ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The information contained in this Form 10-Q is intended to update the information contained in our Annual Report on Form 10-K for the year ended September 30, 2018 and presumes that readers have access to, and will have read, the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other information contained in such Form 10-K. The following discussion and analysis also should be read together with our financial statements and the notes to the financial statements included elsewhere in this Form 10-Q.

The following discussion contains certain statements that may be deemed “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements appear in a number of places in this Report, including, without limitation, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” These statements are not guarantees of future performance and involve risks, uncertainties and requirements that are difficult to predict or are beyond our control. Forward-looking statements speak only as of the date of this quarterly report. You should not put undue reliance on any forward-looking statements. We strongly encourage investors to carefully read the factors described in our Annual Report on Form 10-K for the year ended September 30, 2018 in the section entitled “Risk Factors” for a description of certain risks that could, among other things, cause actual results to differ from these forward-looking statements. We assume no responsibility to update the forward-looking statements contained in this quarterly report on Form 10-Q. The following should also be read in conjunction with the unaudited Financial Statements and notes thereto that appear elsewhere in this report.

Overview

Digipath, Inc. was incorporated in Nevada on October 5, 2010. Digipath, Inc. and its subsidiaries (“Digipath,” the “Company,” “we,” “our” or “us”) is a service-oriented independent testing laboratory, data analytics and media firm focused on the developing cannabis and hemp markets, and supports the cannabis industry’s best practices for reliable testing, cannabis education and training. Our business units as of June 30, 2019 are described below.

Our cannabis testing revenues improved slightly over the previous fiscal quarter, but was substantially lower than our comparative nine month period ending June 30, 2018. This decrease was primarily the result of the temporary suspension by regulators of two of our competitors in the prior year’s quarter, resulting in a significant increase in our sales during that quarter. Our revenues stabilized subsequent to the prior period when these competitors were reinstated. As an ISO 17025:2017 accredited lab, we believe that we are now well positioned to handle future growth in full compliance with Nevada’s regulations applicable to our operations and are actively working to expand to other jurisdictions.

We are currently seeking to expand our lab testing services to Colombia, and to that end have retained Colombian counsel, formed a Colombian subsidiary and hired two local employees. Our goal is to launch a testing lab in Colombia by the end of the fiscal year, although there can be no assurance that we will be successful in that regard.

In January 2019, we entered into an agreement to provide potency testing laboratories for hemp production at sites owned by Hemp, Inc. in North Carolina, Oregon and Arizona. Under the terms of the agreement, we will oversee and manage the construction and build out of a hemp potency-testing laboratory in three of Hemp Inc.’s locations and Hemp. Inc. will provide the space for the testing laboratories at no cost to us.

We are also exploring opportunities to capitalize on the extensive data we have collected from our cannabis testing activities. Through our wholly-owned subsidiary, GroSciences, Inc., we intend to license specific formulations and intellectual property developed from our experience in the cannabis industry. We have not yet commenced operations for this initiative, other than minimal research and development activities and patent filings.

Revenues

Revenues were generated by our cannabis testing lab and to a de minimis extent, from advertising on TNM News’ media outlets. Aggregate revenues for the three months ended June 30, 2019 were $652,920, compared to revenues of $521,772 during the three months ended June 30, 2018, an increase of $131,148, or 25%. The increase in revenue was due to industry growth and expansion to hemp testing during the current period.

Cost of Sales

Cost of sales for the three months ended June 30, 2019 were $424,067, compared to $520,888 during the three months ended June 30, 2018, a decrease of $96,821, or 19%. Cost of sales consists primarily of labor, depreciation, maintenance on lab equipment, and supplies consumed in our testing operations. The decreased cost of sales in the current period was primarily due to better pricing on our consumable supplies, and improved efficiencies with respect to our labor. Our gross margins of approximately 35%, increased during the three months ended June 30, 2019, compared to gross margins of approximately -0-% during the three months ended June 30, 2018, due primarily to decreased cost of sales in the current quarter and increased costs in the prior quarter when we devoted significant resources to the improvement of operations and compliance with regulations, including the ISO 17025:2017 requirement.

General and Administrative Expenses

General and administrative expenses for the three months ended June 30, 2019 were $431,636, compared to $360,689 during the three months ended June 30, 2018, an increase of $70,947, or 20%. The expenses consisted primarily of marketing, rent, salaries and wages, and travel expenses. General and administrative expense increased during the current period due to increased investor relation expenses.

Professional Fees

Professional fees for the three months ended June 30, 2019 were $195,052, compared to $228,482 during the three months ended June 30, 2018, a decrease of $33,430, or 15%. Professional fees included non-cash, stock-based compensation of $114,018 and $177,472 during the three months ended June 30, 2019 and June 30, 2018, respectively. Professional fees decreased primarily due to decreased stock-based compensation during the current period.

Bad Debts Expense (Recoveries)

Bad debts expense (recoveries) for the three months ended June 30, 2019 was $93,340, compared to recoveries of $(45,200) during the three months ended June 30, 2018, an increase of $138,540, or 307%. Bad debts expense increased during the current period as our allowance for doubtful accounts increased with an allowance of $95,000 for potentially uncollectible notes receivable and the change in allowance for doubtful accounts on our trade receivables during the quarter.

