Forward Industries, Inc. 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this report on Form 10-K. The following discussion and analysis compares our results of operations for the year ended September 30, 2023 (“Fiscal 2023”) with those for the year ended September 30, 2022 (“Fiscal 2022”). All dollar amounts and percentages presented herein have been rounded to approximate values. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to those set forth under “Risk Factors.” Cautionary statement regarding Forward-Looking Statements This report includes “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. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular, the risks discussed under the caption "Risk Factors" in Item 1A of this report and those discussed in other documents we file with the SEC. 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. 17 Business Overview Forward Industries, Inc. is a global design, sourcing and distribution Company serving top tier medical and technology customers worldwide. 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 devices 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. Considering the recurring losses incurred by the retail segment, in July 2023, the Company decided to cease operations of our retail distribution segment and we are presenting the results of operations for this segment within discontinued operations in the current and prior periods presented herein. The discontinuation of the retail segment represents a strategic shift in the Company’s business. The primary assets of the retail segment are inventory and accounts receivable. The Company expects to sell, liquidate, or otherwise dispose of remaining retail inventory by June 30, 2024, and to collect remaining retail accounts receivable by the end of Fiscal 2024. After this time, we expect to have no further significant continuing involvement with the retail distribution segment. The inventory of the retail segment is presented as discontinued assets held for sale on the balance sheets at September 30, 2023 and 2022 and the results of operations for the retail segment have been classified as discontinued operations on the consolidated statements of operations for the years ended September 30, 2023 and 2022. All information and results in this annual report on Form 10-K exclude the discontinued operations unless otherwise noted. See Note 3 to our consolidated financial statements for additional information on discontinued operations. On May 11, 2023, the U.S. Department of Health and Human Services declared the end of the Public Health Emergency for COVID-19; however, the effects of COVID-19 continue to linger throughout the global economy and our businesses. Though the severity of COVID-19 has subsided, new variants, or the outbreak of a new pathogen, could interrupt business, cause renewed labor and supply chain disruptions, and negatively impact the global and US economy, which could materially and adversely impact our businesses. Additionally, see Part I, Item 1A “Risk Factors” for a description of the material risks we currently face in connection with COVID-19. 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 have identified the accounting policies and significant estimation processes below as critical to our business operations and the understanding of our results of operations. The discussion below is not intended to be comprehensive. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP, with no need for management’s judgment. In other cases, management is required to exercise judgment in the application of accounting principles with respect to particular transactions. The impact and any associated risks related to these policies on our business operations are discussed throughout this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” where such policies affect reported and expected financial results. For a detailed discussion of the applications of these and other accounting policies, see “Item 8. Financial Statements and Supplementary Data” in this report. The preparation of our consolidated financial statements requires us to make estimates and assumptions that are believed to be reasonable under the circumstances. There can be no assurance that actual results will not differ from those estimates and such differences could be significant. Revenue Recognition OEM Distribution Segment The OEM distribution segment recognizes revenue when: (i) finished goods are shipped to its customers (in general, these conditions occur at either point of shipment or point of destination, depending on the terms of sale and transfer of control); (ii) there are no other deliverables or performance obligations; and (iii) there are no further obligations to the customer after the title of the goods has transferred. If the Company receives consideration before achieving the criteria previously mentioned, it records a contract liability, which is classified as a component of deferred income in the accompanying consolidated balance sheets. 