Algorhythm Holdings, Inc. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS The objective of this Management’s Discussion and Analysis of Financial Condition and Results of Operation is to allow investors to view the Company from management’s perspective, considering items that would have a material impact on future operations. The following discussion should be read in conjunction with the condensed consolidated financial statements and notes included elsewhere in this quarterly report. This document contains certain forward-looking statements including, among others, anticipated trends in our financial condition and results of operations and our business strategy. (See Part II, Item 1A, “Risk Factors “). These forward-looking statements are based largely on our current expectations and are subject to a number of risks and uncertainties. Actual results could differ materially from these forward-looking statements. Statements included in this quarterly report that do not relate to present or historical conditions are called “forward-looking statements.” Such forward-looking statements involve known and unknown risks and uncertainties and other factors that could cause actual results or outcomes to differ materially from those expressed in, or implied by, the forward-looking statements. Forward-looking statements may include, without limitation, statements relating to our plans, strategies, objectives, expectations, and intentions. Words such as “believes,” “forecasts,” “intends,” “possible,” “estimates,” “anticipates,” “expects,” “plans,” “should,” “could,” “will,” and similar expressions are intended to identify forward-looking statements. Our ability to predict or project future results or the effect of events on our operating results is inherently uncertain. Forward-looking statements should not be read as a guarantee of future performance or results and will not necessarily be accurate indications of the times at, or by which, such performance or results will be achieved. Important factors to consider in evaluating such forward-looking statements include, but are not limited to: (i) changes in external factors or in our internal budgeting process which might impact trends in our results of operations; (ii) unanticipated working capital or other cash requirements; (iii) changes in our business strategy or an inability to execute our strategy due to unanticipated changes in the industries in which we operate; and (iv) the effects of adverse general economic conditions, both within the United States and globally, (v) vendor price increases and decreased margins due to competitive pricing during the economic downturn (vi)various competitive market factors that may prevent us from competing successfully in the marketplace and (vii) other factors described in the risk factors section of our Annual Report on Form 10-K, this Quarterly Report on 10-Q, or in our other filings made with the SEC. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s opinions only as of the date hereof. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. OVERVIEW The Singing Machine Company, Inc., a Delaware corporation (the “Company,” “SMC”, “The Singing Machine”), and wholly-owned subsidiaries SMC (Comercial Offshore De Macau) Limitada (“Macau Subsidiary”), SMC Logistics, Inc. (“SMCL”), SMC-Music, Inc. (“SMCM”) and SMC (HK) Limited (“SMH”), are primarily engaged in the development, marketing, and sale of consumer karaoke audio equipment, accessories and musical recordings. The products are sold directly to distributors and retail customers. Our products are sold throughout North America, Europe and Australia primarily through major mass merchandisers and warehouse clubs, on-line retailers and to a lesser extent department stores, lifestyle merchants, direct mail catalogs and showrooms, music and record stores, and specialty stores. Representative customers include Amazon, Best Buy, BJ’s Wholesale, Costco, Sam’s Club, Target, and Wal-Mart. Our business has historically been subject to seasonal fluctuations causing our revenues to vary from quarter to quarter and between the same periods in different fiscal years. Our products are manufactured for the most part based on the purchase indications of our customers. We are uncertain of how significantly our business would be harmed by a prolonged economic recession, but we anticipate that continued contraction of consumer spending would negatively affect our revenues and profit margins. Sales of consumer electronics and toy products in the retail channel are highly seasonal, with a majority of retail sales occurring during the period from September through December in anticipation of the holiday season, which includes Christmas. A substantial majority of our