Applied Digital Corp. 10-Q

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements This Quarterly Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that involve substantial risks and uncertainties. In some cases you can identify these statements by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “seek,” “should,” “will,” and “would,” or similar words. Statements that contain these words and other statements that are forward-looking in nature should be read carefully because they discuss future expectations, contain projections of future results of operations or of financial positions or state other “forward-looking” information. Forward-looking statements involve inherent uncertainty and may ultimately prove to be incorrect or false. These statements are based on our management’s beliefs and assumptions, which are based on currently available information. These assumptions could prove inaccurate. You are cautioned not to place undue reliance on forward-looking statements. Except as otherwise may be required by law, we undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or actual operating results. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including, but not limited to: • labor and other workforce shortages and challenges; • our dependence on principal customers; • the addition or loss of significant customers or material changes to our relationships with these customers; • our ability to timely and successfully build new hosting facilities with the appropriate contractual margins and efficiencies; • our ability to continue to grow sales in our hosting business; • concentration of customers in the crypto mining industry, which customer base may decline due to price volatility and uncertainties around regulation policy of cryptoasset prices; and • equipment failures, power or other supply disruptions. You should carefully review the risks described in Item 1A of the Company’s Annual Report on Form 10-K for the year ended May 31, 2023, which was filed on August 2, 2023, as well as any other cautionary language in this Quarterly Report on Form 10-Q, as the occurrence of any of these events could have an adverse effect, which may be material, on our business, results of operations, financial condition or cash flows. Executive Overview The following discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q. Business Overview We are a designer, builder, and operator of next generation digital infrastructure providing cost-competitive solutions to customers in High-Performance Compute (“HPC”), artificial intelligence cloud service (“Cloud services”), and datacenter hosting (“Hosting”) industries. Trends and Other Factors Affecting Our Business Regulatory Environment We have a material concentration of customers in the crypto mining industry. Our customers’ businesses are subject to extensive laws, rules, regulations, policies and legal and regulatory guidance, including those governing securities, commodities, cryptoasset custody, exchange and transfer, data governance, data protection, cybersecurity and tax. Many of these legal and regulatory regimes were adopted prior to the advent of the Internet, mobile technologies, cryptoassets and related technologies. As a result, they do not contemplate or address unique issues associated with the crypto economy, are subject to significant uncertainty, and vary widely across U.S. federal, state and local and international jurisdictions. These legal and regulatory regimes, including the laws, rules and regulations thereunder, evolve frequently and may be modified, interpreted and applied in an inconsistent manner from one jurisdiction to another, and may conflict with one another. Moreover, the complexity and evolving nature of our business and the significant uncertainty surrounding the regulation of the crypto economy requires us to exercise our judgement as to whether certain laws, rules and regulations apply to us or 14 Table of Contents our customers, and it is possible that governmental bodies and regulators may disagree with our or our customers’ conclusions. To the extent we or our customers have not complied with such laws, rules and regulations, we could be subject to significant fines and other regulatory consequences, which could adversely affect our business, prospects or operations. As cryptoassets have grown in popularity and in market size, the Federal Reserve Board, U.S. Congress and certain U.S. agencies (e.g., the Commodity Futures Trading Commission, the SEC, the Financial Crimes Enforcement Network and the Federal Bureau of Investigation) have begun to examine the operations of cryptoasset networks, cryptoasset users and cryptoasset exchange markets. Other countries around the world are likewise reviewing and, in some cases, increasing regulation of the cryptoasset industry. For instance, on September 24, 2021, China imposed a ban on all crypto transactions and mining. Ongoing and future regulatory actions could effectively prevent our customers’ mining operations and our ongoing or planned co-hosting operations, limiting or preventing future revenue generation by us or rendering our operations and crypto mining equipment obsolete. Such actions could severely impact our ability to continue to operate and our ability to continue as a going concern or to pursue our strategy at all, which would have a material adverse effect on our business, prospects