18 Design Segment The design segment applies the “cost to cost” and “right to invoice” methods of revenue recognition to its contracts with customers. The design segment typically engages in two types of contracts: (i) time and material and (ii) fixed price. The Company recognizes revenue over time on its time and material contracts utilizing a “right to invoice” method. Revenues from fixed price contracts that require performance of services that are not related to the production of tangible assets are recognized by using cost inputs to measure progress toward the completion of its performance obligations, or the “cost to cost” method. Revenues from fixed price contracts that contain specific deliverables are recognized when the performance obligation has been satisfied or the transfer of goods to the customer has been completed and accepted. Recognized revenues that will not be billed until a later date, or contract assets, are recorded as an asset and classified as a component of accounts receivable in the accompanying consolidated balance sheets. Contracts where collections to date have exceeded recognized revenues, or contract liabilities, are recorded as a liability and classified as a component of deferred income in the accompanying consolidated balance sheets. Segment Reporting As a result of discontinuing our retail reportable segment, we now have two reportable segments: OEM distribution and design. The OEM distribution segment sources and distributes carrying cases and other accessories for medical monitoring and diagnostic kits and a variety of other portable electronic and non-electronic devices directly to OEMs or their contract manufacturers worldwide. The design segment consists of two operating segments (IPS and Kablooe, which have been aggregated into one reportable segment) that provide a full spectrum of hardware and software product design and engineering services to customers predominantly located in the U.S. Our chief operating decision maker (“CODM”) regularly reviews revenue and operating income for each segment to assess financial results and allocate resources. For our OEM distribution segment, we exclude general and administrative and general corporate expenses from its measure of profitability as these expenses are not allocated to the segments and therefore not included in the measure of profitability used by the CODM. For the design segment, general and administrative expenses directly attributable to that segment are included in its measure of profitability as these expenses are included in the measure of its profitability reviewed by the CODM. We do not include intercompany activity in our segment results to be consistent with the information that is presented to the CODM. Segment assets consist of accounts receivable and inventory, which are regularly reviewed by the CODM, as well as goodwill and intangible assets resulting from design segment acquisitions (see Note 16 to the consolidated financial statements). Inventory Valuation Inventories consist primarily of finished goods and are stated at the lower of cost (determined by the first-in, first-out method) or net realizable value. Based on management’s estimates, an allowance is made to reduce excess, obsolete, or otherwise unsellable inventories to net realizable value. The allowance is established through charges to cost of sales in the Company’s consolidated statements of operations. In determining the adequacy of the allowance, management’s estimates are based upon several factors, including analyses of inventory levels, historical loss trends, sales history and projections of future sales demand. The Company’s estimates of the allowance may change from time to time based on management’s assessments, and such changes could be material. Goodwill and Intangible Assets We review goodwill for impairment at least annually, or more often if triggering events occur. We have two reporting units with goodwill (the IPS and Kablooe operating segments) and we perform our annual goodwill impairment test on September 30, the end of the fiscal year, or upon the occurrence of a triggering event. We have the option to perform a qualitative assessment to determine if an impairment is more likely than not to have occurred. If we can support the conclusion that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then we would not need to perform a quantitative impairment test for the reporting unit. If we cannot support such a conclusion or do not elect to perform the qualitative assessment, then we will perform the quantitative impairment test by comparing the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, no impairment charge is recognized. If the fair value of the reporting unit is less than its carrying amount, an impairment charge will be recognized for the amount by which the reporting unit’s carrying amount exceeds its fair value. A significant amount of judgment is required in performing goodwill impairment tests including estimating the fair value of a reporting unit. There were no indications of goodwill impairment in Fiscal 2023 or Fiscal 2022. 19 Our intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In assessing the recoverability of our intangible assets, we must make estimates and assumptions regarding future cash flows and other factors to determine the fair value of the respective assets. These estimates and assumptions could have a significant impact on whether an impairment charge is recognized and the magnitude of any such charge. Fair value estimates are made at a specific point in time, based on relevant information. These estimates are subjective in nature and involve uncertainties and matters of significant judgments and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. If these estimates or material related assumptions change in the future, we may be required to record impairment charges related to our intangible assets. There were no indications of impairment of intangible assets in Fiscal 2023 or 2022. Recent Accounting Pronouncements In November 2019, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2019-11, “Codification Improvements to