Liqtech International Inc: Form 10-Q for the period ended Mar 31, 2021

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 31, 2021 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 gas and liquid purification products by manufacturing ceramic silicon carbide filters and membranes. For more than two decades, we have developed and manufactured products of re-crystallized silicon carbide. We specialize in three business areas: ceramic membranes for liquid filtration systems, diesel particulate filters (DPFs) to control soot exhaust particles from diesel engines, and plastic components for usage in various industries. 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 office in Denmark and through local representatives and distributors. The products are shipped directly to customers from our production facilities in 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, 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 Ceramics A/S (“LiqTech Ceramics”), LiqTech Water A/S (“LiqTech Water”), LiqTech Plastics A/S (“LiqTech Plastics”), LiqTech Water Projects A/S ("LiqTech Water Projects”) and LiqTech Emission Control A/S (“LiqTech Emission Control”), all Danish limited companies organized under the Danish Act on Limited Companies of the Kingdom of Denmark, and LiqTech NA, Inc., a Delaware corporation (“LiqTech NA”). Collectively, LiqTech USA, LiqTech Holding, LiqTech Ceramics, LiqTech Water, LiqTech Plastics, LiqTech Water Projects, LiqTech Emission Control and LiqTech NA are referred to herein as our “Subsidiaries”.

We conduct operations in the Kingdom of Denmark. Our Danish operations are located in the Copenhagen area, in Hobro and in Aarhus.

Our Strategy

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

• Retain and acquire new customers in the marine industry. We currently provide water filtration systems for scrubber technology providers, shipowners, and ship operators. We are expanding our range of marine products to better leverage existing customer relationships and develop new relationships.
• Enter new geographic markets and expand existing markets. We plan to continue to manufacture and sell our products from our manufacturing center 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 where we intend to advance our efforts to maintain our market position in this area. Furthermore, we intend to leverage our OEM market experience by expanding our presence with new products and markets 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 of 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 the company significant opportunities.
• 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 membranes, and we will also combine the ceramic membranes with other technologies to offer our customers complete filtration solutions. Moreover, we will continue developing smaller standard systems, like those for groundwater treatment and residential swimming pools.

24

Developments

Results of Operations

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

The following table sets forth our revenues, expenses and net income for the three months ended March 31, 2021 and 2020:

25

Comparison of the Three Months Ended March 31, 2021 and March 31, 2020

Revenues

Revenue for the three months ended March 31, 2021 was $3,997,877 compared to $10,281,844 for the same period in 2020, representing a decrease of $6,283,967, or 61%. The change in sales mainly consists of a decrease in liquid filters of $6,822,950, offset by an increase in plastics of $232,615 and an increase in DPFs of $371,002. The decrease in sales of liquid filters and water treatment systems is a result of the negative impact of the ongoing COVID-19 pandemic, which has resulted in significant restrictions and business limitations across the globe and caused a substantial decline in the demand and delivery of water treatment systems for the marine scrubber industry. The demand for our DPFs increased based on the positive interest in environmental solutions to reduce global CO2 emissions. The increase in sales of plastic components is related to the increased sales activity started in 2020.

Gross Profit

Gross profit for the three months ended March 31, 2021 was $114,615 compared to gross profit of $2,639,076 for the same period in 2020, representing a decrease of $2,524,461, or 96%. 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. Gross profit was further impaired by increased costs related to decisions made prior to the impact of COVID-19, when the Company had invested in the expansion and improvement of production facilities along with the hiring of additional employees. Included in the gross profit is depreciation of $471,885 and $416,265 for the three months ended March 31, 2021 and 2020, respectively.

Operating Expenses

Total operating expenses for the three months ended March 31, 2021 were $2,921,775, representing an increase of $463,628, or 19%, compared to $2,458,147 for the same period in 2020.

Selling expenses for the three months ended March 31, 2021 were $1,009,498 compared to $676,800 for the same period in 2020, representing an increase of $332,698, or 49%. This change is attributable to the implementation of the growth strategy by adding additional sales employees, increasing from an average of 11 in 2020 to an average of 17 in 2021. Further the company has invested in additional marketing activities to help increase future sales.

General and administrative expenses for the three months ended March 31, 2021 were $1,474,670 compared to $1,470,393 for the same period in 2020, representing an increase of $4,277, or 0.3%. Included in general and administrative expenses is non-cash compensation of $102,388 and $141,222 for the three months ended March 31, 2021 and March 31, 2020, respectively, representing a decrease of $38,834, or 27%, 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 March 31, 2021 were $437,607 compared to $310,954 for the same period in 2020, representing an increase of $126,653, or 41%. 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

Net income (loss) for the three months ended March 31, 2021 was $(2,459,429) compared to $303,499 for the comparable period in 2020, representing a decrease of $2,762,928.