sales occur during the second quarter ending September 30 and the third quarter ending December 31. Sales in our second and third quarter, combined, accounted for approximately 81% and 86% of net sales in fiscal 2022 and 2021, respectively. Unfavorable global or regional economic conditions may be triggered by numerous developments beyond our control, including the recent inflation in the United States, geopolitical events, health crises such as the COVID-19 pandemic, and other events that trigger economic volatility on a global or regional basis. Those types of unfavorable economic conditions could adversely affect our business and financial results. In particular, a significant deterioration in economic conditions, including economic slowdowns or recessions, increased unemployment levels, inflationary pressures or disruptions to credit and capital markets, could lead to decreased consumer confidence and consumer spending more generally, thus reducing consumer demand for our products. We are also impacted by our entire supply chain. While we have experienced a significant decrease in container costs for inbound containers due to decreased demand in general, we are continuing to see increases in drayage costs due to cost of fuel increases and other surcharges due to inflation. The cost of labor, employee benefits, pallets and warehouse supplies and other logistics related costs continue to increase at record rates. Such heightened inflationary levels may negatively impact consumer disposable income and discretionary spending and, in turn, reduce consumer demand for our products and increase our costs. 22 RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, certain items related to our consolidated statements of income as a percentage of net sales for the three and nine months ended December 31, 2022 and 2021: For Three Months Ended For the Nine Months Ended December 31, 2022 December 31, 2021 December 31, 2022 December 31, 2021 Net Sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of Goods Sold 81.9 % 75.0 % 76.5 % 77.1 % Gross Profit 18.1 % 25.0 % 23.5 % 22.9 % Operating Expenses Selling expenses 15.8 % 6.6 % 7.3 % 6.1 % General and administrative expenses 33.7 % 10.1 % 20.0 % 12.0 % Depreciation and amortization 0.7 % 0.3 % 0.0 % 0.4 % Total Operating Expenses 50.1 % 17.0 % 27.3 % 18.5 % (Loss) Income from Operations -32.1 % 8.0 % -3.8 % 4.4 % Other (Expenses) Income Gain - related party 0.0 % 0.0 % 0.0 % 0.0 % Gain from Payroll Protection Plan loan forgiveness 0.0 % 0.0 % 0.0 % 1.0 % Gain from settlement of accounts payable 0.7 % 0.0 % 0.1 % 0.5 % Loss from extinguishment of debt -2.6 % 0.0 % -0.5 % 0.0 % Interest expense -1.0 % -0.7 % -1.2 % -0.8 % Finance costs -0.2 % 0.0 % -0.1 % -0.1 % Total Other (Expenses) Income, net -3.1 % -0.7 % -1.7 % 0.6 % (Loss) Income Before Income Tax (Benefit) Provision -35.2 % 7.3 % -5.5 % 5.0 % Income Tax (Benefit) Provision 8.0 % -0.5 % 1.3 % -0.6 % Net (Loss) Income -27.2 % 6.8 % -4.2 % 4.4 % QUARTER ENDED DECEMBER 31, 2022 COMPARED TO THE QUARTER ENDED DECEMBER 31, 2021 NET SALES Net sales for the three months ended December 31, 2022 decreased to approximately $7,111,000 from approximately $21,244,000, a decrease of approximately $14,133,000 as compared to the three months ended December 31, 2021. We experienced a decrease in net sales to all of our major customers compared to the three months ended December 31, 2021. The decrease in net sales was largely due to two main factors: (1) our major customers began the holiday season with excess inventory that was held over from the previous year due to late delivery of shipments caused by significant supply chain issues experienced during the end of calendar year 2021 and early 2022 and (2) the news of economic recession, runaway inflation, and interest rate hikes dampened customers’ expectations for the holiday season which resulted in customers taking a very risk-adverse approach to buying and carrying inventory. Most of our customers either did not take some of the inventory they had committed to earlier in the year or required significant co-op promotion incentives on goods sold during the three months ended December 31, 2022. Co-op promotion incentives for the three months ended December 31, 2022 increased to approximately $1,138,000 or 16.0% of net sales as compared to approximately $795,000 or 3.7% of net sales for the three months ended December 31, 2021. GROSS PROFIT Gross profit for the three months ended December 31, 2022 decreased to approximately $1,291,000 from approximately $5,309,000 a decrease of approximately $4,018,000 as compared to the three months ended December 31, 2021. The decrease in net sales as explained in Net Sales above accounted for approximately $3,532,000 of the