have commenced development plans for the Facility, which will be built to our specifications and leased to us by a third party. We have also entered into negotiations for purchase of the production equipment. The Facility is expected to be in service in the first quarter of 2021, with a total budget of $18.5 million that will be funded with cash on hand.

We are continuing with the intended listing of our common shares on Nasdaq in the second half of 2019 to offset the loss of our foreign private issuer status and enhance the marketability of our common shares (particularly in the United States). To prepare for the U.S. Listing, we have completed the conversion of our financial statements to U.S. GAAP with a U.S. dollar presentation currency. Management has also performed an in-depth assessment of our governance policies and related documentation to comply with U.S. securities laws and listing standards. We expect to incur total costs of approximately $1.5 million to prepare for the U.S. Listing, of which $1.1 million was incurred by June 30, 2019. We intend to cease the current practice of allowing employee stock options to be surrendered for cash and will revert to settling exercises with common shares issued from treasury once our U.S. listing is completed.

At June 30, 2019, we had $66.5 million of working capital (compared to $69.8 million at December 31, 2018), including $58.7 million of cash on hand (compared to $53.4 million at December 31, 2018) and no long-term debt (compared to $3.1 million at December 31, 2018). In July 2019, we entered into a C$50 million senior secured revolving credit facility with the Royal Bank of Canada (the “RBC Credit Facility”) replacing our prior revolving credit facility with Comerica Bank (the “Comerica Credit Facility”) that expired on June 30, 2019. Both Canadian and U.S. dollar denominated drawings are available under the RBC Credit Facility. We believe current working capital and cash generation from operations, combined with the RBC Credit Facility, will provide sufficient financial capacity for us to execute our growth plans for the foreseeable future.

Our management expects that 2019 total revenue will be comparable to 2018 total revenue. Several factors have affected our expected revenue for the second half of 2019, including the revised timing of various projects from 2019 into 2020 and the loss of certain anticipated projects. These factors reinforce our belief that sales in 2019 have been adversely affected by an immature go-to-market approach and an inadequately supported sales force working on a long sales cycle.

Our management expects that Adjusted EBITDA for 2019 will be lower than 2018 as a result of: unusual costs, lower gross profit margin, and foreign exchange losses incurred in 2019 compared to foreign exchange gains in 2018. Unusual costs, all anticipated to be completed by the end of the third quarter of 2019, consist of $2.0 million relating to third-party sales and marketing consultant fees, approximately $1.5 million of U.S. Listing costs, and other operational consultant costs. Of these costs, we have incurred $1.3 million, $1.1 million and $1.1 million, respectively, as of June 30, 2019.

Our management also expects that Adjusted Gross Profit Margin for 2019 will be lower than 2018 as a result of costs associated with the now-resolved tile warping issue and labor additions made in the second half of 2018.

Management views 2019 as a year of transition while we make necessary changes to develop and strengthen our sales function, a core component of implementing our strategic plan. As a part of our strategic plan to further develop a strong and effective sales organization, we created and filled the role of chief commercial officer, established a national accounts function, and are implementing an appropriate sales organization with key processes, systems and metrics.

Non-GAAP Financial Measures

Note Regarding Use of Non-GAAP Financial Measures

Our consolidated financial statements are prepared in accordance with GAAP. These GAAP financial statements include non-cash charges and other charges and benefits that we believe are unusual or infrequent in nature or that we believe may make comparisons to our prior or future performance difficult.

As a result, we also provide financial information in this registration statement that is not prepared in accordance with GAAP and should not be considered as an alternative to the information prepared in accordance with GAAP. Management uses these non-GAAP financial measures in its review and evaluation of the financial performance of the Company. We believe that these non-GAAP financial measures also provide additional insight to investors and securities analysts as supplemental information to our GAAP results and as a basis to compare our financial performance from period to period and to compare our financial performance with that of other companies. We believe that these non-GAAP financial measures facilitate comparisons of our core operating results from period to period and to other companies by removing the effects of our capital structure (net interest income on cash deposits, interest expense on outstanding debt, or foreign exchange movements on debt revaluation), asset base (depreciation and amortization), tax consequences and stock-based compensation. In addition, management bases certain forward-looking estimates and budgets on non-GAAP financial measures, primarily Adjusted EBITDA.

Reorganization expenses, impairment expenses, depreciation and amortization, and stock-based compensation are excluded from our non-GAAP financial measures because management considers them to be outside of the Company’s core operating results, even though some of those expenses may recur, and because management believes that each of these items can distort the trends associated with the Company’s ongoing performance. We believe that excluding these expenses provides investors and management with greater visibility to the underlying performance of the business operations, enhances consistency and comparativeness with results in prior periods that do not, or future periods that may not, include such items, and facilitates comparison with the results of other companies in our industry.

 

25

The following non-GAAP financial measures are presented in this registration statement, and a description of the calculation for each measure is included.

