BARFRESH FOOD GROUP INC. 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The information and financial data discussed below is derived from the audited financial statements of Barfresh for its fiscal years ended December 31, 2022 and 2021. The financial statements of Barfresh were prepared and presented in accordance with generally accepted accounting principles in the United States. The information and financial data discussed below is only a summary and should be read in conjunction with the historical financial statements and related notes of Barfresh contained elsewhere in this Annual Report. This discussion and analysis may contain forward-looking statements based on assumptions about our future business. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors. See “Cautionary Note Regarding Forward Looking Statements” above for a discussion of forward-looking statements and the significance of such statements in the context of this Annual Report. Overview The Company’s products are packaged in three distinct formats. The Company’s ready-to-drink smoothie, Twist & Go™, has initially been focused towards the USDA national school meal program, including the School Breakfast Program, the National School Lunch Program and Smart Snacks in Schools Program. This sweet fruit and creamy yogurt smoothie contains four ounces of yogurt and a half-cup of fruit/fruit juice and comes in three different flavors: strawberry banana, peach and mango pineapple. “Twist & Go”™ contains no added sugars, preservatives, artificial flavors or colors. At only 125 -130 calories and with 5 grams of protein, it makes the perfect start to any day or on-the-go snack. 15 The Company’s bulk “Easy Pour” format, which contains all the ingredients necessary to make the beverage, is packaged in gallon containers in a concentrated formula that is mixed 1:1 with water. The Company has a “no sugar added” version of the bulk “Easy Pour” format that is specifically targeted for the aforementioned USDA national school meal programs. In addition, the Company received approval from the United States Defense Logistics Agency (“DLA”) to sell its smoothie products into all branches of the U.S. Armed Forces and is currently in contract with and selling its bulk Easy Pour products into over one hundred military bases in the United States and abroad. The Company’s single-serve format features portion controlled and ready-to-blend beverage ingredient packs or “beverage packs”. The beverage packs contain all the ingredients necessary to make the beverage, including the base (either sorbet, frozen yogurt, or ice cream), real fruit pieces, juices, and ice – five ounces of water are added before blending. Domestic and international patents and patents pending are owned by Barfresh, as well as related trademarks for all of the single serve products. Patent rights have been granted in 13 jurisdictions including the United States. In addition, the Company has purchased all of the trademarks related to the patented products. The Company conducts sales through several channels, including National Accounts, Regional Accounts, and Broadline Distributors. On October 26, 2015, Barfresh signed a five-year agreement with PepsiCo North America Beverages, a division of PepsiCo, to become its exclusive sales representative within the food service channel to present the Barfresh line of ready-to-blend smoothies and frozen beverages throughout the United States and Canada. In February 2023, Barfresh terminated the agreement. Such termination is not anticipated to have a significant impact on sales. Currently we have 13 employees and 3 consultants. Barfresh utilizes contract manufacturers to manufacture all of the products in the United States. Recent developments Our products are produced to specifications through several contract manufacturers. One of our contract manufacturers (the “Manufacturer”) has provided approximately 52% and 42% of our products in the years ended December 31, 2022 and 2021, respectively, under a Supply Agreement with an initial term through September 2025. Over the course of 2022, we experienced numerous quality issues with the case packaging utilized by the Manufacturer. In addition, in July of 2022, we began receiving customer complaints about the texture of our smoothie products produced by the Manufacturer. In response, we withdrew product from the market and destroyed on-hand inventory, withholding $499,000 in payments due to the Manufacturer. The results reflect the estimated accounting impact of such actions, including an estimated product return allowance of $330,000 and total product returns reducing revenue by $493,000 as of and for the year ended December 31, 2022, and $932,000 in cost of revenue to dispose of unsaleable inventory. We attempted to resolve the issues based on the contractual procedures described in the Supply Agreement. However, on November 4, 2022, in response to a formal proposal of alternate resolutions, we received notification from the Manufacturer that it denied any responsibility for the defective manufacture of the product. In response, on November 10, 2022, we filed a complaint in the United States District Court for the Central District