decrease with the remaining decrease due to a decrease in gross profit margin. Gross profit margin for the three months ended December 31, 2022 was 18.1% compared to 25.0% for the three months ended December 31, 2021, a decrease of 6.9 margin points. Co-op promotion incentives, as explained in Net Sales above, accounted for approximately $342,000 or 4.8 margin points of the gross margin decrease and there was an increase in inventory reserves of approximately $246,000 or 3.5 points of the gross margin decrease. These decreases were offset by approximately $102,000 or 1.5 margin point increase primarily due to lower landed product costs from decreased costs of shipping containers compared to the previous year. 23 OPERATING EXPENSES During the three months ended December 31, 2022, total operating expenses decreased to approximately $3,573,000 compared to approximately $3,616,000 during the three months ended December 31, 2021. This represents a decrease in total operating expenses of approximately $43,000 from the three months ended December 31, 2022. There was a decrease in selling expenses of approximately $281,000 primarily due to the decrease in sales as discussed in Net Sales offset by an increase of approximately $240,000 in general and administrative expenses. General and administrative expenses increased to approximately $2,395,000 during the three months ended December 31, 2022 compared to approximately $2,155,000 during the three months ended December 31, 2021, an increase of approximately $240,000. There was an increase in compensation expense of $400,000 related to a change of control and employment continuation agreement with the Chief Financial Officer. There was an increase in legal and professional expenses of approximately $164,000 which were primarily related to legal and professional costs associated with the arbitration settlement of the alleged employment practice violation lawsuit against a former temporary employee and other regulatory filings. These increases were offset by decreases in bad debt and repair reserves of approximately $388,000 with the remaining variance due to net reductions of other variable expenses. (LOSS) INCOME FROM OPERATIONS There was a loss from operations of approximately $2,282,000 for the three months ended December 31, 2022 compared to income from operations of approximately $1,694,000 for the three months ended December 31, 2021. The decrease in income from operations of approximately $3,976,000 was primarily due to the decrease in net sales and gross profit as explained above. OTHER EXPENSES Other expenses increased by approximately $55,000 to approximately $220,000 in other expenses for the three months ended December 31, 2022 compared to approximately $165,000 in other expenses, net for the three months ended December 31, 2021. During the three months ended December 31, 2022, there was a fee of approximately $183,000 for exiting the Intercreditor Revolving Credit Facility with Crestmark and IHC (See Note 7 – Financing) that was recorded as a loss from extinguishment of debt. This expense was offset by a decrease in interest expense of approximately $88,000 due to a more favorable interest rate with the new financing arrangement and a gain of approximately $49,000 from the forgiveness of accounts payable by Starlight R&D, Ltd and Starlight Consumer Electronics Co. Ltd. who were former related parties. INCOME TAXES For the three months ended December 31, 2022 and 2021, the Company recognized an income tax benefit of approximately $569,000 and an income tax provision of approximately $103,000, respectively, due to management’s best estimate of the Company’s full year effective tax rate of approximately 24% and 11%, respectively. NET (LOSS) INCOME For the three months ended December 31, 2022 there was a net loss of approximately $1,653,000 compared to net income of approximately $1,426,000 for the three months ended December 31, 2021. The decrease in net income was primarily due to the same reasons discussed in (Loss) Income from Operations. NINE MONTHS ENDED DECEMBER 31, 2022 COMPARED TO THE NINE MONTHS ENDED DECEMBER 31, 2021 NET SALES Net sales for the nine months ended December 31, 2022 decreased to approximately $35,916,000 from approximately $44,679,000, a decrease of approximately $8,763,000 as compared to the nine months ended December 31, 2021. We experienced a decrease in net sales to all of our major customers compared to the nine months ended December 31, 2021. The decrease in net sales was largely due to two main factors: (1) our major customers began the holiday season with excess inventory that was held over from the previous year due to late delivery of shipments caused by significant supply chain issues experienced during