Liqtech International Inc: Form 10-Q for the period ended Jun 30, 2020

The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes included elsewhere in this quarterly report. In addition, the following discussion should be read in conjunction with our annual report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 30, 2020 and the financial statements and notes thereto. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Overview

LiqTech International, Inc. is a clean technology company that provides state-of-the-art products for gas and liquid purification by manufacturing ceramic silicon carbide filters. For more than a decade, we have developed and manufactured products of re-crystallized silicon carbide. We specialize in two business areas: ceramic membranes for liquid filtration and diesel particulate filters (DPFs) for the control of soot exhaust particles from diesel engines. Using nanotechnology, we develop proprietary products using patented silicon carbide technology. Our products are based on unique silicon carbide membranes that facilitate new applications and improve existing technologies. We market our products from our offices in the United States and Denmark and through local representatives and distributors. The products are shipped directly to customers from our production facilities in the United States and Denmark.

The terms “LiqTech”, “we”, “our”, “us”, the “Company” or any derivative thereof, as used herein, refer to LiqTech International, Inc., a Nevada corporation, together with its direct and indirect wholly owned subsidiaries, including LiqTech USA, Inc., a Delaware corporation (“LiqTech USA”), which owns all of the outstanding equity interest in LiqTech Holding A/S (formerly known as LiqTech International A/S), a Danish limited company organized under the Danish Act on Limited Companies of the Kingdom of Denmark (“LiqTech Holding”), together with its direct wholly owned subsidiaries LiqTech Water A/S (formerly known as LiqTech Systems A/S) (“LiqTech Water”), LiqTech Ceramics A/S (“LiqTech Ceramics”) and LiqTech Plastics A/S (formerly known as BS Plastic A/S) (“LiqTech Plastics”), three Danish limited companies organized under the Danish Act on Limited Companies of the Kingdom of Denmark and LiqTech NA, Inc., a Delaware corporation (“LiqTech Delaware”). Collectively, LiqTech USA, LiqTech Holding, LiqTech Water, LiqTech Ceramics, LiqTech Plastics and LiqTech Delaware are referred to herein as our “Subsidiaries”.

We conduct operations in the Kingdom of Denmark and the United States. Our Danish operations are located in the Copenhagen area, Hobro and Aarhus, and our U.S. operations are conducted in White Bear Lake, Minnesota.

Our Strategy

Our strategy is to create stockholder value by leveraging our competitive strengths in silicon carbide filters and membranes by focusing on discrete applications in key end markets. Essential features of our strategy include:

• Maintain and gain new marine industry customers. We currently provide water filtration systems for scrubber technology providers, ship owners and ship operators. We are expanding our range of marine products to better leverage existing customer relationships.
• Enter new geographic markets and expand existing markets. We plan to continue to manufacture and sell our products from our core operations in Denmark. We work with distributors, agents and partners to access other important geographic markets.
• Strengthen our position in the DPF market. We believe that we have a strong position in the retrofit market for diesel particulate filter (DPF) systems. We intend to continue our efforts to maintain our market position in this area. Furthermore, we intend to leverage our experience in the OEM market by expanding our presence with new products relating to diesel particulate filter systems.
• Develop and improve technologies and enter new end markets. We intend to continue to develop our ceramic membranes and improve the efficiency for our filtration products. Through continuous research and development, we intend to find new uses for our products and plan to expand into new markets that offer significant opportunity for the Company.
• Focus on the development and sales of standardized water filtration and treatment systems. We will continue our focus on selling systems based on our unique SiC Filters. We will also combine the ceramic membranes with other technologies to offer our customers complete filtration solutions. We will continue our focus on developing smaller standard systems, like our ground water treatment system and our residential swimming pool system.

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Developments

Results of Operations

The financial information below is derived from our unaudited condensed consolidated financial statements included elsewhere in this report.