of California, Western Division (the “Complaint”), claiming that the Manufacturer has not met its obligations under the Supply Agreement, and seeking economic damages. In response, the Manufacturer terminated the Supply Agreement. On January 20, 2023, we filed a voluntary dismissal of the Complaint which allows the parties to reach a potential resolution outside of the court system. However, if the parties are once again unable to come to an agreement, we have the right to refile the Complaint in California State Court. Due to the uncertainties surrounding the claim, we are not able to predict either the outcome or a range of reasonably possible recoveries that could result from its actions against the Manufacturer, and no gain contingencies have been recorded. The disruption in supply resulting from the dispute will adversely impact its results of operations and cash flow until a suitable resolution is reached or new sources of reliable supply at sufficient volume can be identified and developed, the timing of which is uncertain. 16 Critical Accounting Policies Our financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). Revenue Recognition In accordance with ASC 606, “Revenue from Contracts with Customers”, revenue is recognized when a customer obtains ownership of promised goods. The amount of revenue recognized reflects the consideration to which the Company expects to be entitled to receive in exchange for these goods. The Company applies the following five steps: 1) Identify the contract with a customer A contract with a customer exists when (i) the Company enters into an enforceable contract with a customer that defines each party’s rights, (ii) the contract has commercial substance and, (iii) the Company determines that collection of substantially all consideration for goods or services that are transferred is probable. For the Company, the contract is the approved sales order, which may also be supplemented by other agreements that formalize various terms and conditions with customers. 2) Identify the performance obligation in the contract Performance obligations promised in a contract are identified based on the goods or that will be transferred to the customer. For the Company, this consists of the delivery of frozen beverages, which provide immediate benefit to the customer. 3) Determine the transaction price The transaction price is determined based on the consideration to which the Company will be entitled in exchange for transferring goods and is generally stated on the approved sales order. Variable consideration, which typically includes rebates or discounts, are estimated utilizing the most likely amount method. Provisions for refunds and other adjustments are generally provided for in the period the related sales are recorded, based on management’s assessment of historical and projected trends. 4) Allocate the transaction price to performance obligations in the contract Since our contracts contain a single performance obligation, delivery of frozen beverages, the transaction price is allocated to that single performance obligation. 5) Recognize Revenue when or as the Company satisfies a performance obligation The Company recognizes revenue from the sale of frozen beverages when title and risk of loss passes and the customer accepts the goods, which generally occurs at the time of delivery to a customer warehouse. Customer sales incentives such as volume-based rebates or discounts are treated as a reduction of sales at the time the sale is recognized. Shipping and handling costs are treated as fulfilment costs and presented in distribution, selling and administrative costs. Stock-based Compensation We account for share-based employee compensation plans under the fair value recognition and measurement provisions in accordance with applicable accounting standards, which require all share-based payments to employees, including grants of stock options and restricted stock units (RSUs) and performance stock units (PSUs), to be measured based on the grant date fair value of the awards, with the resulting expense generally recognized on a straight-line basis over the period during which the employee is required to perform service in exchange for the award. Expense for PSUs is recognized based on expected performance against targets. 17 Results of Operations Revenue and cost of revenue Revenue increased $2,462,000, or 37%, from $6,700,000 in 2021 to $9,162,000 in 2022. The overall revenue for 2022 was significantly higher due to growing Twist & Go™ revenue prior to our product withdrawal resulting from the quality complaints with product purchased from the Manufacturer. As a result of the withdrawal, we recorded a reserve for anticipated sales claims and administrative fees of $493,000. We anticipate that our revenues will be adversely impacted as a result of the dispute unless and until new sources of reliable supply at sufficient volume can be identified and developed, the timing of which is uncertain. Cost of revenue for 2022 was $7,722,000 as compared to $4,193,000 in 2021. Our gross profit was $1,440,000 (16%) and $2,507,000 (37%) for 2022 and 2021, respectively. Cost of revenue was adversely impacted by the