the end of calendar year 2021 and early 2022 and (2) the news of economic recession, runaway inflation, and interest rate hikes dampened customers’ expectations for the holiday season which resulted in customers taking a very risk-adverse approach to buying and carrying inventory. Most of our customers either did not take some of the inventory they had committed to earlier in the year or required significant co-op promotion incentives on goods sold during the three months ended December 31, 2022. Co-op promotion incentives for the nine months ended December 31, 2022 increased to approximately $2,158,000 or 6.0% of net sales as compared to approximately $1,805,000 or 4.0% of net sales for the nine months ended December 31, 2021. 24 GROSS PROFIT Gross profit for the nine months ended December 31, 2022 decreased to approximately $8,435,000 from approximately $10,215,000 a decrease of approximately $1,780,000 as compared to the same period in the prior year. The decrease in net sales as explained in Net Sales above accounted for approximately $2,003,000 of the decrease offset by an increase in gross profit margin contribution of approximately $223,000. Gross profit margin for the nine months ended December 31, 2022 was 23.5% compared to 22.9% for the nine months ended December 31, 2021, an increase of 0.6 gross margin points. There were increases in gross profit margin of approximately $1,234,000 or 3.4 margin points due to price increases and decreased landed costs for products due to decreasing costs of shipping container costs. These increases in gross profit margin were offset by gross profit margin decreases of approximately $353,000 or 1.0 margin points due to co-op promotion incentives as explained in Net Sales above and an increase in excess and obsolete inventory reserves of approximately $658,000 or 1.8 margin points of the gross margin decrease. OPERATING EXPENSES During the nine months ended December 31, 2022, total operating expenses increased to approximately $9,986,000 compared to approximately $8,261,000 during the nine months ended December 31, 2021. This represents an increase in total operating expenses of approximately $1,725,000 from the nine months ended December 31, 2021. There was an increase of approximately $1,830,000 in general and administrative expenses offset by a decrease in selling expenses of approximately $88,000 primarily due to the decrease in sales as discussed in Net Sales above. General and administrative expenses increased to approximately $7,183,000 during the nine months ended December 31, 2022 compared to approximately $5,353,000 during the nine months ended December 31, 2021, an increase of approximately $1,830,000. There was an increase in legal, professional, investor relations and stock transfer costs of approximately $601,000 primarily related to the public offering, Nasdaq up-listing, change in control issues, regulatory filings and preparation costs relating to the Credit Agreement with Fifth Third and arbitration settlement of the alleged employment practice violation lawsuit against a former temporary employee. There was an increase in compensation of approximately $517,000 primarily due to compensation for new members of the board of directors, and officers’ and employees’ incentive compensation, new hires as well as merit increases. There was an increase in compensation expense of $400,000 related to a change of control and employment continuation agreement with the Chief Financial Officer. There was an increase in travel expenses of approximately $153,000 which includes the participation in the Consumer Electronics Show in Las Vegas which we had not attended since the beginning of COVID-19. There were inflationary expenses increases of approximately $112,000 in our California warehouse operations with the remaining increase due to other expenses that have increased due to inflation. (LOSS) INCOME FROM OPERATIONS There was a loss from operations of approximately $1,551,000 for the nine months ended December 31, 2022 compared to income from operations of approximately $1,954,000 for the nine months ended December 31, 2021. The decrease in income from operations of approximately $3,505,000 was primarily due to the decrease in net sales and gross profit and increase in general and administrative expenses as explained above. OTHER (EXPENSES) INCOME Other expenses, net increased by approximately $868,000 to approximately $574,000 in other expenses, net for the nine months ended December 31, 2022 compared to approximately $294,000 in other income, net for the same period ended December 31, 2021. During the nine months ended December 31, 2022, there was a fee of approximately $183,000 for exiting the Intercreditor Revolving Credit Facility with