Comparison of the Three Months Ended June 30, 2020 and June 30, 2019

The following table sets forth our revenues, expenses and net income for the three months ended June 30, 2020 and 2019:

Revenues

Revenue for the three months ended June 30, 2020 was $4,641,483 compared to $9,297,186 for the same period in 2019, representing a decrease of $4,655,703 or 50%. The change in sales consists of a decrease in sales of liquid filters of $5,901,426, offset by an increase in sales DPFs of $413,460, an increase in sales of plastics of $762,384, and an increase in sales of development projects of $69,878.. The decrease in sales of liquid filters and water treatment systems is a result of the negative impact of the COVID-19 virus that has caused a significant decrease in new orders since the start of 2020. The increase in demand for our DPFs is due to an increased interest in environmental solutions to reduce the CO2-emmissions globally. The increase in sales of plastic components is related to the newly acquired business in 2019.

Gross Profit

Gross profit for the three months ended June 30, 2020 was $494,463 compared to gross profit of $2,075,110 for the same period in 2019, representing a decrease of $1,580,647 or 76%. The decrease in gross profit is due to the decrease in sales of liquid filters and water treatment systems where sales command a higher gross margin. This resulted in the Gross profit being negatively impacted by costs related to the investments in additional employees, improvement of the business facilities and other fixed costs included in Cost of good sold, and therefore had the consequence of a decrease in gross profit due to the decline in Revenue. Included in the gross profit is depreciation of $491,374 and $246,846 for the three months ended June 30, 2020 and 2019, respectively.

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Expenses

Total operating expenses for the three months ended June 30, 2020 were $2,432,278, representing an increase of $717,878, or 42%, compared to $1,714,400 for the same period in 2019.

Selling expenses for the three months ended June 30, 2020 were $605,947 compared to $514,037 for the same period in 2019, representing an increase of $91,910 or 18%. This change is attributable to the addition of new sales employees from an average of 9 in 2019 to an average of 12 in 2020. Other expenses related to the update of the company’s website and other marketing materials have also resulted in increased selling expenses.

General and administrative expenses for the three months ended June 30, 2020 were $1,509,772 compared to $1,001,179 for the same period in 2019, representing an increase of $508,593, or 51%. This change is attributable to the addition of administrative employees, where the number of employees increased from 12 in 2019 to 23 in 2020. The increase in the number of employees also created additional IT and office costs. Included in general and administrative expenses is non-cash compensation expenses, that were $82,335 and $23,167 for the three months ended June 30, 2020 and June 30, 2019, representing an increase of $59,168 or 255%, attributable to stock grants to members of the Board and management.

The following is a summary of non-cash compensation:

Research and development expenses for the three months ended June 30, 2020 were $316,559 compared to $199,184 for the same period in 2019, representing an increase of $117,375, or 59%. This change is attributable to an increase in the number of employees engaged in research and development activities as the Company focuses on the further development of existing and new products for the marine industry.

Net Income (Loss)

Net income (loss) for the three months ended June 30, 2020 was $(2,563,811) compared to $146,786 for the comparable period in 2019, representing a decrease of $2,710,597.

This change was primarily attributable to the significant decrease in revenue and the increase in operating expenses caused primarily by the growth in headcount to support additional sales and production that unfortunately did not persist in the second quarter due to impacts associated with COVID-19. Further losses on currency translations due to the negative impact of the USD/DKK exchange rate and the negative fair value adjustment of $236,900 related to the prefunded warrant liability have influenced the Net Loss for the period.