or operations. Critical Accounting Policies and Estimates Our unaudited condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time our unaudited condensed consolidated financial statements are prepared. On a regular basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our critical accounting policies and estimates are identified and described in our annual consolidated financial statements and the related notes included in our Annual Report, and there have been no material changes since the filing of our Annual Report. Business Update Cloud Services Our Cloud services business operates through our Sai Computing brand and provides cloud services applicable to artificial intelligence. In June 2023, the Company expanded its commitment for up to 26,000 GPUs for the Company's Cloud services business. During the three months ended August 31, 2023, the Company received and deployed an initial production cluster of 1,024 GPUs, and began recognizing revenue on our first cloud services contract. HPC Datacenter Hosting Our HPC datacenter business designs, builds, and operates next-gen datacenters which are designed to provide massive computing power and support high-compute applications within a cost-effective model. The Company is in process of constructing a facility next to the Company’s currently operating facilities in Jamestown, North Dakota, and Ellendale, North Dakota. Datacenter Hosting Our datacenter hosting business provides infrastructure and colocation services to crypto mining customers. As of August 31, 2023, the Company’s 106 MW facility in Jamestown, North Dakota and 180 MW facility in Ellendale, North Dakota were fully operational. The Company’s 200 MW facility in Garden City, Texas is expected to energize during the fourth quarter of calendar 2023. On September 8, 2023, the Company entered into a Facility Extension Agreement with Oncor Electricity Delivery Company LLC for the transmission and metering of power to the Company’s Garden City facility. With this in place, metering and telemetry equipment will be installed onsite by Oncor and once installed, the site will be energized. 15 Table of Contents Results of Operations Comparative Results for the Three Months Ended August 31, 2023 and 2022: The following table sets forth key components of the results of operations (in thousands) during the three months ended August 31, 2023 and 2022. Three Months Ended August 31, 2023 August 31, 2022 Revenues Hosting revenue $ 29,987 $ 4,338 Cloud services revenue 2,152 — Related party hosting revenue 4,184 2,586 Total revenue 36,323 6,924 Costs and expenses: Cost of revenues 24,398 6,093 Selling, general and administrative 17,052 5,008 Total costs and expenses 41,450 11,101 Operating loss (5,127) (4,177) Interest expense, net 2,074 356 Loss on extinguishment of debt 2,353 94 Loss from legal settlement 2,300 — Net loss before income taxes (11,854) (4,627) Income tax expenses — 32 Net loss (11,854) (4,659) Net loss attributable to noncontrolling interest (397) (128) Net loss attributable to Applied Digital Corporation $ (11,457) $ (4,531) Basic and diluted net (loss) gain per share: Basic and diluted net loss per share $ (0.12) $ (0.05) Basic and diluted weighted average number of shares outstanding 100,521,673 93,105,835 Adjusted Amounts (a) Adjusted Operating Loss 1,759 (2,990) Adjusted Operating Margin 5 % (42) % Adjusted Net Income (Loss) 82 (3,378) Basic and diluted net loss per share $ — $ (0.03) Other Financial Data (a) EBITDA (1,523) (3,135) as a percentage of revenues (4) % (45) % Adjusted EBITDA 10,016 (1,854) as a percentage of revenues 28 % (27) % (a) Adjusted Amounts and Other Financial Data are non-GAAP performance measures. A reconciliation of reported amounts to adjusted amounts can be found in the "Non-GAAP Measures and Reconciliation" section of the MD&A. Commentary on Results of Operations Comparative Results for the Three Months Ended August 31, 2023 compared to the Three Months Ended August 31, 2022 Revenue Total revenue increased by $29.4 million, or 425%, from $6.9 million for the three months ended August 31, 2022 to $36.3 million for the three months ended August 31, 2023. The increase in revenue was driven by an increase in online 16 Table of Contents capacity from the Ellendale, North Dakota facility being operational, and revenue from the Company’s first cloud services contract, which started during the three months ended August 31, 2023. Cost of revenues Cost of revenues increased $18.3 million, or 300%, from $6.1 million for the three months ended August 31, 2022 to $24.4 million for the three months ended August 31, 2023. The primary drivers of the change to cost of revenues for the three months ended August 31, 2023 were: • approximately $12.8 million increase in energy costs used to generate hosting revenue; • approximately $3.9 million increase in depreciation and amortization expense attributable to owned and leased assets directly supporting revenue; • approximately $1.2 million increase in personnel expenses for employees directly attributable to generating hosting revenue; and • approximately $0.4 million increase in other expenses directly attributable to generating hosting revenue. Operating Expenses Selling, general and administrative expenses increased $12.1 million, or 241%, from $5.0 million for the three months ended August 31, 2022 to $17.1 million for the three months ended