completed and anticipated disposals of Twist & Go™ product purchased from the Manufacturer, resulting in a charge of $932,000. Depreciation from manufacturing equipment was $29,000 and $18,000 for December 31, 2022 and 2021, respectively. Selling, marketing and distribution expense Year ended December 31, Year ended December 31, 2022 2021 Change Percent Sales and marketing $ 1,394,000 $ 756,000 $ 638,000 84 % Storage and outbound freight 1,467,000 1,054,000 413,000 39 % $ 2,861,000 $ 1,810,000 $ 1,051,000 58 % Sales, marketing and distribution expense increased approximately $1,051,000 (58%) from approximately $1,810,000 in 2021 to $2,861,000 in 2022. Sales and marketing expense increased approximately $638,000 (84%) from approximately $756,000 in 2021 to $1,394,000 in 2022. The increase in sales and marketing expense was primarily the result of the retention of new employees and outside service providers to assist with sales and initiatives, including, beginning in the third quarter of 2022, brokers specializing in the school market. Additionally, the Company increased its participation in education nutrition trade shows in 2022. Storage and outbound freight expense increased approximately $413,000 (39%) from approximately $1,054,000 in 2021 to $1,467,000 in 2022. The increase was primarily a result of the 37% increase in revenue. General and administrative expense Year ended December 31, Year ended December 31, 2022 2021 Change Percent Personnel costs $ 1,340,000 $ 830,000 $ 510,000 61 % Stock-based compensation and payment for outside services 559,000 281,000 278,000 99 % Legal, professional and consulting fees 499,000 396,000 103,000 26 % Director fees paid in cash 100,000 100,000 - 0 % Research and development 382,000 245,000 137,000 56 % Other general and administrative expenses 669,000 318,000 351,000 110 % $ 3,549,000 $ 2,170,000 $ 1,379,000 64 % General and administrative expense increased approximately $1,379,000 (64%) from approximately $2,170,000 in 2021 to $3,549,000 in 2022. Personnel cost represents the cost of employees including salaries, bonuses, employee benefits and employment taxes and continues to be our largest cost. Personnel cost increased by approximately $510,000 (61%) from approximately $830,000 to $1,340,000. The increase in personnel cost was partially offset by the decrease in consulting fees as we choose to hire permanent staff as the critical stages of the COVID-19 pandemic waned, rather than rely on consultants and temporary staff. 18 Stock-based compensation is used as an incentive to attract and compensate employees and other service providers. Stock-based compensation includes stock issued and options granted to employees and non-employees. Stock-based compensation for the year ended December 31, 2022 was approximately $559,000 compared to $281,000 for the year ended December 31, 2021 due to the aforementioned increase in staffing, and the institution of our performance-based stock compensation program in the third quarter of 2022. Stock-based compensation in 2021 benefited from forfeiture credits due to the departure of two key employees. Legal, professional, and consulting fees increased approximately $103,000 (26%) from approximately $396,000 in 2021 to $499,000 in 2022. The increase was primarily due to the dispute and litigation with the Manufacturer and corporate development activities. Research and development expense increased approximately $137,000 (56%) from approximately $245,000 in 2021 to $382,000 in 2022. The increase is primarily due to materials consumed in pre-production runs at a new contract manufacturer that provided our Twist & Go™ product in carton format starting in the fourth quarter of 2022 . Additionally, we incurred costs investigating the quality issue that occurred with the Manufacturer. Other expense increased approximately $351,000 (110%) from approximately $318,000 in 2021 to $669,000 in 2022. In 2022, we incurred approximately $175,000 in one-time costs related to the uplist of our common stock to the NASDAQ Stock Market. Additionally, we experienced maintenance cost increases related to equipment loaned to our bulk product customers, and an increase in annual meeting costs. Asset Impairment We evaluate the recoverability of property and equipment and finite-lived intangible assets for possible impairment whenever events or circumstances indicate that the carrying amount of such assets may not be recoverable. The evaluation is performed at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. Recoverability of these assets is measured by a comparison of the carrying amounts to the future undiscounted cash flows the assets are expected to generate. If such review indicates that the carrying amount of property and equipment and intangible assets is not recoverable, the carrying amount of such assets is reduced to fair value. We recorded impairment charges of $746,000 related to idle equipment resulting from overcapacity for single-serve products and equipment that is held at the Manufacturer. Operating loss We had operating losses of approximately $6,219,000 and $2,095,000 for the years ended December 31, 2022 and 2021, respectively. The increase of approximately $4,124,000 