 

Adjusted Gross Profit		Gross profit before deductions for depreciation and amortization
Adjusted Gross Profit Margin		Adjusted Gross Profit divided by revenue
EBITDA		Net income before interest, taxes, depreciation and amortization
Adjusted EBITDA		EBITDA adjusted for non-cash foreign exchange gains or losses on debt revaluation; impairment expenses; stock-based compensation expense; reorganization expenses; and any other non-core gains or losses
Adjusted EBITDA Margin		Adjusted EBITDA divided by revenue
Adjusted Net Income		Net Income excluding the tax effected impact of impairment, reorganization expenses, and stock-based compensation fair value adjustment

You should carefully evaluate these non-GAAP financial measures, the adjustments included in them, and the reasons we consider them appropriate for analysis supplemental to our GAAP information. Each of these non-GAAP financial measures has important limitations as an analytical tool due to exclusion of some but not all items that affect the most directly comparable GAAP financial measures. You should not consider any of these non-GAAP financial measures in isolation or as substitutes for an analysis of our results as reported under GAAP. You should also be aware that we may recognize income or incur expenses in the future that are the same as, or similar to, some of the adjustments in these non-GAAP financial measures. Because these non-GAAP financial measures may be defined differently by other companies in our industry, our definitions of these non-GAAP financial measures may not be comparable to similarly titled measures of other companies, thereby diminishing their utility.

EBITDA and Adjusted EBITDA for the Three and Six Months Ended June 30, 2019 and 2018

The following table presents a reconciliation for the second quarter and year-to-date results of 2019 and 2018 of EBITDA and Adjusted EBITDA to our net income (loss), which is the most directly comparable GAAP measure for the periods presented:

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2019				2018				2019				2018
		($ in thousands)								($ in thousands)
Net income (loss) for the period		$	2,611			$	770			$	(2,654	)		$	3,840
Add back (deduct):
Interest Expense			25				99				74				203
Interest Income			(38	)			(112	)			(92	)			(226	)
Income Tax Expense			1,722				892				1,708				2,430
Depreciation and Amortization			2,940				3,475				6,335				6,798
EBITDA		$	7,260			$	5,124				5,371			$	13,045
Stock-based Compensation Expense (Recovery)			(1,655	)			564				4,792				1,135
Non-cash Foreign Exchange Loss (Gain) on Debt Revaluation			—				160				(211	)			413
Reorganization Expense			—				764				2,639				2,410
Adjusted EBITDA		$	5,605			$	6,612				12,591			$	17,003
Net Income Margin(1)			4.1	%			1.2	%			(2.1	)%			3.0	%
Adjusted EBITDA Margin			8.7	%			10.6	%			9.7	%			13.5	%

 

(1)	Net income divided by revenue.

For the three months ended June 30, 2019, Adjusted EBITDA and EBITDA Margin decreased to $5.6 million or 8.7% from $6.6 million or 10.6% in the same period of 2018. This reflects the $1.2 million increase in Adjusted Gross Profit, less the $1.1 million increase in operating expenses, other than depreciation and amortization, stock-based compensation and reorganization (which included the impact of the Sales & Marketing Plan, U.S. Listing costs, and other one-time costs noted below), and $0.9 million increase in foreign exchange losses.

For the six months ended June 30, 2019, Adjusted EBITDA and Adjusted EBITDA Margin decreased to $12.6 million or 9.7% from $17.0 million or 13.5% in the same period of 2018. This reflects the $1.3 million decrease in Adjusted Gross Profit, $0.3 million increase in operating expenses, other than depreciation and amortization, stock-based compensation and reorganization (which included the impact of the Sales & Marketing Plan, U.S. Listing costs, and other one-time costs noted below), and a $2.2 million increase in foreign exchange losses.

EBITDA and Adjusted EBITDA for the Year Ended December 31, 2018, 2017 and 2016

The following table presents a reconciliation for 2018, 2017, and 2016 of EBITDA and Adjusted EBITDA to our net income (loss), which is the most directly comparable GAAP measure for the periods presented:

 

		Year Ended December 31,
		2018				2017				2016
		($ in thousands)
Net income (loss) for the period		$	5,550			$	(7,725	)		$	3,899
Add back (deduct):
Interest Expense			503				500				213
Interest Income			(425	)			(399	)			(457	)
Income Tax Expense			3,280				458				2,942
Depreciation and Amortization			13,699				12,856				11,425
EBITDA		$	22,607			$	5,690			$	18,022
Stock-based Compensation			3,661				2,738				2,576
Non-cash Foreign Exchange Loss (Gain) on Debt Revaluation			546				(731	)			43
Impairment Expense			8,680				—				—
Reorganization Expense			7,380				1,143				—
Adjusted EBITDA		$	42,874			$	8,840			$	20,641
Net Income (Loss) Margin(1)			2.0	%			(3.4	)%			1.9	%
Adjusted EBITDA Margin			15.6	%			3.9	%			10.3	%

 

(1)	Net income (loss) divided by revenue.

 

26

Adjusted EBITDA and Adjusted EBITDA Margin increased respectively by 385% to $42.9 million or to 15.6% of revenue in 2018 from $8.8 million or 3.9% of revenue in 2017. These increases were due to increased sales activity and associated gross profit, a reduction in operating expenses, and foreign exchange gains. Additionally, revenue and associated Adjusted EBITDA for the fourth quarter of 2017 were reduced by construction delays resulting from hurricanes in parts of the United States. These reductions in 2017 partially contributed to the increases to 2018 revenue and Adjusted EBITDA.

Adjusted EBITDA in 2017 decreased by 57% to $8.8 million or 3.9% of revenue from $20.6 million or 10.3% of revenue in 2016. These decreases were due to increases in operating expenses in 2017, partially offset by increases in gross profit.