August 31, 2023. The primary drivers of the increase in selling, general and administrative expense for the three months ended August 31, 2023 were: • approximately $1.8 million increase in employee salaries and benefits expense not directly attributable to revenues; • approximately $0.2 million increase in professional service expenses incurred to support the growth of the business; • approximately $2.8 million increase in depreciation and amortization expense not attributable to owned and leased assets directly supporting revenue; • approximately $2.2 million increase in other selling, general, and administrative expenses such as insurance premiums and computer and software expenses; and • approximately $5.1 million increase in stock based compensation expense. The increase was driven by an increase in awards to be expensed between the periods. Other Expense Interest expense increased $1.7 million, or 483%, from $0.4 million for the three months ended August 31, 2022 to $2.1 million for the three months ended August 31, 2023. The increase was driven by the increase in finance leases and interest-bearing loans between periods. Loss on extinguishment of debt increased $2.3 million, or 2403%, from $0.1 million for the three months ended August 31, 2022 to $2.4 million for the three months ended August 31, 2023.The increase was driven by the termination fees to extinguish the B. Riley loan during the three the three months ended August 31, 2023. Loss from legal settlement was $2.3 million for the three months ended August 31, 2023 due to a settlement agreement entered into by the Company in respect to employment-related claims by a former executive. The terms of the settlement include payment to the claimant of $2.3 million, which was included in accrued liabilities on the condensed consolidated balance sheets as of August 31, 2023. Income tax benefit The income tax expense decreased $32 thousand, or 100%, from a $32 thousand expense for the three months ended August 31, 2022 to zero for the three months ended August 31, 2023. This change was driven by a change in valuation allowance for the three months ended August 31, 2023 compared to the three months ended August 31, 2022. 17 Table of Contents Commentary on Segments Revenue The following table sets forth segment revenue (excluding HPC as that segment has no revenue) (in thousands) during the three months ended August 31, 2023 and 2022: Three Months Ended August 31, 2023 August 31, 2022 Cloud services segment $ 2,152 $ — Hosting segment 34,171 6,924 Total revenue $ 36,323 $ 6,924 Cloud Services Revenue Cloud services revenue increased $2.2 million, or 100%, from zero for the three months ended August 31, 2022 to $2.2 million for the three months ended August 31, 2023. The increase is due the Company beginning to provide services within the Cloud services segment during three months ended August 31, 2023. Hosting Revenue Hosting revenue increased $27.2 million, or 394%, from $6.9 million for the three months ended August 31, 2022 to $34.2 million for the three months ended August 31, 2023. The increase is due to the full energization of the Company’s Ellendale, North Dakota and Jamestown, North Dakota facilities during the three months ended August 31, 2023, compared to the Company providing limited capacity at only the Jamestown, North Dakota facility during the three months ended August 31, 2022. Commentary on Segments Operating Profit and Loss The following table sets forth the Company’s operating profit for each of our segments for the three months ended August 31, 2023 and 2022 (in thousands): Three Months Ended August 31, 2023 August 31, 2022 Segment Operating (Loss) Profit: Cloud services segment $ (7,434) $ — Hosting segment 8,958 (658) HPC hosting segment (730) — Total segment profit 794 (658) Cloud Services Operating Loss Cloud services operating loss increased $7.4 million, or 100% from zero for the three months ended August 31, 2022 to $7.4 million for the three months ended August 31, 2023 as the Company began providing cloud services during the first quarter of fiscal year 2024. The change from the three months ended August 31, 2022 is driven by the segment expanding operations during the current period. The operating loss is primary driven by amortization expense on finance leases on computing equipment, stock-based compensation expense attributable to the segment, and the segment only generating revenue for part of the period. Hosting Operating Profit Hosting operating profit increased $9.7 million, or 1,462% from a loss of $0.7 million for the three months ended August 31, 2022 to a profit of $9.0 million for the three months ended August 31, 2023. The change is driven by full energization of the Company’s Ellendale, North Dakota and Jamestown, North Dakota facilities during the three months ended August 31, 2023, relative to operations only at the Company’s Jamestown facility during the the three months ended August 31, 2022 and the Jamestown facility operating at less than full capacity for a portion of the comparative period. 