Topic 326, Financial Instruments – Credit Losses.” ASU 2019-11 is an accounting pronouncement that provides clarity to and amends earlier guidance on this topic and would be effective concurrently with the adoption of such earlier guidance. This pronouncement is effective for us for fiscal years beginning after December 15, 2022 and interim periods within those fiscal years and is not expected to have a material impact on our consolidated financial statements. RESULTS OF OPERATIONS FOR FISCAL 2023 COMPARED TO FISCAL 2022 Consolidated Results The table below summarizes our consolidated results of continuing operations for Fiscal 2023 as compared to Fiscal 2022: Consolidated Results of Operations Fiscal 2023 Fiscal 2022 Change ($) Change (%) Net revenues $ 36,688,000 $ 38,207,000 $ (1,519,000 ) (4.0% ) Cost of sales 28,324,000 29,407,000 (1,083,000 ) (3.7% ) Gross profit 8,364,000 8,800,000 (436,000 ) (5.0% ) Sales and marketing expenses 1,663,000 1,478,000 185,000 12.5% General and administrative expenses 6,541,000 6,734,000 (193,000 ) (2.9% ) Operating income 160,000 588,000 (428,000 ) (72.8% ) Other expense/(income), net (19,000 ) 135,000 (154,000 ) (114.1% ) Income tax provision 20,000 3,000 17,000 566.7% Income from continuing operations $ 159,000 $ 450,000 $ (291,000 ) (64.7% ) The decrease in net revenues in Fiscal 2023 was primarily driven by a decline in revenue in the OEM distribution segment, which was partially offset by revenue growth in the design segment. Gross profit decreased and gross margin declined from 23.0% in Fiscal 2022 to 22.8% in Fiscal 2023. This decrease was mainly driven by the OEM distribution segment because of continued pricing pressures from our customers, high product, importation and logistics costs and inflation. Sales and marketing expenses increased primarily due to higher sales related expenses in the design segment, partially offset by lower marketing related overhead in our OEM distribution segment. Sales and marketing expenses as a percentage of revenue increased from 3.9% in Fiscal 2022 to 4.5% in Fiscal 2023. General and administrative expenses decreased in Fiscal 2023, primarily related to bad debt recoveries in the design segment and lower non-employee directors share-based compensation expense, partially offset by higher professional fees and personnel costs. 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. 20 We reported other income of $19,000 in Fiscal 2023 as compared to other expense of $135,000 in Fiscal 2022. The variance is due to fair value adjustments of $70,000 in the 2023 Period 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 Period, interest income from interest bearing deposits, foreign currency fluctuations and a decrease in interest expense resulting from a reduction in the amount of debt outstanding. In Fiscal 2023, we recorded a tax provision of $20,000, generated income from continuing operations before income taxes of $179,000 and had an effective tax rate of 11.2%. In Fiscal 2022, we recorded a tax provision of $3,000, generated income from continuing operations before income taxes of $452,000 and had an effective tax rate of 0.5%. Consolidated basic and diluted earnings per share from continuing operations was $0.02 and $0.04 for Fiscal 2023 and Fiscal 2022, respectively. Segment Results The discussion that follows below provides further details about the results of operations for each continuing segment as compared to the prior year. Segment Results of Operations OEM Distribution Design Corporate Expenses Consolidated Fiscal 2023 revenues $ 14,002,000 $ 22,686,000 $ – $ 36,688,000 Fiscal 2022 revenues 18,036,000 20,171,000 – 38,207,000 Change $ (4,034,000 ) $ 2,515,000 $ – $ (1,519,000 ) Fiscal 2023 operating income $ 440,000 $ 2,182,000 $ (2,462,000 ) $ 160,000 Fiscal 2022 operating income 905,000 2,148,000 (2,465,000 ) 588,000 Change $ (465,000 ) $ 34,000 $ 3,000 $ (428,000 ) OEM Distribution Net revenues in the OEM distribution segment decreased from lower sales volume from both diabetic customers and 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 expired. Due to increased pricing pressures, we did not extend our contract with this customer. Revenue from this customer represented approximately 12% of our consolidated net revenues in the 2022 Period. 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 Fiscal 2023 Fiscal 2022 Change ($) Change (%) Diabetic products $ 11,805,000 $ 15,403,000 $ (3,598,000 ) (23.4% ) Other products 2,197,000 2,633,000 (436,000 ) (16.6% ) Total net revenues $ 14,002,000 $ 18,036,000 $ (4,034,000 ) (22.4% ) Diabetic Product Revenues Our OEM distribution segment sources 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. 21 Revenues from diabetic products decreased due to the loss of a major customer in March 2023, lower demand from one major customer and the loss of one product to a competitor. These decreases were partially offset by an increase in demand from another customer, which was timing related. As mentioned above, management believes that revenues from diabetic customers will continue to decline. Revenues from diabetic products represented 84% of net revenues for the OEM distribution segment in Fiscal 2023 compared to 85% in Fiscal 2022. 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 some 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. Operating Income Operating income for the OEM distribution segment declined and operating income margin declined to 3.1% in Fiscal 2023, compared to 5.0% in Fiscal 2022, driven by lower gross margins and a shift in the mix of revenue. While revenues decreased in both diabetic and other products, a large portion of the decrease in diabetic revenue was from more profitable products, thus driving overall gross margins down. 