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Comparison of the Six Months Ended June 30, 2020 and June 30, 2019

The following table sets forth our revenues, expenses and net income for the six months ended June 30, 2020 and 2019:

Revenues

Revenue for the six months ended June 30, 2020 was $14,923,327 compared to $16,718,384 for the same period in 2019, representing a decrease of $1,795,057 or 11%. The change in sales consists of a decrease in sales of liquid filters and water treatment systems of $2,961,472 and a decrease of sales in DPFs of $269,745 offset by an increase in sales of plastics of $1,343,794 and an increase in sales of development projects of $92,366. The increase in sales of plastic components is related to the newly acquired business in 2019. The decrease in demand for our liquid filters and water treatment systems is mainly due to impacts of the ongoing COVID-19 pandemic, which have resulted in significant restrictions and business limitations across the globe causing a significant decline in delivery of water treatment systems for the marine scrubber industry. The decrease in demand for our DPFs is mainly due to the relative decline in sales realized in the first quarter of 2020 compared to 2019 and even though sales in the second quarter of 2020 improved compared to 2019, accumulated sale of DPFs for the six months ended June 30, 2020 is 9% lower than the same period in 2019.

Gross Profit

Gross profit for the six months ended June 30, 2020 was $3,133,539 compared to gross profit of $3,550,190 for the same period in 2019, representing a decrease of $416,651 or 12%. The decrease in gross profit is due to the decline in sales of liquid filters and water treatment systems, where sales command a higher gross margin. Included in the gross profit is depreciation of $907,639 and $554,129 for the six months ended June 30, 2020 and 2019, respectively.

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Expenses

Total operating expenses for the six months ended June 30, 2020 were $4,969,790, representing an increase of $1,761,384, or 55%, compared to $3,208,406 for the same period in 2019.

Selling expenses for the six months ended June 30, 2020 were $1,282,747 compared to $997,623 for the same period in 2019, representing an increase of $285,124, or 29%. This change is attributable to the addition of new sales employees from an average of 8 in 2019 to an average of 12 in 2020.

General and administrative expenses for the six months ended June 30, 2020 were $3,059,530 compared to $1,808,427 for the same period in 2019, representing an increase of $1,251,103, or 69%. This change is attributable to the addition of administrative employees, where the number of employees increased from 12 in 2019 to 25 in 2020. The increase in the number of employees also created additional IT and office costs. Included in general and administrative expenses is Non-cash compensation expenses, that were $223,557 and $151,611 for the six months ended June 30, 2020 and June 30, 2019, representing an increase of $71,946 or 47%, attributable to stock grants to members of the Board and management.

The following is a summary of non-cash compensation:

Research and development expenses for the six months ended June 30, 2020 were $627,513 compared to $402,356 for the same period in 2019, representing an increase of $225,157, or 56%. This change is attributable to an increase in the number of employees engaged in research and development activities as the Company focuses on the further development of existing and new products for the marine industry.

Net Income (Loss)

Net income (loss) for the six months ended June 30, 2020 was $(2,260,312) compared to $181,030 for the comparable period in 2019, representing a decrease of $2,441,342.

This change was primarily attributable to the significant decrease in revenue and the increase in operating expenses caused primarily by the growth in headcount to support additional sales and production. Further losses on currency translations due to the negative impact of the USD/DKK exchange rate and the negative fair value adjustment of $236,900 related to the prefunded warrant liability have influenced the Net Loss for the period.

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Liquidity and Capital Resources

In March 2020, the World Health Organization declared the outbreak of novel corona virus ("COVID-19"), a pandemic which has resulted in authorities across the globe implementing numerous measures to contain the virus, including travel bans and restrictions, quarantines, shelter-in-place orders, and business limitations and shutdowns. In response to measures taken by state and local governments in mid-March, we elected to temporarily introduce 2-shifts at our production facilities to minimize the risk of infection and to implement health and safety actions recommended by government and health officials to better protect our employees who are required to be present at our production facilities. In addition, the majority of our employees were working remotely during the shutdown. However since the beginning of May, the majority of the businesses in Denmark have been opening up as the effect of the COVID-19 had been constrained and the number of diseases and fatalities were going down to a minimum, which resulted in an incremental opening of social and business environment.