Operating Loss

Our operating loss for the three months ended June 30, 2019 was $491,175, compared to $543,087 during the three months ended June 30, 2018, a decrease of $51,912, or 10%. Our operating loss decreased primarily due to increased margins, as offset in part by increased marketing expenses, during the three months ended June 30, 2019, compared to the three months ended June 30, 2018.

Other Income

Other income for the three months ended June 30, 2019 was $1,547, compared to other income of $43,012 during the three months ended June 30, 2018, a decrease of $41,465, or 96%. Other income consisted of $21,000 of sublease rents, as offset by a $1,250 reversal of interest income and $18,203 of interest expense for the three months ended June 30, 2019. Other income during the three months ended June 30, 2018 consisted of $19,200 of subleased rents and $23,812 of restitution payments received from a former employee.

Net Loss

Net loss for the three months ended June 30, 2019 was $489,628, compared to $500,075 during the three months ended June 30, 2018, a decrease of $10,447, or 2%. The decreased net loss was due primarily to increased gross profits as described above, as offset in part by increased investment relation expenses, increased bad debts expense, and interest on debt financing.

Revenues

Revenues were generated by our cannabis testing lab and to a de minimis extent, from advertising on TNM News’ media outlets. Aggregate revenues for the nine months ended June 30, 2019 were $1,946,590, compared to revenues of $2,223,630 during the nine months ended June 30, 2018, a decrease of $277,040, or 12%. The decrease in revenue was due to a spike in revenues in the comparative fiscal period ending June 30, 2018 due to regulators’ temporary suspension of two of our competitors during that period. Our revenues normalized when these competitors were reinstated.

Cost of Sales

Cost of sales for the nine months ended June 30, 2019 were $1,334,217, compared to $1,563,518 during the nine months ended June 30, 2018, a decrease of $229,301, or 15%. Cost of sales consists primarily of labor, depreciation, maintenance on lab equipment, and supplies consumed in our testing operations. The decreased cost of sales in the current period was primarily due to better pricing on our consumable supplies, and improved efficiencies with respect to our labor. Our gross margins of approximately 31%, increased slightly during the nine months ended June 30, 2019, compared to gross margins of approximately 30% during the nine months ended June 30, 2018.

General and Administrative Expenses

General and administrative expenses for the nine months ended June 30, 2019 were $1,240,612, compared to $1,108,202 during the nine months ended June 30, 2018, an increase of $132,410, or 12%. The expenses consisted primarily of marketing, rent, salaries and wages, and travel expenses. General and administrative expense increased during the current period due to increased investor relation and travel expenses.

Professional Fees

Professional fees for the nine months ended June 30, 2019 were $677,299, compared to $964,269 during the nine months ended June 30, 2018, a decrease of $286,970, or 30%. Professional fees included non-cash, stock-based compensation of $413,427 and $815,887 during the nine months ended June 30, 2019 and June 30, 2018, respectively. Professional fees decreased primarily due to decreased stock-based compensation, as diminished by increased marketing efforts during the current period.

Bad Debts Expense

Bad debts expense for the nine months ended June 30, 2019 was $143,170, compared to $53,041 during the nine months ended June 30, 2018, an increase of $90,129, or 170%. Bad debts expense increased during the current period as our allowance for doubtful accounts increased with an allowance of $95,000 for potentially uncollectible notes receivable was recognized during the current period. Our bad debts expense due to the change in our allowance for doubtful accounts was 2.5% and 2.4% of sales for the nine months ended June 30, 2019 and 2018, respectively.

Operating Loss

Our operating loss for the nine months ended June 30, 2019 was $1,448,708, compared to $1,465,400 during the nine months ended June 30, 2018, a decrease of $16,692, or 1%. Our operating loss decreased primarily due to decreased revenues and an increased change in our allowance for doubtful accounts, as offset in part by decreased stock-based compensation, during the nine months ended June 30, 2019, compared to the nine months ended June 30, 2018.

Other Income

Other income for the nine months ended June 30, 2019 was $45,441, compared to other income of $85,912 during the nine months ended June 30, 2018, a decrease of $40,471, or 47%. Other income consisted of $62,400 of sublease rents and a $30,000 gain on settlement of a previously written off note receivable, as offset by $46,959 of interest expense for the nine months ended June 30, 2019. Other income during the nine months ended June 30, 2018 consisted of $57,600 of subleased rents and $28,312 of restitution payments received from a former employee.

Net Loss

Net loss for the nine months ended June 30, 2019 was $1,403,267, compared to $1,379,488 during the nine months ended June 30, 2018, an increase of $23,779, or 2%. The increased net loss was due primarily to decreased gross profits and increased marketing costs and bad debts expense as described above, as offset in part by decreased stock-based compensation, over the comparative nine month period.

