Forward Industries, Inc. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements, and the notes thereto, and other financial information appearing elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2022. The following discussion and analysis compares our consolidated results of operations for the three months ended December 31, 2022 (the “2023 Quarter”) with those for the three months ended December 31, 2021 (the “2022 Quarter”). All dollar amounts and percentages presented herein have been rounded to approximate values. Cautionary Note Regarding Forward-Looking Statements This report contains “forward-looking statements”, as such term is used within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding our liquidity, plans on repaying outstanding debt obligations, expectations regarding the effect of the pandemic and inflation on our business, as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements generally can be identified by words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,” “will be,” “will continue,” “will likely result,” and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially and adversely from those reflected in the forward-looking statements. These risks include the inability to expand our customer base, loss of additional customers, pricing pressures, lack of success of our sales people, failure to develop products at a profit, failure to commercialize products that we develop, continued supply chain issues, inability of our design division’s customers to pay for our services, unanticipated issues with our affiliated sourcing agent, issues at Chinese factories that source our products as a result of the pandemic or otherwise, and failure to obtain acceptance of our products. No assurance can be given that the actual results will be consistent with the forward-looking statements. Investors should read carefully the factors described in the “Risk Factors” section of the Company’s filings with the SEC, including the Company’s Form 10-K for the year ended September 30, 2022 for information regarding risk factors that could affect the Company’s results. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Business Overview Forward Industries, Inc. is a global design, manufacturing, sourcing and distribution company serving top tier medical and technology customers worldwide. As a result of the continued expansion of our design development capabilities through our wholly-owned subsidiaries, IPS and Kablooe, we are now able to introduce proprietary products to the market from concepts brought to us from a number of different sources, both inside and outside the Company. Our design division provides hardware and software product design and engineering services to customers predominantly located in the U.S. Our OEM distribution division sources and sells carrying cases and other accessories for medical monitoring and diagnostic kits as well as a variety of other portable electronic and non-electronic devises to OEMs, or their contract manufacturers worldwide, that either package our products as accessories “in box” together with their branded product offerings or sell them through their retail distribution channels. Our retail distribution division sources and sells smart-enabled furniture, hot tubs and various other products through online retailer websites to customers predominately located in the U.S. The effects of the COVID-19 pandemic continue to impact our business with higher historical costs for ocean freight and ground transportation, particularly from the Asia-Pacific region. We expect to see the benefits of declining ocean freight costs in future periods. Inflation, in part associated with the pandemic, continues to increase the cost of acquiring and retaining our employees and acquiring inventory. The instability of transportation costs and future inflation are still largely unknown but are expected to continue throughout Fiscal 2023. 18 The effects of COVID-19 may further impact our business in ways we cannot predict, and such impacts could be significant. The current economic conditions may continue to negatively impact our results of operations, cash flows and financial position in future periods as well as that of our customers, including their ability to pay for our services and to choose to allocate their budgets to new or existing projects which may or may not require our services. The long-term financial impact on our business cannot be reasonably estimated at this time. As a result, the effects of COVID-19 may not be fully reflected in our financial results until future periods. Until the effects of the pandemic and associated inflationary impact have fully receded, we expect business conditions to remain challenging. In response to these challenges, we will continue to focus on those factors that we can control: closely managing and controlling our expenses and inventory levels; aligning our design and development schedules with demand in a proactive manner to minimize our cash operating costs; pursuing further improvements in the productivity and effectiveness of our development, selling and administrative activities and, where appropriate, taking advantage of opportunities to enhance our business growth and strategy. Variability of Revenues and Results of Operations A significant portion of our revenue is concentrated with several large customers, some of which are the same and some of which change over time. Orders from some of these customers can be highly