We are unable to accurately predict the full impact that COVID-19 will have on our long-term financial condition, result of operations, liquidity and cash flows due to uncertainties, and our compliance with the measures taken to avoid the spreading of the virus did have a material adverse impact on our financial results for the second quarter of the fiscal year 2020. We have taken precautionary measures to manage our resources conservatively by reducing and/or deferring capital and operating expenses to mitigate any potential adverse impacts of the pandemic as well as to conserve cash. Based on current projections, which are subject to numerous uncertainties, including the duration and severity of the pandemic and containment measures and the effect of these on the industries in which we compete, we believe our cash on hand, as well as our ongoing cash generated from operations, should be sufficient to cover our capital requirements for the next 12 months from the issuance of this quarterly report. In addition, as a result of reduced order intake and reduced manufacturing levels, our future gross profit will likely be impacted until such time that we are able to operate our manufacturing facilities as originally planned prior to the COVID-19 pandemic. Notwithstanding the reduction in our manufacturing levels, based on our current rate of production, we believe that we will be able to fulfill most, if not all, of our existing delivery obligations in fiscal year 2020.

While we anticipate that the foregoing measures are temporary, we cannot predict the specific duration for which these precautionary measures will stay in effect, and our business may be adversely impacted as a result of the pandemic’s global economic impact. In the future, the pandemic may cause reduced demand for our products if it results in a recessionary global economic environment. It could also lead to volatility in access to our products due to government actions impacting our ability to produce and ship products.

We have historically satisfied our capital and liquidity requirements through offerings of equity instruments, internally generated cash from operations and our available lines of credit. At the filing date, the Company had an available line of credit from the bank amounting to DKK20,000,000 ($3,000,000), which is used for a leasing arrangement and guarantees issued to customers for prepayments and for warranties after delivery.

Additionally, on May 21, 2020, the Company completed a Securities Purchase Agreement with certain accredited investors in a private placement pursuant to which the Company issued and sold an aggregate of 1,085,000 shares of common stock, par value $0.001 per share, at a purchase price of $5.00 per share for gross proceeds of $4,744,048 including costs of $680,952 for placement fee, lawyer fee, auditor fee and other cost related to the capital raise, and a prefunded warrant to purchase an aggregate of 515,000 shares of Common Stock, at a purchase price of $5.00 per share for gross proceeds of $2,575,000.

On June 30, 2020, we had cash of $16,230,269 and net working capital of $21,400,770, and at December 31, 2019, we had cash of $9,783,932 and net working capital of $17,155,126. On June 30, 2020, our net working capital has increased by $4,245,644 compared to December 31, 2019 primarily related to the increase in cash as a result of the private placement in May 2020.

In connection with certain orders, we provide the customer a working guarantee, a prepayment guarantee or a security bond. For that purpose, we maintain a guarantee credit line of DKK10,000,000 (approximately $1,500,000). The credit line is secured by a cash deposit of $2,700,000. Further, we have a guarantee for a specific project delivered in 2016 of DKK 94,620 (approximately $14,217 at June 30, 2020) with a bank, subject to certain base limitations. This line of credit is guaranteed by Vækstfonden (the Danish state's investments fund) and is secured by certain assets of LiqTech Systems such as receivables, inventory, and equipment.

Cash Flows

Six months ended June 30, 2020 compared to six months ended June 30, 2019

Cash provided (used) by operating activities is net income adjusted for certain non-cash items and changes in assets and liabilities. Cash provided by operating activities for the six months ended June 30, 2020 was $1,229,936, representing an increase of $6,300,563 compared to cash used by operating activities of $5,070,627 for the six months ended June 30, 2019. The change in cash provided by operating activities for the six months ended June 30, 2020 was mainly due to reductions in Account receivable of $8,972,271 and Contract assets/liabilities (net) of $2,180,120, off-set by the decrease in Net Income (Loss) of $(2,353,792) and a decrease in Accounts payable of $4,860,284.

Net cash used in investing activities was $2,194,618 for the six months ended June 30, 2020 as compared to net cash used in investing activities of $327,559 for the six months ended June 30, 2019, representing an increase of $1,867,059. This increase was due primarily to the purchase of property and equipment related to the installation of new furnaces in Ballerup to increase production capacity.