Net Cash Used in Operating Activities

During the nine months ended June 30, 2019, net cash used in operating activities was $889,401, compared to net cash used in operating activities of $212,707 for the same period ended June 30, 2018. The increase in cash used in operating activities is primarily attributable to our increased net loss as we didn’t benefit from the decreased competition from the suspension of two competing cannabis testing labs in the current period, as we did in the prior period.

Net Cash Used in Investing Activities

During the nine months ended June 30, 2019, net cash used in investing activities was $125,261, compared to $194,008 for the same period ended June 30, 2018. The decrease is attributable to investments made for cannabis testing equipment in the prior period that was not necessary in the current period, in addition to the advancement of short-term loans during the current period.

Net Cash Provided by Financing Activities

During the nine months ended June 30, 2019, net cash provided by financing activities was $1,125,000, compared to $268,608 for the same period ended June 30, 2018. The current period consisted of $500,000 of proceeds received on fixed convertible debt financing at $0.14 per share and the sale of $625,000 of common stock, while the comparative period consisted of proceeds received from the sale of $268,608 of common stock and warrants.

Ability to Continue as a Going Concern

As of June 30, 2019, our balance of cash on hand was $286,365. We currently may not have sufficient funds to sustain our operations for the next twelve months and we may need to raise additional cash to fund our operations and expand our lab testing business. As we continue to develop our lab testing business and attempt to expand operational activities, we expect to experience net negative cash flows from operations in amounts not now determinable, and will be required to obtain additional financing to fund operations through common stock offerings to the extent necessary to provide working capital. We have and expect to continue to have substantial capital expenditure and working capital needs.

The Company has incurred recurring losses from operations resulting in an accumulated deficit, and, as set forth above, the Company’s cash on hand is not sufficient to sustain operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. Management is actively pursuing new customers to increase revenues. In addition, the Company is currently seeking additional sources of capital to fund short term operations. In the event sales do not materialize at the expected rates, management would seek additional financing or would attempt to conserve cash by further reducing expenses. There can be no assurance that we will be successful in achieving these objectives, becoming profitable or continuing our business without either a temporary interruption or a permanent cessation. In addition, additional financing may result in substantial dilution to existing stockholders.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates continuity of operations, realization of assets, and liquidation of liabilities in the normal course of business. The unaudited consolidated financial statements do not include any adjustments related to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

Off-Balance Sheet Arrangements

We have no outstanding off-balance sheet guarantees, interest rate swap transactions or foreign currency contracts. We do not engage in trading activities involving non-exchange traded contracts.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires our management to make assumptions, estimates and judgments that affect the amounts reported, including the notes thereto, and related disclosures of commitments and contingencies, if any. We have identified certain accounting policies that are significant to the preparation of our financial statements. These accounting policies are important for an understanding of our financial condition and results of operations. Critical accounting policies are those that are most important to the presentation of our financial condition and results of operations and require management’s subjective or complex judgment, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. Certain accounting estimates are particularly sensitive because of their significance to financial statements and because of the possibility that future events affecting the estimate may differ significantly from management’s current judgments.

While our significant accounting policies are more fully described in notes to our consolidated financial statements appearing elsewhere in this Form 10-Q, we believe that the following accounting policies are the most critical to aid you in fully understanding and evaluating our reported financial results and affect the more significant judgments and estimates that we used in the preparation of our financial statements.

Revenue Recognition

Effective October 1, 2018, the Company adopted ASC 606 — Revenue from Contracts with Customers. Under ASC 606, the Company recognizes revenue from the sale of lab testing services through our subsidiary Digipath Labs, Inc., and to a lesser extent, through the sale of advertising through one of our other subsidiaries, TNM News Corp. For the comparative periods, revenue has not been adjusted and continues to be reported under ASC 605 — Revenue Recognition.

There was no impact on the Company’s financial statements as a result of adopting ASC 606 for the nine months ended June 30, 2019, or the twelve months ended September 30, 2018.

Revenue is primarily generated through our subsidiary, Digipath Labs, Inc., which recognizes revenue from the analytical testing of cannabis products to licensed producers and cultivators within the state of Nevada on a determinable fixed fee per test, or panel of tests basis. Revenue from the performance of those services is recognized upon completion of the tests, at which time test results are delivered to the customer, provided collectability of the fee is reasonably assured. We typically require payment within thirty days of the delivery of results. Management estimates an allowance for doubtful accounts based on the aging of its receivables.

The Company also recognizes revenue through our subsidiary, TNM News Corp., which primarily recognizes revenue from advertisements through partnered merchants. Payment for ad revenues are received prior to the distribution of the ad campaign, and the revenues are recognized ratably over the campaign. The Company defers any revenue for which the term of the campaign has not yet been realized. To date, these revenues have not been materially significant.

Stock-Based Compensation

The Company accounts for equity instruments issued to employees in accordance with the provisions of ASC 718 Stock Compensation (ASC 718) and Equity-Based Payments to Non-employees pursuant to ASC 505-50 (ASC 505-50). All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date of the fair value of the equity instrument issued is the earlier of the date on which the counterparty’s performance is complete or the date at which a commitment for performance by the counterparty to earn the equity instruments is reached because of sufficiently large disincentives for nonperformance.