or 196%, was primarily due to $1,425,000 in charges related to the aforementioned product quality issue and withdrawal, the asset impairment of $746,000 and other increases in operating expense. Other income and expense The change in the value of the derivative liability is based upon the Black-Scholes model from one period to another. The gain of approximately $16,000 for the year ended December 31, 2021 was a result of the change in components of the Black-Scholes model. The derivative liability was settled upon conversion and repayment of the convertible notes in the second quarter of 2021, which resulted in an extinguishment loss of $194,000. We recorded a gain on extinguishment of Covid-19 related Paycheck Protection Program (“PPP”) loan of $1,136,000 in the year ended December 31, 2021. Interest expense was approximately $128,000 for the year ended December 31, 2021. Interest related to convertible debt that was converted and repaid in 2021. We did not incur any interest expense for the year ended December 31, 2022. Net loss We had net losses of approximately $6,219,000 and $1,265,000 in the years ended December 31, 2022 and 2021, respectively, an increase of $4,954,000 due primarily to the $1,425,000 charges related to the product withdrawal and the asset impairment of $746,000 in 2022, increases in operating expense and the $1,136,000 gain on forgiveness of the PPP loan in 2021. 19 Liquidity and Capital Resources As of December 31, 2022, we had working capital of $1,801,000 compared with $6,172,000 at December 31, 2021. The decrease in working capital is primarily due to the operating loss of $6,219,000, partially offset by non-cash expenses of $1,834,000. During the year ended December 31, 2022, we used $2,648,000 in operations and $13,000 for the purchase of equipment. The impact of COVID-19 on the Company is constantly evolving. The direct impact to our operations had begun to take effect at the close of the first quarter ended March 31, 2020. Specifically, our business was impacted by dining bans targeted at restaurants to reduce the size of public gatherings. Such bans precluded our single serve products from being served at those establishments for a number of weeks, and in some instances, resulted in abandoned product launches. Furthermore, many school districts closed regular attendance for a period of time thereby disrupting sales of product into that channel. More recently, we have experienced a disruption in the supply chain for manufacturing our products due to COVID-19. The developments surrounding COVID-19 remain fluid and dynamic, and consequently, will require the Company to continue to monitor news headlines from government and health officials, as well as the business community. In each of the years ended December 31, 2021 and 2020, the Company was granted a $568,000 loan under the PPP administered by a Small Business Administration (SBA) approved partner. The loans were forgiven, and the Company recorded a gain of $1,136,000 upon being legally released from the loan obligations during the year ended December 31, 2021. On June 1, 2021, the Company completed a private placement of 1,282,051 shares of its common stock at $4.68 per share, resulting in gross proceeds of $6,000,000. In addition, holders of debt converted a total of $399,000 in principal and $234,000 in interest into 133,991 shares of common stock and debt in the amount of $840,000 was retired, leaving the Company with no debt. We have entered into a direct lease covering the period April 1, 2019 to March 31, 2023. The aggregate minimum requirements under the non-cancellable direct lease as of December 31, 2022 is approximately $20,000. The Company extended its lease through June 2023 while management evaluates options for renewal or relocation. Our liquidity needs will depend on how quickly we are able to profitably ramp up sales, as well as our ability to control and reduce variable operating expenses, and to continue to control and reduce fixed overhead expense. Our recent business developments with the Manufacturer impact our supply chain and will result in increased legal cost and are expected to have a negative impact on our financial position, results of operations and cash flow. Our operations to date have been financed by the sale of securities, the issuance of convertible debt and the issuance of short-term debt, including related party advances. If we are unable to generate sufficient cash flow from operations with the capital raised we will be required to raise additional funds either in the form of equity or in the form of debt. There are no assurances that we will be able to generate the necessary capital to carry out our current plan of operations. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to stockholders. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Not applicable because we are a smaller reporting company. 20 Item 8. Financial Statements and Supplementary Data. Our consolidated financial statements are included beginning immediately following the signature page to this report. See Item 15 for a list of the consolidated financial statements included herein. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None.