Adjusted Gross Profit and Adjusted Gross Profit Margin for the Three and Six Months Ended June 30, 2019 and 2018

The following table presents a reconciliation for the three and six months ended June 30, 2019 and 2018 of Adjusted Gross Profit to our gross profit, which is the most directly comparable GAAP measure for the periods presented:

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2019				2018				2019				2018
		($ in thousands)
Gross Profit		$	24,421			$	23,331			$	48,025			$	49,305
Gross Profit Margin			38.1	%			37.3	%			37.2	%			39.0	%
Add: Depreciation Expense		$	2,559			$	2,443			$	4,739			$	4,774
Adjusted Gross Profit		$	26,980			$	25,774			$	52,764			$	54,079
Adjusted Gross Profit Margin			42.1	%			41.3	%			40.9	%			42.8	%

Gross profit and gross profit margin increased to $24.4 million or 38.1% for the three months ended June 30, 2019, from $23.3 million or 37.3% for the three months ended June 30, 2018. During the quarter, we began to realize the benefits of operational improvement activities in our manufacturing facilities. Reductions in direct material and transportation costs, due to improved efficiency and product mix, offset the incremental costs of $0.5 million (0.8% of gross profit) to mitigate further warping of our tiles, $1.0 million of costs associated with headcount additions throughout 2018 in anticipation of higher volumes, and a $0.7 million reduction in gross profit due to delivering certain installation projects in the current quarter that were contracted under unfavorable terms.

Gross profit and gross profit margin increased to $48.0 million, or 37.2%, for the six months ended June 30, 2019, from $49.3 million or 39.0% for the six months ended June 30, 2018. During the period, we incurred $2.0 million of incremental costs (1.6% of gross profit) to mitigate further warping of our tiles and $2.0 million of costs associated with headcount additions throughout 2018 in anticipation of higher volumes. We also experienced a $0.7 million reduction in gross profit due to reductions in second quarter gross profit on installation revenue, as previously discussed. These cost increases were partially offset by the benefits of the operational improvement activities as described above. We expect to further realize benefits from these activities as the year progresses.

Adjusted Gross Profit and Adjusted Gross Profit Margin for the Year Ended December 31, 2018, 2017 and 2016

The following table presents a reconciliation for 2018, 2017 and 2016 of Adjusted Gross Profit to our gross profit, which is the most directly comparable GAAP measure for the periods presented:

 

		Year Ended December 31,
		2018				2017				2016
		($ in thousands)
Gross Profit		$	107,009			$	85,489			$	79,144
Gross Profit Margin			39.0	%			37.7	%			39.3	%
Add: Depreciation Expense		$	9,528			$	8,705			$	7,312
Adjusted Gross Profit		$	116,537			$	94,194			$	86,456
Adjusted Gross Profit Margin			42.4	%			41.6	%			42.9	%

For 2018, gross profit and gross profit margin increased respectively to $107.0 million or 39.0% of revenue from $85.5 million or 37.7% of revenue for 2017. Adjusted Gross Profit and Adjusted Gross Profit Margin increased respectively to $116.5 million or 42.4% of revenue in 2018 from $94.2 million or 41.6% of revenue in 2017. In 2018, we experienced savings from the increased leverage on fixed manufacturing overhead costs and improved installation margins; however, we also experienced a higher-than-normal volume of warping of tiles, resulting in approximately $3.5 million of repair costs and provisions, which reduced gross profit margin by 1.2%. We commenced an analysis into the root cause of the tile warping issue in late 2018 and concluded that a regulatory change in late 2017 affected the composition of the tiles, resulting in increased moisture absorption rates. We believe we have identified a permanent solution to this issue. Increases in depreciation and amortization during 2018 included in cost of goods sold reflects investments in manufacturing equipment in 2017.

For 2017, gross profit increased to $85.5 million, or 37.7% of revenue, from $79.1 million or 39.3% of revenue for 2016. Adjusted Gross Profit increased to $94.2 million or 41.6% of revenue in 2017 from $86.5 million or 42.9% of revenue in 2016. The increase in gross profit and Adjusted Gross Profit was due to the previously explained increase in revenue. The decrease in gross profit margin and Adjusted Gross Profit Margin was due to higher aluminum costs, lower margins on increased installation revenue, and higher depreciation related to investment in manufacturing equipment.

Adjusted Net Income for the Three and Six Months Ended June 30, 2019 and 2018

The following table presents a reconciliation for the second quarter and year-to-date results of 2019 and 2018 of Adjusted Net Income (loss) to our net income (loss), which is the most directly comparable GAAP measure for the periods presented:

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2019				2018				2019				2018
		($  in thousands)
Net Income (Loss) for the Period		$	2,611			$	770			$	(2,654	)		$	3,840
Add back (deduct):
Stock-based compensation fair value adjustments			(1,922	)			—				3,761
Reorganization Expense			—				764				2,639				2,410
Tax Impact of Adjustments			—				(207	)			(712	)			(651	)
Adjusted Net Income (Loss)		$	689			$	1,327			$	3,034			$	5,599

 

27

During the third quarter of 2018, we determined that we no longer qualified as a Foreign Private Issuer (“FPI”) as of June 30, 2018, under the rules of the US Securities and Exchange Commission (“SEC”). As a result, until such time that we requalify as a FPI or register our offers and sales of securities with the SEC, equity issuances including those under our Amended and Restated Incentive Stock Option Plan (“Option Plan”) are subject to a one-year holding period. To minimize any undue effects on employees, our board of directors approved the availability of a cash surrender feature for certain options until we requalify as a FPI is returned or we register our shares with the SEC. Accordingly, we currently account for the fair value of outstanding stock-options at the end of the reporting period as a liability, with changes in the liability recorded through net income as a stock-based compensation fair value adjustment. Adjusted Net Income for the three and six months ended June 30, 2019, removes the stock-based fair value adjustment, because this accounting charge is material and not comparable to prior year charges. Upon the listing of our common shares on Nasdaq, we expect to revert to equity accounting under the Option Plan without quarterly fair value adjustments because we will no longer have a cash surrender feature.