variable, with short lead times, which can cause our quarterly revenues, and consequently our results of operations, to vary over a relatively short period of time. Critical Accounting Policies and Estimates We discussed the material accounting policies that are critical in making the estimates and judgments in our Annual Report on Form 10-K for the fiscal year ended September 30, 2022, under the caption “Management’s Discussion and Analysis—Critical Accounting Policies and Estimates”. There has been no material change in critical accounting policies or estimates during the period covered by this report. Recent Accounting Pronouncements For information on recent accounting pronouncements and impacts, see Note 2 to the unaudited condensed consolidated financial statements. RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED DECEMBER 31, 2022 COMPARED TO THE THREE MONTHS ENDED DECEMBER 31, 2021 Consolidated Results The table below summarizes our consolidated results of operations for the 2023 Quarter as compared to the 2022 Quarter: Consolidated Results of Operations 2023 Quarter 2022 Quarter Change ($) Change (%) Revenues, net $ 10,810,000 $ 11,614,000 $ (804,000 ) (6.9% ) Cost of sales 8,891,000 8,995,000 (104,000 ) (1.2% ) Gross profit 1,919,000 2,619,000 (700,000 ) (26.7% ) Sales and marketing expenses 690,000 738,000 (48,000 ) (6.5% ) General and administrative expenses 1,696,000 1,667,000 29,000 1.7% (Loss)/income from operations (467,000 ) 214,000 (681,000 ) (318.2% ) Other (income)/expense, net (37,000 ) 34,000 (71,000 ) (208.8% ) Provision for income taxes – – – – Net (loss)/income $ (430,000 ) $ 180,000 $ (610,000 ) (338.9% ) 19 The discussion that follows below provides further details about our results of operations for the 2023 Quarter as compared to the 2022 Quarter. Net revenues declined in the OEM and retail distribution segments, but these declines were partially offset by higher revenues in the design segment. Our gross profit decreased across all segments and our gross margin declined from 22.6% in the 2022 Quarter to 17.8% in the 2023 Quarter, driven by continued pricing pressures from our customers, higher importation and logistics costs and inflation. Management believes there will be continued volatility in OEM and retail distribution cost of sales for the remainder of Fiscal 2023. Sales and marketing expenses decreased in the 2023 Quarter primarily due to a decrease in advertising costs and sales commissions in the OEM and retail distributions segments, partially offset by higher sales related expenses in our design segment. Sales and marketing as a percentage of revenues remained flat at 6.4% in the 2023 Quarter. If revenues from the retail segment grow to comprise a larger portion of the overall business, management expects sales and marketing costs, both in total and as a percentage of revenues, to increase in future periods. General and administrative expenses increased in the 2023 Quarter, primarily related to increases in corporate expenses, which were partially offset by declines in design segment expenses. These increase in corporate expenses were primarily driven by higher payroll costs and professional fees, partially offset by lower equity compensation for non-employee board members. Management continues to monitor the various components of general and administrative expenses and how these costs are affected by inflationary and other factors. We intend to adjust these costs as needed based on the overall needs of the business. We recorded net other income of $37,000 in the 2023 Quarter compared to net other expense of $34,000 in the 2022 Quarter. The variance is due to fair value adjustments of $40,000 in the 2023 Quarter to reduce to the fair value of the earnout consideration related to the Kablooe acquisition, $18,000 of net duty drawback income received in the 2023 Quarter, foreign currency fluctuations and a decrease in interest expense resulting from a reduction in the amount of debt outstanding. We generated a net loss of $430,000 and net income of $180,000 in the 2023 Quarter and 2022 Quarter, respectively. We maintain significant net operating loss carryforwards and do not recognize a significant income tax expense or benefit as our deferred tax provision is typically offset by a full valuation allowance on our net deferred tax asset. Consolidated basic and diluted (loss)/earnings per share were $(0.04) and $0.02 for the 2023 Quarter and the 2022 Quarter, respectively. Segment Results The discussion that follows below provides further details about the results of operations for each segment as compared to the prior year quarter. Segment Results of Operations OEM Distribution Retail Distribution Design Corporate Expenses Consolidated 2023 Quarter revenues $ 4,377,000 $ 1,057,000 $ 5,376,000 $ – $ 10,810,000 2022 Quarter revenues 5,242,000 1,392,000 4,980,000 – 11,614,000 Change $ (865,000 ) $ (335,000 ) $ 396,000 $ – $ (804,000 ) 2023 Quarter operating income/(loss) $ 112,000 $ (326,000 ) $ 433,000 $ (686,000 ) $ (467,000 ) 2022 Quarter operating income/(loss) 497,000 (228,000 ) 585,000 (640,000 ) 214,000 Change $ (385,000 ) $ (98,000 ) $ (152,000 ) $ (46,000 ) $ (681,000 ) 20 OEM Distribution Segment Net revenues in the OEM distribution segment decreased from lower sales volume from both diabetic customers as well as other OEM customers. As consumer demand increases for diabetic testing products which require no carrying case, we expect diabetic product sales to