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. The decline in gross margin was partially mitigated by lower selling and marketing costs related to OEM sales commissions. We continue to work on expanding our product offerings to include higher margin products and enhancing our sales efforts to grow revenue and increase gross profit. Considering the loss of a significant diabetic customer, management reduced its OEM distribution segment sales and marketing personnel in March 2023 and reduced its sourcing fee with Forward China. Effective April 1, 2023, the Company and Forward China agreed to reduce the fixed portion of the sourcing fee from $100,000 to $83,333 per month for the remaining term of the sourcing agreement, which resulted in cash savings of $100,000 for Fiscal 2023. The Company and Forward China signed a new Supply Agreement effective October 2023, which further reduced the fixed portion of the sourcing fee to $65,833 per month. See Note 14 to the consolidated financial statements for more information on the sourcing agreement with Forward China. Design Segment The increase in net revenues in the design segment was driven by an increase in revenue from one major customer, coupled with 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 increased slightly but operating income margin decreased from 10.6% in Fiscal 2022 to 9.6% in Fiscal 2023. 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 and lower general and administrative expenses, driven by bad debt recoveries. 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 September 30, 2023, our working capital was $26,000 compared to $1,209,000 at September 30, 2022, which excludes discontinued assets held for sale. The decrease was primarily due to higher payables and accrued expenses and a decrease in accounts receivable, partially offset by an increase in cash. At November 30, 2023, we had approximately $3,800,000 cash on hand and $1,300,000 available under our line of credit with a bank which matures May 31, 2024. There are no assurances this line of credit will extend beyond May 31, 2024. 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 14 to the consolidated financial statements). The balance of the FC Note was reduced to $1,100,000 after we made principal payments of $500,000 in Fiscal 2023 and Fiscal 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 additional extensions as deemed necessary. Additionally, Forward China has extended payment terms on our outstanding payables due to them when necessary. At September 30, 2023, our accounts payable due to Forward China was approximately $8,246,000. In connection with the new sourcing agreement (see Note 14 to the consolidated financial statements) and in order to preserve our future liquidity, Forward China agreed to limit the amount of outstanding payables it would seek to collect from us to $500,000 in any 12-month period, which we agreed to pay within 30 days of any such request. This agreement pertains only to payables that were outstanding at October 30, 2023 of $7,365,000. Purchases from Forward China made after October 30, 2023, are not covered by this agreement and are expected to be paid according to normal payment terms. We can provide no assurance that (i) Forward China will extend the FC Note again if we request an extension, (ii) Forward China will extend additional payment terms on any payables not covered by the agreement, if needed, 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 any 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 Fiscal 2023 and Fiscal 2022, our sources and uses of cash were as follows: Operating Activities During Fiscal 2023, cash provided by operating activities of $1,041,000 resulted from a decrease in discontinued assets held for sale of $2,642,00, an increase in accounts payable and amounts due to Forward China of $783,000, an increase in accounts receivable of $495,000, non-cash charges for depreciation, amortization, share-based compensation and bad debt expense of $481,000 and the net change in other operating assets and liabilities of $427,000, partially offset by the $70,000 non-cash adjustment to the fair value of the Kablooe earnout consideration and the net loss of $3,737,000. During Fiscal 2022, cash provided by operating activities of $1,535,000 resulted from an increase in accounts payable and amounts due to Forward China of $1,856,000, a decrease in accounts receivable of $953,000, non-cash charges for depreciation, amortization, share-based compensation and bad debt expense of $775,000, an increase in accrued expenses of $624,000 and the net change in other operating assets and liabilities of $552,000, partially offset by the net loss of $1,378,000 and an increase in discontinued assets held for sale of $1,847,000. Investing Activities In Fiscal 2023 and Fiscal 2022, cash used for investing activities of $136,000 and $170,000, respectively, resulted from purchases of property and equipment. Financing Activities In Fiscal 2023 and Fiscal 2022, cash used in financing activities of $300,000 and $200,000, respectively, consisted of principal payments on the promissory note held by Forward China. 23 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and notes thereto included in this Annual Report may be found beginning on page F-1 of this Annual Report on Form 10-K. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None.