18 Table of Contents HPC Hosting Operating Loss High performance compute hosting operating loss increased $0.7 million, or 100% from zero to $0.7 million due to the Company launching the segment during the current period. The loss is largely comprised of stock-based compensation expense, payroll, and amortization expense related to finance leases in the HPC hosting buildout. Non-GAAP Measures Adjusted Operating Loss and Adjusted Net Loss “Adjusted Operating Loss” and “Adjusted Net Loss” are non-GAAP measures that represents operating loss and net loss, respectively, excluding stock-based compensation and nonrecurring expenses. We believe these are useful metrics as they provide additional information regarding factors and trends affecting our business and provide perspective on results absent one-time or significant non-cash items. However, Applied Digital’s presentation of these measures should not be construed as an inference that its future results will be unaffected by unusual or non-recurring items. Applied Digital’s computation of Adjusted Operating Loss and Adjusted Net Loss may not be comparable to other similarly titled measures computed by other companies, because all companies may not calculate Adjusted Operating Loss and Adjusted Net Loss in the same fashion. Because of these limitations, Adjusted Operating Loss and Adjusted Net Loss should not be considered in isolation or as a substitute for performance measures calculated in accordance with GAAP. Applied Digital compensates for these limitations by relying primarily on its GAAP results and using Adjusted Operating Loss and Adjusted Net Loss on a supplemental basis. You should review the reconciliation of operating loss to Adjusted Operating Loss and net loss to Adjusted Net Loss above and not rely on any single financial measure to evaluate Applied Digital’s business. EBITDA and Adjusted EBITDA “EBITDA” is defined as earnings before interest, taxes, and depreciation and amortization. “Adjusted EBITDA” is defined as EBITDA adjusted for stock-based compensation, loss on extinguishment of debt, one-time professional service costs, and other nonrecurring costs. These costs have been adjusted as they are not indicative of business operations. Adjusted EBITDA is intended as a supplemental measure of Applied Digital’s performance that is neither required by, nor presented in accordance with, GAAP. Applied Digital believes that the use of EBITDA and Adjusted EBITDA provides an additional tool for investors to use in evaluating ongoing operating results and trends and in comparing its financial measures with those of comparable companies, which may present similar non-GAAP financial measures to investors. We also believe EBITDA and Adjusted EBITDA are useful metrics to investors because they provide additional information regarding factors and trends affecting our business, which are used in the business planning process to understand expected operating performance, to evaluate results against those expectations, and because of their importance as measures of underlying operating performance, as the primary compensation performance measure under certain programs and plans. However, you should be aware that when evaluating EBITDA and Adjusted EBITDA, Applied Digital may incur future expenses similar to those excluded when calculating these measures. In addition, Applied Digital’s presentation of these measures should not be construed as an inference that its future results will be unaffected by unusual or non-recurring items. Applied Digital’s computation of Adjusted EBITDA may not be comparable to other similarly titled measures computed by other companies, because all companies may not calculate Adjusted EBITDA in the same fashion. Because of these limitations, EBITDA and Adjusted EBITDA should not be considered in isolation or as a substitute for performance measures calculated in accordance with GAAP. Applied Digital compensates for these limitations by relying primarily on its GAAP results and using EBITDA and Adjusted EBITDA on a supplemental basis. You should review the reconciliation of net loss to EBITDA and Adjusted EBITDA above and not rely on any single financial measure to evaluate Applied Digital’s business. 19 Table of Contents Reconciliation of GAAP to Non-GAAP Measures Three Months Ended $ in thousands August 31, 2023 August 31, 2022 Adjusted operating loss Operating loss (GAAP) $ (5,127) $ (4,177) Stock-based compensation 5,641 579 Non-recurring professional service costs 592 408 Other non-recurring expenses 653 200 Adjusted operating income (loss) (Non-GAAP) $ 1,759 $ (2,990) Adjusted operating margin 4.8 % (43.2) % Adjusted net income (loss) Net loss attributable to Applied Digital Corporation (GAAP) $ (11,457) $ (4,531) Stock-based compensation 5,641 579 Loss on extinguishment of debt 2,353 94 Loss from legal settlement 2,300 — Non-recurring professional service costs 592 408 Other non-recurring expenses 653 200 Adjusted net income (loss) (Non-GAAP) $ 82 $ (3,250) Adjusted net income (loss) per share (Non-GAAP) $ — $ (0.03) EBITDA and Adjusted EBITDA Net loss attributable to Applied Digital Corporation (GAAP) $ (11,457) $ (4,531) Interest expense 2,074 356 Income tax benefit (expense) — 32 Depreciation and amortization 7,860 1,136 EBITDA (Non-GAAP) $ (1,523) $ (3,007) Stock-based compensation 5,641 579 Loss on extinguishment of debt 2,353 94 Loss from legal settlement 2,300 — Non-recurring professional service costs 592 408 Other non-recurring expenses 653 200 Adjusted EBITDA (Non-GAAP) $ 10,016 $ (1,726) Sources of Liquidity As of August 31, 2023, the Company had approximate cash and cash equivalents of $5.9 million and negative working capital of $118.1 million. Historically the