continue to represent a smaller portion of our OEM distribution revenue. In March 2023, a contract with one of our major diabetic customers will expire. Due to increased pricing pressures, we will not be extending our contract with this customer. Revenue from this customer represented 12% of our consolidated net revenues in both the 2023 Quarter and the 2022 Quarter. We expect the loss of this customer to cause a significant decline in OEM distribution segment revenues in future periods. The following tables set forth revenues by product line of our OEM distribution segment customers for the periods indicated: OEM Revenues by Product Line 2023 Quarter 2022 Quarter Change ($) Change (%) Diabetic products $ 3,985,000 $ 4,234,000 $ (249,000 ) (5.9% ) Other products 392,000 1,008,000 (616,000 ) (61.1% ) Total net revenues $ 4,377,000 $ 5,242,000 $ (865,000 ) (16.5% ) Diabetic Product Revenues Our OEM distribution segment manufactures to the order of, and sells carrying cases for, blood glucose diagnostic kits directly to OEMs (or their contract manufacturers). The OEM customer or its contract manufacturer packages our carry cases “in box” as a custom accessory for the OEM’s blood glucose testing and monitoring kits, or to a lesser extent, sells them through their retail distribution channels. Revenues from diabetic products decreased due to lower volumes in the 2023 Quarter related to timing of orders relative to our fiscal quarters and the loss of one product to a competitor. These decreases were partially offset by an increase in demand from another customer, which was also timing related. As mentioned above, management believes that revenues from diabetic customers will decline in future periods. Revenues from diabetic products represented 91% of net revenues for the OEM distribution segment in the 2023 Quarter compared to 81% in the 2022 Quarter. Other Product Revenues Our OEM distribution segment also sources and sells cases and protective solutions for a diverse array of portable electronic and non-electronic products (such as sporting and recreational products, bar code scanners, GPS devices, tablets and firearms) on a made-to-order basis that are customized to fit the products sold by our OEM customers. Revenues from other products decreased due to lower sales volume with several existing customers, partially driven by the delayed rollout of certain customer product lines and reduced demand from some customers. We will continue to focus on our sales and sales support teams in our continued efforts to expand and diversify our other products customer base. 21 Operating Income Operating income for the OEM distribution segment decreased and operating income margin decreased from 9.5% in the 2022 Quarter to 2.6% in the 2023 Quarter, driven by lower gross margins due to lower revenues and a shift in the mix of revenue in each period. While revenues decreased in both diabetic and other products, a higher portion of revenue in the 2023 Quarter was generated from sales to diabetic customers, which yield a lower gross margin, while a lower portion of revenue was generated from other OEM customers, which yield a higher gross margin. The cost of importing all products from China has increased and both the diabetic and other OEM product lines have experienced pricing pressures from customers. Considering the loss of a significant diabetic customer and expected performance in the OEM and retail distribution segments, the Company is currently assessing the terms of its sourcing agreement with Forward China, which is scheduled to expire on October 22, 2023 (See Note 8 to the condensed consolidated financial statements). The Company and Forward China have agreed to begin negotiations on a new sourcing agreement early in the third quarter of Fiscal 2023. While we believe a new agreement will be reached, we cannot provide any assurances that we will be successful. If an agreement cannot be reached, which could have a significant impact on the Company’s operations, we will look at other alternatives for our OEM and retail distribution businesses prior to the expiration of the agreement. Retail Distribution Segment Net revenues decreased in the 2023 Quarter primarily due to a reduction in sales volume with one existing retailer, which was partially offset by new business and higher sales volumes from other retailers. As the cost of products increases and inflation continues to reduce consumer spending, profitability becomes more challenging in the retail segment. We plan to focus our sales and sales support teams on efforts to match our product offerings with consumer demand, sell off slow-moving inventory to reduce storage and other inventory holding costs, strategically increase the volume of revenue from more profitable products and expand these product offerings through additional retailer websites. The rising cost of freight, storage and other logistics services outpaced revenue leading to a decline in gross margin from the 2022 Quarter to the 2023 Quarter. This was partially offset by lower sales and marketing expenses driven by lower sales commissions resulting from the decrease in revenue. The operating loss margin increased from 16.4% in the 2022 Quarter to 30.8% in the 2023 Quarter. Management continues to evaluate plans to reduce costs in efforts to improve operating results in the retail distribution segment. Design Segment The increase in net revenues in the design segment was driven by an increase in projects from new