Crestmark and IHC (See Note 7 – Financing) that was recorded as a loss from extinguishment of debt. During the nine months ended December 31, 2022 there was a gain of approximately $49,000 from the forgiveness of accounts payable by Starlight R&D, Ltd and Starlight Consumer Electronics Co. Ltd. who were former related parties. During the nine months ended December 31, 2022, there was an increase in interest expense of approximately $48,000. During the nine months ended December 31, 2021 there was a one-time gain from the forgiveness of the Payroll Protection Plan loan of approximately $448,000 and a gain from the settlement of accounts payable with one of our factories of $236,000 for a previous year’s damaged goods incident. INCOME TAXES For the nine months ended December 31, 2022 and 2021 the Company recorded an income tax benefit of approximately $472,000 and an income tax provision of approximately $249,000, respectively, due to management’s best estimate of the Company’s full year effective tax rate of approximately 24% and 11%, respectively. 25 NET (LOSS) INCOME For the nine months ended December 31, 2022 there was a net loss of approximately $1,653,000 compared to net income of approximately $2,000,000 for the same period a year ago. The decrease in net income was primarily due to the same reasons discussed in (Loss) Income from Operations, Other (Expense) Income and Income Taxes. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2022, the Company had cash on hand of approximately $2,795,000 as compared to cash on hand of approximately $7,375,000 on December 31, 2021. We had working capital of approximately $10,473,000 as of December 31, 2022. Net cash used in operating activities was approximately $2,264,000 for the nine months ended December 31, 2022. During the nine months ended December 31, 2022 there was an increase in accounts receivable of approximately $4,255,000 due to a seasonal increase in net sales and a seasonal decrease in accounts payable of approximately $3,258,000 primarily due to payment of factory invoices. These increases in net cash used in operating activities were offset by a seasonal decrease in inventory of approximately $2,780,000 and an increase in accrued expenses of approximately $1,502,000 primarily due to the increase in co-op promotion incentives granted to customers during the third quarter ended December 31, 2022. There was an increase in reserve for sales returns of approximately $1,945,000 which included an additional reserve of approximately $1,300,000 for anticipated overstock returns from one customer. Net cash used in operating activities was approximately $3,113,000 for the nine months ended December 31, 2021. During the nine months ended December 31, 2021 there was an increase in accounts receivable of approximately $10,124,000 due to a seasonal increase in sales and an increase in inventories of approximately $5,933,000 due to in-transit and receipt of inventory intended for peak season shipments but were received too late to ship due to global logistics issues. These increases in net cash used in operating activities were offset by an increase in in accounts payable and accrued expenses of approximately $4,531,000 due to delayed receipt of seasonal purchases of product for the peak season due to global logistics issues. There was a decrease in amounts due from Crestmark Bank of approximately $4,557,000 as cash collected in excess of amounts due on the revolving credit during the first quarter was used to pay for the seasonal increase in inventory. There was a seasonal increase in reserve for sales returns of approximately $1,962,000. Net cash used in investing activities for the nine months ended December 31, 2022 was approximately $149,000 as compared to approximately $78,000 used in investing activities for the same period ended a year ago and consisted primarily of purchases of molds and tooling for new products. Net cash provided by financing activities for the nine months ended December 31, 2022 was approximately $3,101,000 compared to cash provided by financing activities of approximately $10,170,000 for the same period ended of the prior year. In May 2022, we received net proceeds of approximately $3,363,000 from the public offering we executed in conjunction with our up-listing to Nasdaq as summarized in the next two paragraphs. In addition, during the nine months ended December 31, 2022, we received proceeds of approximately $1,144,000 from the exercise of pre-funded and common stock warrants. All proceeds were used for working capital. In October 2022, we exited our financing facility with Crestmark and IHC and entered into a new financing arrangement with Fifth Third Bank. We incurred an exit fee of approximately $183,000 