This change was primarily attributable to the significant decrease in revenue due to decreased demand for marine scrubbers, higher relative costs of goods sold as a percentage of revenue due to investments in production capacity, and the increase in operating expenses caused primarily by the growth in headcount to support additional sales and production.

Liquidity and Capital Resources

Based on the still ongoing negative effects of the global pandemic, we are unable to predict the full impact that COVID-19 will have on our long-term financial condition, results of operations, liquidity and cash flows due to uncertainties. Our compliance with the measures implemented to avoid the spread of the virus have had a material adverse impact on our financial results since March 2020. To the extent possible, we have taken precautionary measures to reduce and/or defer operating expenses and preserve liquidity. Based on current projections, which are subject to numerous uncertainties, including the duration and severity of the pandemic and containment measures along with 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 at least the next 12 months from the issuance of this report. In addition, as a result of the reduced order intake and decreased manufacturing levels, our future gross profit will also likely be unfavorably impacted until such time that we are able to operate our manufacturing facilities at higher capacity levels 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 2021.

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 how our business may be adversely affected as a result of the pandemic’s global economic impact. In the future, the pandemic may cause reduced demand for our products, especially if it results in a global recession. It could also lead to limitations in our ability to produce and ship products caused by governmental actions and regulations to contain the spread of the virus.

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 amounting to DKK 20,000,000 ($3,000,000), which is used for a leasing arrangement and guarantees issued to customers for prepayments and for warranties after delivery. On March 31, 2021, we had cash of $10,657,307 and net working capital of $12,507,792, and on December 31, 2020, we had cash of $13,264,449 and net working capital of $15,839,992. On March 31, 2021, our net working capital had decreased by $3,332,200 compared to December 31, 2020 as a result of a reduction in cash and cash equivalents, account receivables, contract assets, account payables and other accrued expenses.

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 guaranteed credit line of DKK10,000,000 (approximately $1,500,000). The credit line is secured by a cash deposit of $1,500,000. Further, we have a guarantee for a specific project delivered in 2016 of DKK 94,620 (approximately $14,917 on March 31, 2021) 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 Water such as receivables, inventory, and equipment.

Cash Flows

Three months ended March 31, 2021 compared to three months ended March 31, 2020

Cash provided (used) by operating activities is net income adjusted for certain non-cash items and changes in assets and liabilities. Cash used by operating activities for the three months ended March 31, 2021 was $1,303,890, representing a decrease of $653,780 compared to cash used by operating activities of $1,957,670 for the three months ended March 31, 2020. The cash used by operating activities for the three months ended March 31, 2021 consists mainly of the net loss for the period of $(2,459,429) adjusted for depreciation and other non-cash related items of $717,139. Further changes in assets and liabilities include decreased accounts receivables of $657,926, a decline in contract assets/liabilities of $914,006, and tax refunds of $336,232, offset by a decrease in accrued expenses of $492,028 and decrease in accounts payable of $372,530.

Net cash used in investing activities was $414,875 for the three months ended March 31, 2021 as compared to net cash used in investing activities of $1,067,699 for the three months ended March 31, 2020, representing a decrease of $652,824. The investing activities include the purchase of property and equipment primarily related to the installation of new furnaces in Ballerup to increase production capacity.

Cash used in financing activities was $101,192 for the three months ended March 31, 2021 as compared to net cash used by financing activities of $8,434 for the three months ended March 31, 2020. This change of $92,758 was mainly due to start-up of the finance lease agreement for the furnaces.

Off Balance Sheet Arrangements

As of March 31, 2021, we had no off-balance sheet arrangements. We are not aware of any material transactions that are not disclosed in our consolidated financial statements.

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 margin;
• 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 margin 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 margin 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 March 24, 2021, the Company entered into a Securities Purchase Agreement with an institutional investor pursuant to which the Company agreed to issue and sell a $15.0 million principal amount Senior Convertible Note due 2023 and an aggregate of 80,000 shares of common stock, par value $0.001 per share for an aggregate purchase price of $15.0 million upon the satisfaction of the closing conditions set forth in the Purchase Agreement. The closing occurred on April 8, 2021 and the Company issued to the investor the securities in connection with the closing.

We are not required to provide quantitative and qualitative disclosures about market risk because we are a smaller reporting company.

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. 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 overriding 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 March 31, 2021 were not effective as of the period covered by this Quarterly Report due to material weaknesses in internal controls over financial reporting, described below. For more information on material weaknesses identified by management, please reference our Form 10-K filed on March 31, 2021 for the year ended December 31, 2020.

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 has hired additional employees into the finance department, and we plan to continue to work on remediating the material weaknesses during 2021 by improving competencies and processes. Further, an investment in a new ERP system has been made along with other supporting IT systems to support the controls and processes of the Company, and these investments 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.

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.