Adjusted Net Income for the Year Ended December 31, 2018, 2017 and 2016

The following table presents a reconciliation for 2018, 2017 and 2016 of Adjusted Net Income (loss) to our net income (loss), which is the most directly comparable GAAP measure for the periods presented:

 

		Year Ended December 31,
		2018				2017				2016
		($ in thousands)
Net Income (Loss) for the Period		$	5,550			$	(7,725	)		$	3,899
Add back (deduct):
Impairment Expense			8,680				—				—
Reorganization Expense			7,380				1,143				—
Tax Impact of Adjustments			(4,336	)			(309	)			—
Adjusted Net Income (Loss)		$	17,274			$	(6,891	)		$	3,899

Results of Operations

Three and Six Months Ended June 30, 2019, Compared to Three and Six Months Ended June 30, 2018

 

		Three Months Ended June 30,												Six Months Ended June 30,
		2019				2018				% Change				2019				2018				% Change
		($ in thousands)
Revenue		$	64,091			$	62,480				3	%		$	129,152			$	126,328				2	%
Gross Profit		$	24,421			$	23,331				5	%		$	48,025			$	49,305				(3	)%
Gross Profit Margin			38.1	%			37.3	%			2	%			37.1	%			39.0	%			(5	)%
Operating Expenses
Sales and Marketing		$	9,543				10,102				(6	)%			17,330			$	20,174				(14	)%
General and Administrative			6,856				7,789				(12	)%			13,753				14,422				(5	)%
Operations Support			2,870				1,897				51	%			5,352				3,996				34	%
Technology and Development			2,046				1,035				98	%			4,163				2,126				96	%
Stock-based compensation			(1,655	)			564				NA				4,792				1,135				322	%
Reorganization			—				764				(100	)%			2,639				2,410				10	%
Total Operating Expenses		$	19,660			$	22,151				(11	)%		$	48,029			$	44,263				9	%
Operating Income (Loss)		$	4,761			$	1,180				303	%		$	(4	)		$	5,042				NA
Operating Margin			7.4	%			1.9	%			289	%			0	%			4.0	%			(100	)%

Revenue

Revenue reflects sales to our Distribution Partners for resale to their clients and, in limited circumstances, our direct sales to clients. Our revenue is generally affected by the timing of when orders are executed, particularly large orders, which can add variability to our financial results and shift revenue between quarters. The following table sets forth the contribution to revenue of our DIRTT Solutions and related offerings.

 

		Three Months Ended June 30,												Six Months Ended June 30,
		2019				2018				% Change				2019				2018				% Change
		($ in thousands)
Product		$	54,886			$	54,626				—			$	111,835			$	110,346				1	%
Transportation			5,856				5,328				10	%			12,215				10,184				20	%
Licenses			531				598				(11	)%			1,063				1,129				(6	)%
Total Product Revenue		$	61,273			$	60,552				1	%		$	125,113			$	121,658				3	%
Installation and other services			2,818				1,928				46	%			4,039				4,670				(14	)%
Total		$	64,091			$	62,480				3	%		$	129,152			$	126,328				2	%

Product and associated transportation revenue increased in the three months ended June 30, 2019 by $0.7 million or 1% compared to the same period of 2018. As discussed in “—Outlook,” we believe the distraction from significant management changes during 2018 adversely affected 2018 project bidding efforts quoting levels and thus 2019 sales to a greater extent than we previously expected. The recent enhancements to our organizational structure and senior management team have not yet positively affected sales due to, we believe, our long sales cycle. For the six months ended June 30, 2019, product and transportation revenue increased by $3.5 million or 3% compared to the same period of 2018. Revenue for the six months of 2018 included an estimated $4.0 million to $7.0 million (3% to 5% of year-to-date 2018 revenue) of projects that were delayed from the fourth quarter of 2017 to the first quarter of 2018 as a result of significant hurricanes in the southern United States affecting 2017 project schedules.

Installation revenue increased $0.9 million for the three months ended June 30, 2019 compared to the same period in 2018 and decreased $0.6 million for the six months ended June 30, 2019 compared to the same period in 2018. The changes in installation revenue are primarily due to the timing of projects. Except under certain circumstances, our Distribution Partners perform installation services rather than us, and accordingly, we are not anticipating significant growth in this revenue stream.

Our success is partly dependent on our ability to profitably develop our Distribution Partner network to expand our market penetration and ensure best practices are shared across local markets. We had 92 Distribution Partners at June 30, 2019. Our clients, as serviced primarily through our Distribution Partners, exist within a variety of industries, including healthcare, education, financial services, government and military, manufacturing, non-profit, energy, professional services, retail, technology and hospitality.