Company has incurred losses and has relied on equity and debt financings to fund its operations. Based on an analysis of cash flows, current net working capital, and expected operations revenue, the Company believes its current cash on hand is sufficient to meet its operating and capital requirement for at least next twelve months from the date these financial statements are issued. We have primarily generated cash in the last 12 months from the proceeds of our term loans, issuance of common stock, and the receipt of contractual deposits and revenue payments from customers. See Note 6 - Debt to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for more information on our term loans. On June 27, 2023, the Company began issuing and selling common stock under an "at the market" sales agreement, with Craig-Hallum Capital, pursuant to which the Company may sell up to $125 million in shares of common stock. As of August 31, 2023, the Company has sold approximately 7.9 million shares. Net proceeds, less commission and legal fees of approximately $2.2 million, were approximately $64.5 million. The Company received an additional $2.7 million in proceeds subsequent to August 31, 2023. 20 Table of Contents During the three months ended August 31, 2023, we received $39.5 million in payments for future hosting services. On September 13, 2023, Sai Computing borrowed an additional $5.0 million under the remaining capacity from the existing B. Riley Loan that the Company entered into in May 2023. The Company has also received prepayments from new cloud services customers totaling $9.6 million for future services. Funding Requirements We have experienced net losses through the period ended August 31, 2023. Our transition to profitability is dependent on the successful operation of our co-hosting facilities. We believe that amounts we received from proceeds from our term loans, proceeds from stock offerings, and payments we have received from our hosting operations will be sufficient to meet our working capital needs for at least the next 12 months and all of the Company’s known requirements and plans for cash. We have based our estimates as to how long we expect we will be able to fund our operations on assumptions that may prove to be wrong, and we could use our available capital resources sooner than we currently expect, in which case, we would be required to obtain additional financing sooner than currently projected, which may not be available to us on acceptable terms, or at all. Our failure to raise capital as and when needed would have a negative impact on our financial condition and our ability to pursue our business strategy. We expect that our general and administrative expenses and our operating expenditures will continue to increase as we continue to expand our operations and as we bear the costs of being a public company. We believe that the significant investments in property and equipment will begin remain throughout during calendar 2023 as we continue construction of our HPC facilities and acquire assets to support our cloud services business. We also expect that our revenues will increase as we continue to bring online additional capacity at our Garden City, Texas location and within our cloud services contracts. Summary of Cash Flows The following table provides information about Applied Digital’s net cash flow (in thousands) for the three months ended August 31, 2023 and August 31, 2022, respectively. Three Months Ended $ in thousands August 31, 2023 August 31, 2022 Net cash provided by operating activities $ 4,517 $ 17,294 Net cash used in investing activities (40,541) (31,673) Net cash provided by financing activities 23,663 8,910 Net decrease in cash and cash equivalents (12,361) (5,469) Cash, cash equivalents, and restricted cash at beginning of year 43,574 46,299 Cash, cash equivalents, and restricted cash at end of period $ 31,213 $ 40,830 Commentary on the change in cash flows between the Three Months Ended August 31, 2023 and Three Months Ended August 31, 2022 Operating Activities The net cash provided by operating activities decreased by $12.8 million, or 74%, from $17.3 million for the three months ended August 31, 2022 to $4.5 million for the three months ended August 31, 2023. The primary reason for the change was decrease in revenue prepayments received relative to revenue earned during the three months ended August 31, 2023. Investing Activities The net cash used in investing activities increased by $8.9 million, or 28%, from $31.7 million for the three months ended August 31, 2022 to $40.5 million for the three months ended August 31, 2023. The primary reason for the change was finance lease prepayments made for leases on hosting equipment to support the Company’s cloud services business during the three months ended August 31, 2023. Financing Activities The net cash provided by financing activities increased by $14.8 million, or 166%, from $8.9 million for the three months ended August 31, 2022 to $23.7 million for the three months ended August 31, 2023. The primary reason for the change 21 Table of Contents was receipt of net proceeds from the Company’s common stock offering the three months ended August 31, 2023 which was partially offset by an increase in term lease payments during the three months ended August 31, 2023. Item 3. Quantitative and Qualitative Disclosures About Market Risk Not Applicable