and existing customers, which was partially offset by declines in revenues from certain prior year customers. Operating income for the design segment decreased and operating income margin decreased from 11.7% in the 2022 Quarter to 8.1% in 2023 Quarter. The impact of higher direct labor costs driven by inflationary pressures, coupled with higher sales and marketing expenses, was slightly offset by better utilization and increased billing rates. LIQUIDITY AND CAPITAL RESOURCES Our primary source of liquidity is our operations. The primary demand on our working capital has historically been (i) operating losses, (ii) repayment of debt obligations, and (iii) any increases in accounts receivable and inventories arising in the ordinary course of business. Historically, our sources of liquidity have been adequate to satisfy working capital requirements arising in the ordinary course of business. At December 31, 2022, our working capital was $3,919,000 compared to $4,359,000 at September 30, 2022, the decrease primarily due to higher payables, partially offset by higher accounts receivable balances. At January 31, 2023, we had approximately $2,100,000 cash on hand and $1,300,000 available under our line of credit with a bank which matures May 31, 2023. As this line of credit has been renewed on multiple prior occasions, management expects it will be renewed again. Considering the loss of a significant OEM distribution segment customer (see Note 5 to the condensed consolidated financial statements) and the retail distribution segment operating losses, management is planning to evaluate the Company’s cost structure and implement cost cutting initiatives as deemed necessary. 22 Forward China, our largest vendor and an entity owned by our Chairman of the Board and Chief Executive Officer, holds a $1,600,000 promissory note (the “FC Note”) issued by us which matures on December 31, 2024 (see Note 8 to the condensed consolidated financial statements). The balance of the FC Note was reduced to $1,350,000 after we made principal payments of $250,000 through December 31, 2022. Although the FC Note has been extended on multiple occasions to assist us with our liquidity position, we plan on funding the repayment at maturity using existing cash balances and/or obtaining an additional credit facility as deemed necessary. Additionally, Forward China has extended payment terms on our outstanding payables due to them when necessary. We can provide no assurance that (i) Forward China will extend the FC Note again if we request an extension, (ii) Forward China will continue to extend payment terms on outstanding payables when we need them, or (iii) any additional credit facility will be available on terms acceptable to us or at all. We anticipate that our liquidity and financial resources for the 12 months following the date of this report will be adequate to manage our operating and financial requirements. If we have the opportunity to make a strategic acquisition (as we have in the past with the acquisitions of IPS and Kablooe) or an investment in a product or partnership, we may require additional capital beyond our current cash balance to fund the opportunity. If we seek to raise additional capital, there is no assurance that we will be able to raise funds on terms that are acceptable to us or at all. In the current environment of rising interest rates, any future borrowing is expected to result in higher interest expense. Although we do not anticipate the need to purchase additional material capital assets in order to carry out our business, it may be necessary for us to purchase equipment and other capital assets in the future, depending on need. Cash Flows During the 2023 Quarter and 2022 Quarter, our sources and uses of cash were as follows: Operating Activities During the 2023 Quarter, cash used in operating activities of $149,000 resulted from a net loss of $430,000, an increase in accounts receivable of $994,000, an increase in inventories of $338,000, a decrease in accrued expenses and other current liabilities of $459,000 and the net change in other operating assets and liabilities of $73,000, partially offset by an increase in accounts payable and amounts due to Forward China of $2,070,000 and non-cash expenses of $75,000 related to fair value adjustments, depreciation, amortization, share-based compensation and bad debt expense. During the 2022 Quarter, cash provided by operating activities of $1,138,000 primarily resulted from net income of $180,000, an increase in accounts payable, accrued expenses and amounts due to Forward China of $1,276,000, an increase in deferred income of $565,000 and non-cash expenses of $112,000 for depreciation, amortization and share-based compensation, partially offset by an increase in inventories of $910,000 and the net change in other operating assets and liabilities of $85,000. Investing Activities Cash used in investing activities in the 2023 Quarter and the 2022 Quarter of $45,000 and $66,000, respectively, resulted from purchases of property and equipment. Financing Activities Cash used in financing activities in the 2023 Quarter and the 2022 Quarter of $50,000 consisted of principal payments on the promissory note held by Forward China. Related Party Transactions For information on related party transactions and their financial impact, see Note 8 to the unaudited condensed consolidated financial statements contained herein. 23 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable.