Algorhythm Holdings, Inc. 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The objective of this Management’s Discussion and Analysis of Financial Condition and Results of Operation is to allow investors to view our company from management’s perspective, considering items that would have a material impact on future operations. The following discussion summarizes the significant factors affecting our results of operations and financial condition as of and during the years ended March 31, 2023 and 2022 and should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. This discussion contains forward-looking statements based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results and the timing of certain events could differ materially from those anticipated in or implied by these forward-looking statements as a result of several factors, including those discussed in the section captioned “Risk Factors” included under Part I, Item 1A and elsewhere in this Annual Report. See also the section captioned “Disclosure on Forward-Looking Statements” in this report. Overview We are primarily engaged in the development, marketing, and sale of consumer karaoke audio equipment, accessories and musical recordings. We believe we are a leading global karaoke and music entertainment company that specializes in the design and production of quality karaoke and music enabled consumer products for adults and children. Our products are among the most widely available karaoke products in the world. Our mission is to “create joy through music.” In order to deliver on this mission, we are focused on the following multi-prong approach: ● In the short-term, improve profitability by optimizing operations and continue to expand gross margins; and ● In the mid-to-long-term, continue to grow our global distribution and expand into new product categories that take advantage of our vast distribution relationships and sourcing abilities. 20 Results of Operations for the Fiscal Year Ended March 31, 2023 Compared With Fiscal Year Ended March 31, 2022 The following table sets forth, for the periods indicated, certain income and expense items expressed as a percentage of our total revenues: For the Fiscal Years Ended March 31, 2023 March 31, 2022 Net Sales 100.0 % 100.0 % Cost of Sales 76.6 % 77.2 % Operating Expenses 32.8 % 22.7 % Operating (Loss) Income -9.4 % 0.1 % Other Income, Net 0.2 % 0.4 % (Loss) Income Before Income Tax Provision -9.2 % 0.5 % Income Tax Provision -2.6 % -0.1 % Net (Loss) Income -11.8 % 0.4 % Net Sales Net sales for the year ended March 31, 2023 (“Fiscal 2023”) were approximately $39.3 million. This represents a decrease of approximately $8.2 million from the approximately $47.5 million in the fiscal year ended March 31, 2022 (“Fiscal 2022”). We experienced a decrease in net sales to four of our five major customers in Fiscal 2023 compared to Fiscal 2022. 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 globally during the calendar year 2022; and (2) the news of economic recession, inflation, and interest rate hikes dampened customers’ expectations for the holiday season, which resulted in our customers taking a very risk-adverse approach to buying and carrying inventory for the 2022 holiday season. Most of our major 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 to assist in holiday inventory sell-through. Co-op promotion incentives for the fiscal year ended March 31, 2023 increased to approximately $2.3 million, or 6.0% of net sales, as compared to approximately $1.7 million, or 3.6% of net sales, for the fiscal year ended March 31, 2022. Gross Profit Gross profit for Fiscal 2023 was approximately $9.2 million, or 23.4% of total revenues, compared to approximately $10.8 million, or 22.8% of sales for Fiscal 2022, a decrease of approximately $1.6 million. The decrease in net sales accounted for approximately $1.9 million of the decrease, offset by an increase in gross profit margin of approximately $0.3 million. Gross profit margin for Fiscal 2023 was 23.4%, compared to 22.8% for Fiscal 2022, an increase of 0.6%. There were increases in gross margin of approximately $1.7 million, or 5.1%, primarily due to increased pricing and lower landed product costs from significantly decreased costs of shipping containers compared to the previous year. These increases in gross profit margin were offset by co-op promotion incentives that accounted for approximately $0.6 million, or 2.3%, of the gross margin decrease and an increase in inventory reserves contributing to approximately $0.8 million, or 2.2% of the gross margin decrease. Operating Expenses During the fiscal year ended March 31, 2023, total operating expenses increased to approximately $12.9 million compared to approximately $10.7 million during the fiscal year ended March 31, 2022. This represents an increase in total operating expenses of approximately $2.2 million. There was a decrease in selling expenses of approximately $0.1 million primarily due to the decrease in sales, offset by an increase of approximately $2.3 million in general and administrative expenses. General and administrative expenses increased to approximately $9.2 million during the fiscal year ended March 31, 2023, compared to approximately $6.9 million during the fiscal year ended March 31, 2022, an increase of approximately $2.3 million. There was an increase in legal, professional, investor relations and stock transfer costs of approximately $0.9 million primarily related to the Nasdaq up-listing, change in control issues, regulatory filings, Delaware franchise fees and arbitration settlement. in the amount of $30,000. There was an increase in compensation of approximately $0.5 million, 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 compensation expense of $0.4 million related to a change of control and employment continuation agreement with the Chief Financial Officer. There was an increase in travel expenses of approximately $0.3 million, which includes participation in trade shows which we had not attended since the beginning of COVID-19. There were inflationary expenses increases of approximately $0.1 million in our California warehouse operations with the remaining increase due to other expenses that have increased due to inflation. 21 Other Income (Expenses) Other income, net decreased by approximately $0.1 million, to approximately $0.1 million for the fiscal year ended March 31, 2023, compared to approximately $0.2 million for the fiscal year ended March 31, 2022. During the fiscal year ended March 31, 2023, there was a refund of approximately $0.7 million, net of expenses, from the Employee Retention Credit Program. This increase in other income was offset by fees of approximately $0.2 million for exiting the intercreditor revolving credit facility with Crestmark Bank (“Crestmark”) and Iron Horse Credit (“IHC”) (See Note 6 – Financing) that was recorded as a loss from extinguishment of debt and interest expense of approximately $0.4 million. During the fiscal year ended March 31, 2022, there was a one-time gain from the forgiveness of the Payroll Protection Plan loan of approximately $0.4 million and a gain from the settlement of accounts payable with one of our factories of $0.3 million for a previous year’s damaged goods incident. These increases in other income were offset by interest expense of approximately $0.5 million during the fiscal year ended March 31, 2022. (Loss) Income Before Income Tax (Provision) We had a net loss before income tax provision of approximately $3.6 million in Fiscal 2023, compared to income before income tax provision of approximately $0.3 million in Fiscal 2022. The increase was primarily due to the increase in operating expenses of approximately $2.2 million and a decrease in gross profit of approximately $1.6 million, as discussed above. Income Tax Provision Significant management judgment is required in developing our provision for income taxes, including the determination of foreign tax liabilities, deferred tax assets and liabilities and valuation allowances that are against deferred tax assets. Management evaluates its ability to realize its deferred tax assets on a quarterly basis and adjusts its valuation allowance when it believes that it is not likely to be realized. As of March 31, 2023, management determined that a full valuation allowance was required. On March 31, 2023 and 2022, we had net deferred tax assets of approximately $0.0 million and $0.9 million, respectively. The deferred tax assets on March 31, 2023 and 2022 were net of a valuation allowance of approximately $2.0 million and approximately $0.1 million, respectively. In Fiscal 2023, we recognized an income tax provision of approximately $1.0 million, compared to an income tax provision of approximately $0.1 million in Fiscal 2022. Our effective tax rate for the fiscal year ended March 31, 2023 was approximately 28.6% as compared to 19.9% for Fiscal 2022. We operate within multiple taxing jurisdictions and are subject to audit in those jurisdictions. Because of the complex issues involved, any claims can require an extended period to resolve. In management’s opinion, adequate provisions for income taxes have been made. Net (Loss) Income As a result of the foregoing, we had a net loss of approximately $4.6 million and net income of approximately $0.2 million for Fiscal 2023 and Fiscal 2022, respectively. Liquidity And Capital Resources On March 31, 2023, we had cash on hand of approximately $2.9 million as compared to cash on hand of approximately $2.3 million on March 31, 2022. The increase of cash on hand of approximately $0.6 million was primarily due to approximately $1.2 million provided by financing activities and offset by approximately $0.6 million in net cash used in operating and investing activities. As of March 31, 2023, our working capital was approximately $9.1 million. During the next twelve-month period, we plan on financing our working capital needs primarily from: 1) Vendor financing – All our key vendors in China have agreed to manufacture on our behalf without advanced payments and have extended payment terms to us. The terms with the factories are sufficient to cover the factory direct import sales which are expected to account for approximately 50% of the total revenues in the fiscal year ending March 31, 2024; and 2) Credit Facility - We currently have a three-year revolving Credit Facility with Fifth Third Bank for a $15.0 million facility (decreasing to $7.5 million in off-peak season) on eligible accounts receivable and inventory which terminates on October 14, 2025. As of the date of the filing of this Annual Report, there was approximately $1.8 million available to borrow on the revolving Credit Facility. As of March 31, 2023, we were in default under the Credit Agreement due to non-compliance with the fixed charge coverage ratio covenant of 1:05 : 1.0. On May 19, 2023, we executed a Waiver and First Amendment agreement which provides for a waiver of previous defaults and new covenants that are required. We must comply monthly with minimum liquidity (defined as excess loan availability plus cash on hand) of $2.5 million between February and July and $4.0 million between September and June. We must also maintain pre-defined minimum operating cash flows between February and August 2023, until we achieve a fixed charge ratio of 1.15 : 1.0 beginning in September 2023 and throughout the remaining term of the Credit Agreement. As of the date of filing this Annual Report, we are in compliance with the amended covenants and there is no outstanding balance on the Credit Facility. 22 We believe that our cash on hand (including proceeds from the ATM Offering), working capital (net of cash), cash expected to be generated from our operating forecast, along with the availability of cash from our Credit Facility, will be adequate to meet our liquidity requirements for at least twelve months from the filing of this Annual 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 July 14, 2024. Cash used in operating activities in Fiscal 2023 was approximately $0.3 million. There was a decrease in inventory of approximately $4.0 million, of which approximately $3.3 million was due to the sale of new products purchased for one major customer that were in-transit at the end of last fiscal year. This was offset by a decrease in accounts payable of approximately $3.5 million due to a decrease in product purchases as we were able to sell prior year excess inventory from later than usual shipments due to global logistics issues. Cash used in operating activities in Fiscal 2022 was approximately $2.0 million. There was an increase in inventory of approximately $8.4 million, of which approximately $3.7 million was additional inventory due to products that were delivered too late for seasonal shipments as a result of global logistics difficulties, approximately $3.3 million was new products purchased for one major customer that were in-transit with the remaining increase primarily due to CPK inventory to be re-launched during the upcoming fiscal year. There was an increase in accounts receivable of approximately $0.6 million due to later than usual shipments due to global logistics issues. These decreases in cash used in operations were offset by an increase in amounts due from banks of approximately $4.5 million due to cash required to pay vendors for the additional inventory and an increase in accounts payable of approximately $3.2 million primarily due to new seasonal goods in-transit. Cash used in investing activities for Fiscal 2023 and Fiscal 2022 was approximately $0.2 million and $0.1 million, respectively, primarily for the purchase of molds and tooling for new karaoke models. Net cash provided by financing activities for Fiscal 2023 was approximately $1.2 million, compared to cash provided by financing activities of approximately $4.0 million for Fiscal 2022. In May 2022, we received net proceeds of approximately $3.4 million from the public offering we executed in conjunction with our up-listing to Nasdaq. In addition, during Fiscal 2023, we received proceeds of approximately $1.2 million 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 $0.2 million for early termination of the financing facility with Crestmark and IHC. We used net proceeds of approximately $3.1 million from the new financing agreement to pay the subordinated debt to a former related party of approximately $0.3 million, closing costs of approximately $0.3 million, with the remaining $2.5 million used to settle amounts due on the prior financing with IHC. Net cash provided by financing activities for Fiscal 2022 was approximately $4.0 million. We received loan proceeds from our inventory line of credit of approximately $2.4 million. In August 2021, we received net proceeds of approximately $1.8 million from the execution of the securities purchase agreement and Redemption Agreement as discussed below. These financing activities were offset by a payment of approximately $0.2 million on the subordinated related party debt, with the remaining offset primarily due to payments made on scheduled installments on installment notes and finance leases. In August 2021, we entered into a securities purchase agreement (the “Purchase Agreement”) with large institutional investors and a strategic investor for private placement of (i) 550,000 shares of our common stock together with common warrants to purchase up to 550,000 shares of common stock for an exercise price of $10.50 per share, and (ii) 561,111 pre-funded warrants (“Pre-Funded Warrants”) with each Pre-Funded Warrant exercisable for one share of common stock at an exercise price of $0.01 per share, together with Common Warrants to purchase up to 561,111 shares of common stock at an exercise price of $10.50 per share (the “Private Placement”). At the closing of the Private Placement, we received approximately $9.8 million, of which approximately $7.2 million was used to repurchase shares of our common stock pursuant to that certain Redemption Agreement discussed below. We received an increase in working capital of approximately $1.8 million after settlement of expenses associated with closing of these transactions. In August 2021, we entered into the Redemption Agreement with koncepts and Treasure Green, pursuant to which we acquired the 654,105 Redeemed Shares. The closing of the transactions set forth in the Redemption Agreement took place on August 10, 2021, at which time the Redeemed Shares were assigned and transferred back to us in consideration of a payment of approximately $7.2 million to koncepts and Treasure Green. The Redeemed Shares were retired and returned as unissued authorized capital. For the fiscal year ended March 31, 2022, we secured additional vendor invoice credits of approximately $0.2 million from vendors relating to the same damaged goods incident. Exchange Rates We sell most of our products in U.S. dollars with some sales to certain Canadian customers in Canadian Dollars and pay for all of our manufacturing costs in either U.S. or Hong Kong dollars. We are subject to risks involved in the exchange rate between the Canadian and US dollar, however, even though the exchange rate has fluctuated between $1.29 to $1.35 CAD to the U.S. Dollar during peak selling and collection season in Fiscal 2023 sales volume sold in Canadian dollars was not significant and the associated exchange rates did not have a material impact on our financial results. Operating expenses of the Macau office are paid in either Hong Kong dollars or Macau Pataca (MOP). The exchange rate of the Hong Kong dollar to the U.S. dollar has been relatively stable at approximately HK $7.75 to U.S. $1.00 since 1983 and, accordingly, has not represented a currency exchange risk to the U.S. dollar. The exchange rate of the MOP to the U.S. dollar is approximately MOP $8.00 to U.S. $1.00. While exchange rates have been stable for several years, we cannot assure you that the exchange rate between the United States, Macau, Hong Kong and Canadian currencies will continue to be stable and exchange rate fluctuations may have a material effect on our business, financial condition or results of operations. 23 Seasonal and Quarterly Results Historically, our operations have been seasonal, with the highest net sales occurring in the second and third quarters (reflecting increased orders for equipment and music merchandise during the Christmas selling months) and to a lesser extent the first and fourth quarters of the fiscal year. Sales in our fiscal second and third quarter, combined, accounted for approximately 62% and 81% of net sales in Fiscal 2023 and Fiscal 2022, respectively. Our results of operations may also fluctuate from quarter to quarter as a result of the amount and timing of orders placed and shipped to customers. We may experience quarter to quarter fluctuations in product landed cost as the cost of shipping containers, drayage port delay charges and other logistics related costs increase as peak shipping season arrives. The fulfillment of orders can therefore significantly affect results of operations on a quarter-to-quarter basis. During 2022 and continuing into 2023, the United States has experienced a rapid increase in inflation levels of approximately 6.5% year-over year in 2022 and approximately 4.0% year-over-year in 2023. 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 and could significantly affect results of operations on a quarter-to-quarter basis. Critical Accounting Policies and Estimates We prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. As such, management is required to make certain estimates, judgments and assumptions that it believes are reasonable based on the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the periods presented. The significant accounting policies which management believes are the most critical to aid in fully understanding and evaluating our reported financial results included accounts receivable allowance for doubtful accounts, reserves on inventory, revenue recognition and reserve for sales returns and allowances and income taxes. Accounts Receivable and Collectibility Our accounts receivable consist of amounts due from customers in the ordinary course of business. Accounts receivable are carried at cost, net of allowances for uncollectible amounts. Provisions for losses are charged to operations in amounts sufficient to maintain an allowance for losses at a level considered adequate to cover probable losses inherent in our accounts receivable. Our allowance for doubtful accounts is based on management’s estimates of the creditworthiness of our customers, current economic conditions and historical information, and, in the opinion of management, is believed to be an amount sufficient to respond to normal business conditions. Management sets 100% reserves for customers in bankruptcy and other reserves based upon historical collection experience and future expectations. Should business conditions deteriorate or any major customer default on its obligations to us, this allowance may need to be significantly increased, which would have a negative impact on operations. We are subject to chargebacks from customers for co-op promotion incentives, defective returns, return freight and handling charges that are deducted from open invoices, charged against revenue, and reduce collectability of open invoices. Reserves On Inventories We establish a reserve on inventory based on the expected net realizable value of inventory on an item-by-item basis when it is apparent that the expected realizable value of an inventory item falls below its original cost. A charge to cost of sales results when the estimated net realizable value of specific inventory items declines below cost. Management regularly reviews our investment in inventories for such declines in value due to excess supply on-hand, slow-moving product and end-of-life product. On March 31, 2023 and 2022, we had inventory reserves of approximately $0.9 million and $0.4 million, respectively. Revenue Recognition And Reserve For Sales Returns and Allowances We recognize revenue in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification 606, “Revenue from Contracts with Customers”. All revenue is generated from contracts with customers. We recognize revenue when control of the goods sold is transferred to the customer, in an amount, referred to as the transaction price, that reflects the consideration to which we are expected to be entitled in exchange for those goods. We determine revenue recognition utilizing the following five steps: (1) identification of the contract with a customer; (2) identification of the performance obligations in the contract (promised goods or services that are distinct); (3) determination of the transaction price; (4) allocation of the transaction price to the performance obligations; and (5) recognition of revenue when, or as, we transfer control of the product or service for each performance obligation. Our contracts with customers consist of one performance obligation (the sale of our products). Our contracts have no financing elements, payment terms are less than 120 days and have no further contract asset or liability obligations once control of goods is transferred to the customer. Revenue is recorded in the amount of consideration we expect to receive for the sale of these goods. 24 Costs incurred in fulfilling contracts with customers include administrative costs associated with the procurement of goods are included in general and administrative expenses, in-bound freight costs are included in the cost of goods sold and accrued sales representative commissions are included in selling expenses in the accompanying consolidated statements of operations as our underlying customer agreements are less than one year. We selectively participate in a retailer’s co-op promotion incentives to maximize sales of our products on the retail floor or to assist in developing consumer awareness of new product launches, by providing marketing fund allowances to our customers. As these co-op promotion incentives are not a distinct good or service and we cannot reasonably estimate the fair value of the benefit we receive from these arrangements, the cost of these allowances at the time they are offered to the customers are recorded as a reduction to net sales. For the fiscal years ended March 31, 2023 and 2022, co-op promotion incentives were approximately $2.3 million and $1.7 million, respectively. We disaggregate revenues by product line and major geographic region as most of its revenue is generated by the sales of karaoke hardware and we have no other material business segments (See NOTE 14 – SEGMENT INFORMATION). While we generally do not contractually provide for overstock returns, we do provide for variable consideration contingent upon the occurrence of uncertain future events. Variable consideration is estimated at the expected value or at the most likely amount depending on the type of consideration. Estimated amounts are included in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. We estimate variable consideration under our return allowance programs for goods returned from the customer for various reasons, whereby a sales return reserve is recorded based on historic return amounts, specific events as identified and management estimates. For the fiscal years ended March 31, 2023 and 2022, we received sales returns of approximately $5.0 million and $3.6 million, respectively. The return of products is due to a variety of reasons including defective units, customers’ overstock and buyers’ remorse. The primary reason for the increase of approximately $1.4 million in returns was an increase in overstock returns from one major customer. Our reserves for sales returns were approximately $0.9 million and $1.0 million as of March 31, 2023 and 2022, respectively (See NOTE 18 – RESERVE FOR SALES RETURNS). Income Taxes We operate within multiple taxing jurisdictions and are subject to audit in those jurisdictions. Because of the complex issues involved, any claims can require an extended period to resolve. In management’s opinion, adequate provisions for potential income taxes in the jurisdictions have been made. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. If it is more likely than not that some portion of a deferred tax asset will not be realized, a valuation allowance is recognized. Other Estimates We make other estimates in the ordinary course of business relating to sales returns and allowances, warranty reserves, and reserves for promotional incentives. Historically, past changes to these estimates have not had a material impact on our financial condition. However, circumstances could change which may alter future expectations. Recent Accounting Pronouncements In June 2016, the FASB issued ASU 2016-13, “Financial Instruments—Credit Losses” (Topic 326) . This ASU represents a significant change in the current accounting model by requiring immediate recognition of management’s estimates of current expected credit losses. Under the prior model, losses were recognized only as they were incurred, which delayed recognition of expected losses that might not yet have met the threshold of being probable. The amendments in ASU 2016-03 are effective for our fiscal year beginning April 1, 2023 including interim periods within that fiscal year. We adopted ASU 2016-03 on April 1, 2023, and the adoption did not have any material effect on our consolidated financial statements and related disclosures. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this item.