We periodically analyze our revenue growth by vertical markets in the defined markets of commercial, healthcare, government and education. The following table presents our product and transportation revenue by vertical market.

 

		Three Months Ended June 30,												Six Months Ended June 30,
		2019				2018				% Change				2019				2018				% Change
		($ in thousands)
Commercial		$	39,189			$	39,519				(1	)%			81,338				77,904				4	%
Healthcare			10,346				11,990				(14	)%			23,260				21,761				7	%
Government			4,313				4,543				(5	)%			8,412				12,774				(34	)%
Education			6,894				3,902				77	%			11,040				8,090				36	%
License fees from distribution partners			531				598				(11	)%			1,063				1,129				(6	)%
Total Product Revenue		$	61,273			$	60,552				1	%		$	125,113			$	121,658				3	%
Installation and other services		$	2,818			$	1,928				46	%			4,039				4,670				(14	)%
Total Revenue		$	64,091			$	62,480				3	%		$	129,152			$	126,328				2	%
		Three Months Ended June 30,												Six Months Ended June 30,
		2019				2018				% Change				2019				2018				% Change
		(in %)
Commercial			65				65				—				65				64				2
Healthcare			17				20				(15	)			19				18				6
Government			7				8				(13	)			7				11				(36	)
Education			11				7				57				9				7				29
% of Product Revenue(1)			100				100				—				100				100				—

 

(1)	excluding licenses from distribution partners

Revenue growth of 3% in the three months ended June 30, 2019 over the prior year period was driven primarily by increased sales in the education sector, reflecting a higher number of post-secondary school projects in the quarter. This increase, combined with consistent revenue in the commercial sector and increased installation activity, was partially offset by lower healthcare sales, which reflect the timing of projects, and modest reductions in government sales. For the six months ended June 30, 2019, revenue grew by 2% compared to the prior year period, with continued growth in the commercial, healthcare and education sectors, partially offset by the completion of a major government project in 2018 that was not replicated in 2019, and reduced installation activity.

Revenue continues to be derived almost exclusively from projects in North America and predominantly from the United States, with periodic international projects from North American Distribution Partners. The following table presents our revenue dispersion by geography.

 

		Three Months Ended June 30,												Six Months Ended June 30,
		2019				2018				% Change				2019				2018				% Change
		($ in thousands)												($ in thousands)
Canada		$	8,771			$	8,214				7	%		$	15,839			$	18,371				(14	)%
United States			55,320				53,633				3	%			113,313				107,094				6	%
International			—				633				(100	)%			—				863				(100	)%
Total		$	64,091			$	62,480				3	%		$	129,152			$	126,328				2	%

Sales & Marketing Expenses

Sales and marketing expenses decreased $0.6 million to $9.5 million for the three months ended June 30, 2019, from $10.1 million for the three months ended June 30, 2018. Sales and marketing expenses decreased $2.8 million to $17.3 million for the six months ended June 30, 2019, from $20.2 million for the six months ended June 30, 2018. Included in sales and marketing expenses in the three months ended June 30, 2019 was $1.3 million of consulting costs related to the Sales & Marketing Plan. These costs were offset by continued reductions in travel, meals and entertainment costs and cost reductions related to trade shows. None of these expense reductions are expected to materially affect our sales revenue.

Our sales and marketing efforts in 2019 are largely concentrated on establishing the appropriate sales organization, significantly improving our marketing approach and driving returns on sales and marketing expenditures. In April 2019, we engaged an internationally recognized consulting firm to evaluate our current sales and marketing approach and assist in the development of action plans necessary to drive accelerated growth. Along with the incremental costs associated with this consulting engagement in 2019, we expect sales and marketing expense to increase in conjunction with higher sales due to higher commissions as well as investment in sales generating initiatives. Our ongoing focus is to continue to control costs by emphasizing return on investment on our sales and marketing expenditures.

General and Administrative Expenses

General and administrative (“G&A”) expenses decreased $0.9 million to $6.9 million for the three months ended June 30, 2019 from $7.8 million for the three months ended June 30, 2018. In the second quarter of 2018, we incurred $0.9 million related to proxy defense costs which did not reoccur in 2019. This reduction was partially offset by $0.4 million of costs related to the U.S. Listing incurred in the second quarter of 2019.

G&A expenses decreased $0.7 million to $13.8 million for the six months ended June 30, 2019 from $14.4 million for the six months ended June 30, 2018. In 2018, we incurred $1.4 million related to proxy defense costs which did not reoccur in 2019. This reduction was partially offset by $1.1 million of costs related to the U.S. Listing incurred in the second quarter of 2019.

Operations Support Expenses

Operations support expenditures include the fixed costs associated with delivery and project management of our DIRTT Solutions, as well as the operating costs of our manufacturing facilities. Operations support expenses increased $1.0 million to $2.9 million for the three months ended June 30, 2019, from $1.9 million for the three months ended June 30, 2018. The increase is due to $0.7 million of consultant costs incurred to assist with the evaluation of current operations and to assist with the rectification of the tile warping issue and increases in personnel costs due to increased headcount and an increased provision for variable compensation.

Operations support costs increased $1.4 million to $5.4 million for the six months ended June 30, 2019, from $4.0 million for the six months ended June 30, 2018, due to $1.1 million of consultant costs incurred for the same evaluations discussed for the three-month period as well as increases in personnel costs.