for early termination of the financing facility with Crestmark and IHC. We used net proceeds of approximately $1,345,000 from the new financing agreement to pay the subordinated debt to a former related party of approximately $353,000, closing costs of approximately $254,000, the remaining used to settle amounts due on the prior financing. On May 23, 2022, the Company entered into an underwriting agreement (the “Underwriting Agreement”) with Aegis Capital Corp., who acted as the sole underwriter (the “Underwriter”), in a firm commitment underwritten public offering (the “Offering”) pursuant to which the Company sold to the Underwriter 1,000,000 shares (the “Shares”) of common stock, par value $0.01 per share (the “Common Stock”) for gross proceeds of $4,000,000 prior to deducting underwriting discounts and commissions and other estimated offering expenses of approximately $637,000. The price to the public in the Offering was $4.00 per Share, before underwriting discounts and commissions. The offering closed on May 26, 2022. The Company received net proceeds of approximately $3,363,000 which was used for working capital. On May 24, 2022, the Company’s Common Stock was approved to list on the Nasdaq Capital Market under the symbol “MICS” and began trading on the Nasdaq Capital Market on May 24, 2022. On October 14, 2022 the Company entered into the Credit Agreement with Fifth Third, as Lender replacing the existing credit facilities with Crestmark Bank and Iron Horse Credit that were terminated by the Company on October 13, 2022 . The Credit Agreement provides for a three-year secured revolving credit facility in an aggregate principal amount of up to $15,000,000 decreased to $7,500,000 during the period of January 1 through July 31 of each year. The Credit Agreement matures on October 14, 2025. As of December 31, 2022 the Company was in default under the Credit agreement due to non-compliance with the fixed charge ratio covenant primarily due to the decrease in revenue for the three months ended December 31, 2022 and increased general and administrative expenses. To date, Fifth Third has not taken action to accelerate the Company’s obligations under the Credit Agreement and the Company is currently in negotiations with Fifth Third to obtain a waiver and renegotiate the fixed charge coverage ratio covenant. There can be no assurance that the negotiations will be successful and that Fifth Third will grant the Company a waiver or renegotiate the covenant. As of this filing there was no outstanding balance on the Credit Agreement. 26 The Company expects cash flows from operations as well as other financing resources to be adequate to satisfy working capital requirements for at least the next twelve months from the date the accompanying condensed consolidated financial statements are issued. The Company plans to supplement cash flows from operations from several activities and resources including the following: ● Continue to negotiate remediation of the existing default on the Revolving Credit Facility with Fifth Third. ● Raise additional cash through equity offering. ● Utilize “dynamic discount” programs offered by several of the Company’s major customers which allow for accelerated payment of invoices in exchange for an early pay discount. The Company believes that our cash on hand, working capital (net of cash), cash expected to be generated from our operating forecast, cash expected to be raised with our ATM offering along with the availability of cash from our Credit Agreement with Fifth Third (See Note 7 –FINANCING) will be adequate to meet the Company’s liquidity requirements for at least twelve months from the date of this report. While the Company is optimistic that it will be successful in these efforts to achieve our plan, there can be no assurances that we will be successful in doing so. As such, the Company has a continued support letter from its parent company, Ault Alliance, through March 31, 2024. CRITICAL ACCOUNTING POLICIES The Company’s interim financial statements were prepared in accordance with United States generally accepted accounting principles, which require management to make subjective decisions, assessments and estimates about the effect of matters that are inherently uncertain. As the number of variables and assumptions affecting the judgement increases such judgements become even more subjective. While management believes that its assumptions are reasonable and appropriate, actual results may be materially different than estimated. The critical accounting estimates and assumptions have not materially changed from those identified in the Company’s 2022 Annual Report. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not required for small reporting companies.