Cash provided by financing activities was $7,302,077 for the six months ended June 30, 2020 as compared to net cash provided by financing activities of $14,799,350 for the six months ended June 30, 2019. This change of $7,497,273 was mainly due to net cash proceeds of $7,319,050 related to the capital raise in May 2020 compared to net proceeds of $14,807,938 from the capital raise in May 2019.

Off Balance Sheet Arrangements

As of June 30, 2020, we had no off-balance sheet arrangements. We are not aware of any material transactions that are not disclosed in our consolidated financial statements.

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Significant Accounting Policies and Critical Accounting Estimates

The methods, estimates, and judgments that we use in applying our accounting policies have a significant impact on the results that we report in our consolidated financial statements. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain. Our most critical accounting estimates include:

• The assessment of revenue recognition, which impacts revenue and cost of sales;
• the assessment of allowance for product warranties, which impacts gross profit;
• the assessment of collectability of accounts receivable, which impacts operating expenses when and if we record bad debt or adjust the allowance for doubtful accounts;
• the assessment of recoverability of long-lived assets, which impacts gross profit or operating expenses when and if we record asset impairments or accelerate their depreciation;
• the recognition and measurement of current and deferred income taxes (including the measurement of uncertain tax positions), which impact our provision for taxes;
• the valuation of inventory, which impacts gross profit; and
• the recognition and measurement of loss contingencies, which impact gross profit or operating expenses when we recognize a loss contingency, revise the estimate for a loss contingency, or record an asset impairment.

Recently Enacted Accounting Standards

For a description of accounting changes and recent accounting standards, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements, see “Note 1: Recently Enacted Accounting Standards” in the accompanying Financial Statements.

Subsequent Events

On July 8, 2020 the Company issued a total of 3,100 shares in connection with employees exercising options in relation to the stock option plan entered in 2015. The shares were issued at a share price of $2.96 and generated net proceeds of $9,176.

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Evaluation of Disclosure Controls and Procedures

Management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the design and effectiveness of our internal controls over financial reporting and disclosure controls and procedures (pursuant to Rule 13a-15(b) and (c) under the Exchange Act) as of the end of the period covered by this Quarterly Report. We have excluded the acquired company BS Plastic from the assessment of internal controls over financial reporting as of June 30, 2020 due to the limited time that the Company has been part of the LiqTech Group and an immaterial impact on the consolidated financial statements. A weakness is a control deficiency, or combination of control deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a misstatement of the registrant's financial statements will not be prevented or detected on a timely basis.

There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or override of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives

Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures as of June 30, 2020 were not effective as of the period covered by this Quarterly Report due to material weaknesses in internal controls over financial reporting. For more information on material weaknesses identified by management, please reference our Form 10-K filed on March 30, 2020 for the year ended December 31, 2019.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Management's Remediation Initiatives

In response to the identified material weaknesses, our management, with oversight from the Company’s Audit Committee, has been and will continue to dedicate necessary resources to enhance the Company’s internal control over financial reporting and remediate the identified material weaknesses. As an example of such remediation, the Company in 2019 hired additional employees into the finance department, and we plan to continue to work on remediating the material weaknesses during 2020 by improving competencies and processes. Further, an investment in a new ERP system has been made along with other supporting IT programs to support the controls and processes of the Company, are an important part of the remediation of the material weaknesses. Lastly, the Company has started the process of redesigning and ensuring documentation of all processes and procedures related to the financial reporting process to ensure the effective design and operation of process-level controls.

While management believes that the steps that we have taken and plan to take will improve the overall system of internal control over financial reporting and will remediate identified material weaknesses, the material weaknesses cannot be considered remediated until the applicable relevant controls operate for a sufficient period of time.

Limitations on the Effectiveness of Internal Controls

An internal control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, a control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

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