Technology and Development Expenses

Technology and development expenses relate to non-capitalizable costs associated with our product and software development teams and are primarily comprised of salaries and benefits of technical staff.

Technology and development expenses increased $1.0 million to $2.0 million for the three months ended June 30, 2019, compared to $1.0 million for the three months ended June 30, 2018. Technology and development expenses increased $2.1 million to $4.2 million for the six months ended June 30, 2019, compared to $2.1 million for the six months ended June 30, 2018. These increases are due to a $0.5 million and $1.6 million decrease in capitalized salaries for the three and six months ended June 30, 2019, respectively, as the current mix of projects undertaken by us included a higher portion of efforts related to business process improvements that were not eligible for capitalization. Additionally, we have accrued $0.3 million and $0.5 million higher provision for variable compensation in the three and six months ended June 30, 2019, respectively, and $0.3 million and $0.5 million additional salary and benefit costs were classified as cost of sales of technical services during the three and six months ended June 30, 2018.

Stock-Based Compensation

Stock-based compensation reflected a $1.7 million recovery for the three months ended June 30, 2019, compared to an expense of $0.6 million for the same period of 2018, reducing the expense to $4.8 million for the six months ended June 30, 2019, compared to $1.1 million for the same period of 2018. We recorded fair value adjustments on cash settled stock options during the three and six months ended June 30, 2019, respectively, with no fair value adjustment required in the respective prior year periods.

Reorganization Expenses

We incurred $2.6 million for the first quarter of 2019 and no material additional reorganization costs in the second quarter of 2019, compared to $0.8 million and $2.4 million in the three and six months ended June 30, 2018, respectively. These costs included severance payments, and related legal and consulting costs, associated with management and organizational changes and legal and consulting costs related to these changes. No further material expenditures are anticipated in 2019.

Income Tax

Alberta’s general provincial tax rate was decreased on June 28, 2019 from 11.5% to 11% for the second half of 2019, to 10% for 2020, to 9% for 2021 and to 8% thereafter. As a result of the rate change, we reduced our deferred tax asset by $0.9 million, with a corresponding deferred income tax expense recorded in the second quarter of 2019.

The provision for income taxes is comprised of federal, state, provincial and foreign taxes based on pre-tax income. Income tax expense for the three months ended June 30, 2019, inclusive of the previously noted charge associated with the Alberta tax rate change, was $1.7 million, compared to $0.9 million for the same period of 2018, and income tax expense for the six months ended June 30, 2019 was $1.7 million, as compared to $2.4 million for the same period of 2018. As at June 30, 2019, we had C$39.2 million of loss carry-forwards in Canada and none in the United States, compared to C$43.6 million in Canada and none in the United States on December 31, 2018. These loss carry-forwards will begin to expire in 2030.

Net Income (loss)

Net income was $2.6 million or $0.03 per share in the second quarter of 2019, compared to net income of $0.8 million or $0.01 per share for the second quarter of 2018. The variances are the result of changes in gross margin and operating expenses as described above. Net income for the three months ended June 30, 2019 includes a $1.7 million recovery in stock-based compensation, compared to a $0.6 million expense in the same period of 2018, and $nil of reorganization costs for the three months ended June 30, 2019, compared to $0.8 million in the same period of 2018.

On a year-to-date basis, net loss was $2.7 million or $0.03 net loss per share in the first six months of 2019, compared to net income of $3.8 million or $0.05 net income per share for the first six months of 2018. The variances are the result of changes in gross margin and operating expenses as described above. Net income for the six months ended June 30, 2019 includes a $4.8 million expense in stock-based compensation, compared to $1.1 million in the same period of 2018, and $2.6 of reorganization costs for the six months ended June 30, 2019, compared to $2.4 million expense in the same period of 2018.

Year Ended December 31, 2018, Compared to Year Ended December 31, 2017

 

		Year Ended December 31,
		2018				2017				% Change
		($ in thousands)
Revenue		$	274,681			$	226,539				21	%
Gross Profit		$	107,009			$	85,489				25	%
Gross Profit Margin			39.0	%			37.7	%			3	%
Operating Expenses
Sales and Marketing		$	40,731			$	46,355				(12	)%
General and Administrative			30,861				29,383				5	%
Operations Support			8,960				8,234				9	%
Technology and Development			4,703				6,875				(32	)%
Reorganization			7,380				1,143				546	%
Impairments			8,680				—				NA
Total Operating Expenses		$	101,315			$	91,990				10	%
Operating Income (Loss)		$	5,694			$	(6,501	)			NA
Operating Margin(1)			2.1	%			(2.9	)%			NA

 

(1)	Operating income (loss) divided by revenue.

Revenue

The following table sets forth the contribution to revenue of our DIRTT Solutions and related offerings.

 

		Year Ended December 31,
		2018				2017				% Change
		($ in thousands)
Product		$	240,482			$	195,676				23	%
Transportation			24,552				19,519				26	%
Licenses			1,400				1,021				37	%
Total Product Revenue		$	266,434			$	216,216				23	%
Installation and other services			8,247				10,323				(20	)%
Total		$	274,681			$	226,539				21	%

 

 

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Revenue increased in 2018 by $48.1 million to $274.7 million, or 21%, compared to $226.5 million for 2017. The increase was attributable to an increase in product and associated transportation revenue from product shipments in the healthcare market, combined with continued growth in commercial markets. Revenue for installations declined by $2.1 million in 2018 from 2017 due to reduced levels of installation with a major client. Installation services are typically outsourced to third parties through our Distribution Partners. Installation revenue therefore varies from time to time and, over time, is expected to decrease as a percentage of overall revenue as we expand our network of Distribution Partners. Revenue in 2017 also decreased as record-breaking hurricanes in the year delayed certain project schedules, with a reduction of our fourth-quarter revenue in 2017 estimated to be between $4.0 million and $8.0 million, which contributed to the revenue increase in 2018.

Our success is partly dependent on our ability to profitably develop our Distribution Partner network to expand our market penetration and ensure best practices are shared across local markets. We had 97 Distribution Partners in 2018, as compared to 95 Distribution Partners in 2017.

We periodically review our revenue growth by vertical markets in the defined markets of commercial, healthcare, government and education. The following table presents our product and transportation revenue by vertical market.

 

		Year Ended December 31,
		2018				2017				% Change
		($ in thousands)
Commercial		$	163,199			$	142,494				15	%
Healthcare			60,748				38,455				58	%
Government			21,477				18,927				13	%
Education			19,610				15,319				28	%
License fees from distribution partners			1,400				1,021				37	%
Total Product Revenue		$	266,434			$	216,216				23	%
Installation and other services			8,247				10,323				(20	)%
Total Revenue		$	274,681			$	226,539				21	%

 

		Year Ended December 31,
		2018				2017				% Change
		(in %)
Commercial			62				66				(6	)
Healthcare			23				18				28
Government			8				9				(11	)
Education			7				7				—
% of Product Revenue(1)			100				100

 

(1)	Excluding license fees from distribution partners

In 2018, we experienced strong growth in the healthcare market as a result of successful sales and business development activities and increasing acceptance of our DIRTT Solutions. Year-over-year healthcare sales increased 58% in 2018 over 2017, and proportionally as a percentage of product and transportation revenue, reflecting continued penetration into the sector and the positive effect of certain large projects.

The following table presents our revenue dispersion by geography.

 

		Year Ended December 31,
		2018				2017				% Change
		($ in thousands)
Canada		$	41,153			$	35,035				17	%
United States			232,035				190,245				22	%
International			1,493				1,259				19	%
Total		$	274,681			$	226,539				21	%

 

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Sales & Marketing Expenses

Sales and marketing expenses decreased to $40.7 million in 2018 from $46.4 million in 2017. The decrease was primarily due to $6.1 million targeted reductions in non-revenue generating marketing and tradeshow expenses and associated travel, meals and entertainment costs, and the elimination in 2018 of $1.3 million incurred in 2017 on a collaborative project built to showcase DIRTT Solutions in the prior Executive Chairman’s primary residence. These cost reductions were partially offset by a $1.6 million increase in commission expense due to increases in orders.

General and Administrative Expenses

General and administrative expenses increased to $30.9 million in 2018 from $29.4 million in 2017. In 2018, we incurred $1.4 million of one-time advisor and other costs associated with activist defense and $0.7 million of board, advisor and other costs associated with the work of a special committee of the Board of Directors in response to an unsolicited and unsuccessful acquisition bid by a third party. Stock-based compensation expense included in general and administrative expense increased $1.1 million as a modification to the awards, allowing them to be cash-settled, resulted in a higher 2018 charge. Depreciation and amortization increased $0.6 million in 2018 due to the expense attributable to prior-year office equipment and leasehold additions. Additional increases in 2018 also included additions to the Company’s variable pay provision as a result of improved corporate performance. These increases were offset by reductions in non-essential travel and entertainment, office and other expenditures, recognized through improvements in process and increased focus on cost control. In 2017, we also incurred one-time expenses of $1.0 million related to a collaborative project built to showcase DIRTT Solutions in the prior Executive Chairman’s primary residence.

Operations Support Expenses

Operations support expenses increased to $9.0 million in 2018 from $8.2 million in 2017 as a result of increases in personnel costs year-on-year put in place to handle higher sales activity levels.

In the fourth quarter of 2018, we closed our Kelowna plant in British Columbia, with associated power and network production reallocated to our other existing facilities, and we consolidated our Calgary distribution center with the Calgary aluminum fabrication facility. Management expects operation support expenses to increase in general with revenue but to decrease as a percentage of revenue as efficiency and productivity are improved over time.

 

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Technology and Development Expenses

Technology and development expenses were $4.7 million in 2018 compared to $6.9 million in 2017. Prior-year expenditures included costs associated with the DIRTT for Life and DIRTT Timber product lines that were curtailed in 2018, which resulted in technology and development costs decreasing by $2.2 million from 2017 to 2018.

Reorganization Expenses

Reorganization expenses in 2018 were $7.4 million compared to $1.1 million in 2017. These expenses include severance payments associated with management and organizational changes to the Company, retention bonuses paid to key employees, a one-time payment to terminate a benefit program of the Company, and legal and consulting costs related to these changes. Management currently anticipates $2.6 million of reorganization charges in the first quarter of 2019 and no material reorganization expenditures outside of the normal course of operations thereafter.

Impairment Expenses

DIRTT Timber

During 2018, management decided to shift from the early stage development of its DIRTT Timber market to a commercialized approach focused on large, standalone timber projects and as a tie-in to our other DIRTT Solutions. Management concluded that this strategy required significantly less timber capacity than existed and took steps to right-size its timber capacity by the end of 2018. Management determined these decisions to be an indicator of impairment of the assets of the DIRTT Timber line.

During 2018, management performed an assessment of the carrying values of DIRTT Timber’s property, plant and equipment (“PP&E”). To determine the impairment of the DIRTT Timber assets, the net book value of the assets was evaluated against the fair value of the assets. The fair value of the DIRTT Timber assets reflects current projected sales for timber projects on a standalone basis and the pull-through impact to other DIRTT Solutions. In its evaluation, management determined it was unable to reliably quantify the pull-through impact of timber on other DIRTT Solutions. The equipment related to the timber market was custom built for DIRTT, and there is no active market for resale. Therefore, the fair value was determined to be management’s estimate of scrap value for the specialized assets and an estimated resale value for less specialized assets that cannot be redeployed for other DIRTT Solutions. Management estimated the expected resale values based on the current market and industry knowledge. The fair value of the timber assets was estimated to be $1.1 million. This assessment resulted in an impairment charge of $6.1 million during 2018.

Leasehold and Other Assets

During 2018, management reviewed the facilities used in our operations and the corresponding leases in place to determine whether assets were impaired or whether the costs of meeting lease obligations exceeded the economic benefits expected to be received. The outcome of this review was the consolidation of our production in Kelowna, British Columbia, into other plants, the consolidation of a distribution center in Calgary, Alberta, into an existing facility, and discontinued use of other locations that were not considered necessary in our operations. In 2018, we recognized a lease exit liability of $0.5 million related to these facilities, net of $1.0 million of estimated recoveries from subleases.

The lease exit liability represents the present value of the difference between the minimum future lease payments that we are obligated to make under the non-cancellable operating lease contract and any estimated sublease recoveries. This estimate may vary as a result of changes in estimated sublease recoveries. The lease exit liability is estimated to be settled in periods up to and including the year 2023.

 

31

In connection with management’s review of our facilities, certain leasehold assets were identified as no longer having future value. These assets related to leases of locations where activity is being relocated, as well as projects in process that were eliminated. These leasehold and other assets represented assets with a carrying value of $2.0 million in 2018. As these assets cannot be resold and there is no future use for the assets, the entire carrying amount was impaired and a corresponding impairment charge of $2.0 million was recorded.

Foreign Exchange

Foreign exchange gains were $3.2 million in 2018, primarily because of the impact of a weakening of the Canadian dollar on the revaluation of U.S. dollar-denominated intercompany receivables due from our U.S. subsidiary. In 2017, we recorded $0.7 million of foreign exchange losses primarily as a result of the impact of a strengthening Canadian dollar on revaluation of intercompany accounts receivables.

Translation adjustments recorded in other comprehensive income were a $10.0 million loss in 2018 and a $7.4 million gain in 2017. These translation adjustments occurred on the translation of our Canadian entities’ net asset positions into our U.S. dollar reporting currency at period end and were affected by the weakening of the Canadian dollar in 2018 and the strengthening of the Canadian dollar in 2017.

Income Tax

Provision for income taxes is comprised of federal, state or provincial, local and foreign taxes based on pre-tax income. Income tax expense for 2018 was $3.3 million, compared to $0.5 million for 2017. The increase in income taxes reflects year-over-year changes in temporary differences partially offset by the impact of higher taxable income. The income tax expense incurred in 2017 reflected the impact of the reduction to the U.S. federal tax rate from 35% to 21% on deferred income taxes.

In 2018, DIRTT had C$43.6 million of non-capital loss carry-forwards in Canada and none in the United States, compared to C$48.0 million and $4.2 million, respectively, in 2017. These loss carry-forwards will begin to expire in 2031. The change in the loss carry-forward from year to year is due to differences in accounting and tax treatments of certain expenses and realized foreign currency gains on intercompany funding.

Net Income (loss)

Net income increased to $5.6 million ($0.07 per share) in 2018, from a net loss of $7.7 million ($0.09 loss per share) for 2017. This increase was a result of higher revenue, and a $3.2 million foreign currency gain, which offset an $9.3 million increase in operating costs. Operating costs for 2018 included the impact of $8.7 million in impairment expenses and $7.4 million of reorganization costs, compared to $1.1 million in reorganization costs for 2017. Excluding these costs, Adjusted Net Income was $17.3 million or $0.20 per share in 2018, an increase of $24.2 million from a $6.9 million loss ($0.08 loss per share) in 2017.

Year Ended December 31, 2017, Compared to Year Ended December 31, 2016

 

		Year Ended December 31,
		2017				2016				% Change
		($ in thousands)
Revenue		$	226,539			$	201,364				13	%
Gross Profit		$	85,489			$	79,144				8	%
Gross Profit Margin			37.7	%			39.3	%			(4	)%
Operating Expenses			—
Sales and Marketing		$	46,355			$	35,079				32	%
General and Administrative			29,383				23,006				28	%
Operations Support			8,234				8,194				1	%
Technology and Development			6,875				5,835				18	%
Reorganization			1,143				—				NA
Total Operating Expenses		$	91,990			$	72,114				28	%
Operating Income (Loss)		$	(6,501	)		$	7,030				NA
Operating Margin(1)			(2.9	)%			3.5	%			NA

 

(1)	Operating income (loss) divided by revenue.

 

32