Liqtech International Inc: Form 10-Q for the period ended Jun 30, 2022

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, 2022 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 NA, Inc., a Delaware corporation (“LiqTech NA”) and 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”), 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 Environment Technologies (China) Co., Ltd. (“LiqTech China”), a Chinese company organized under the Chinese Act on Limited Companies in the Peoples Republic of China. Collectively, LiqTech USA, LiqTech NA, LiqTech Holding, LiqTech Ceramics, LiqTech Water, LiqTech Plastics, LiqTech Water Projects, LiqTech Emission Control and LiqTech China are referred to herein as our “Subsidiaries”.

At present, we conduct our 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 leverage our core competencies in material science, advanced filtration, and systems integration, creating differentiated products with compelling value propositions to penetrate attractive end markets with regulatory and ESG tailwinds. Essential imperatives associated with our strategy include the following:

• Develop and reinforce new products and applications to provide clean water and reduce pollution. We currently provide water filtration systems for scrubber technology providers, shipowners, and ship operators as well as tailored filtration systems for oil & gas operators and services companies. We are expanding our range of products to better leverage existing customer relationships and develop new relationships within the oil & gas, marine, and global chemical industries.
• Better penetrate existing end markets where our value proposition is strong. We have successfully sold products and installed systems into several end markets--including automotive/transportation, clean water and pool filtration, marine, industrial wastewater, and oil & gas. We are focused on targeting and activating new customers in these end markets while working with distributors, agents, and partners to access other important geographic markets.
• Develop new end markets for our core products and applications. Our existing products and systems are relevant for and valuable to other end markets, and we regularly evaluate opportunities to partner with strategic customers to perfect new applications and validate associated value propositions.

28

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 loss for the three months ended June 30, 2022 and 2021:

Revenue

Revenue for the three months ended June 30, 2022 was $5,018,292 compared to $4,016,563 for the same period in 2021, representing an increase of $1,001,729, or 25%. The increase was particularly attributed to an increase in sales of liquid filters and water treatment systems of $1,064,007, partly offset by a decrease in sales of development projects of $83,204. Sales of DPFs and Plastics components were comparable to the same period in 2021, reflecting stable activity amid volatile market conditions and more recently, geopolitical unrest and macroeconomic uncertainty impacting demand.

Gross Profit

Gross profit for the three months ended June 30, 2022, was $148,140 compared to gross profit of $320,710 for the same period in 2021, representing a decrease of $172,570. The decrease in gross profit was mainly caused by reduced profitability in our Ceramics business driven by lower share of ceramic membranes, lost productivity linked to quality issues, and finally negative impact from rising input cost inflation associated with the production of our silicon carbide products, more specifically increased electricity and raw material prices, labor cost inflation, and general price increases on freight and logistic services. This was partly offset by an increase in system sales with deliveries in both the Middle East and Europe, coupled with elevated profitability from sales of plastics components, systems spare-parts, and general commission activities. Included in the gross profit was depreciation of $473,697 and $496,049 for the three months ended June 30, 2022 and 2021, respectively.

Expenses

Total operating expenses for the three months ended June 30, 2022 were $4,741,719, representing an increase of $1,857,372, or 64%, compared to $2,884,347 for the same period in 2021, mainly driven by this quarter’s restructuring costs of $1,788,827.

Selling expenses for the three months ended June 30, 2022 of $1,196,513 compared to $1,202,586 for the same period in 2021, representing a decrease of $6,073, or 1%. The current quarter was negatively impacted by a bad debt provision of approximately $150,000 pertaining to a European Ceramics client, offset by cost reductions associated with direct sales and consulting activities.

General and administrative expenses for the three months ended June 30, 2022, were $1,265,543 compared to $1,247,132 for the same period in 2021, representing an increase of $18,411, or 2%. Included in general and administrative expenses was increased cost associated with the CFO and CEO transition and non-cash compensation of $221,472 and $125,076 for the three months ended June 30, 2022, and 2021, respectively. Notably, the second quarter general and administrative expenses have decreased by $650,974 compared to the first quarter, which was mainly driven by project management and leasehold expenses in China, coupled with the implementation of a new ERP platform and general recruitment costs, all underpinned by the Company’s cost reduction efforts.

The following is a summary of non-cash compensation:

Research and development expenses for the three months ended June 30, 2022, were $490,836 compared to $434,629 for the same period in 2021, representing an increase of $56,207, or 13%. The increase represents the completion of several development projects during the quarter mainly related to improvement and optimization of filtration systems.

Restructuring costs for the three months ended June 30, 2022, were $1,788,827 compared to $0 for the same period in 2021. During the quarter, the Company completed a restructuring program to reduce costs, decrease operating losses and improve cash flow. Total restructuring and restructuring-related net charges pursuant to this program were $1,788,827 (see Note 3).

Other Income (Expenses)

Other Income (Expenses) for the three months ended June 30, 2022 was $(1,927,517) compared to $(549,964) for the comparable period in 2021, representing a negative variance of $1,377,553. This change was mainly related to the repayment of the Convertible Note issued in April 2021, with $1,922,618 for the amortization discount and $121,458 for interest expenses. Further, Other Income (Expenses) was positively affected by the receipt of COVID-19 grants and the gain on lease termination related to the China closings, offset by a loss on currency transactions due to a less favorable DKK/USD exchange rate during the period.

Net Loss

Net loss for the three months ended June 30, 2022, was $(6,507,059) compared to $(3,098,108) for the comparable period in 2021, representing an increase in net loss of $3,408,951.

This change was primarily attributable to this quarter’s recognized restructuring costs of $1,788,827 and other expenses including interest and amortization discount primarily related to the repayment of the Convertible Note.

Comparison of the Six Months Ended June 30, 2022 and June 30, 2021

The following table sets forth our revenues, expenses and net loss for the six months ended June 30, 2022 and 2021:

Revenue

Revenue for the six months ended June 30, 2022, was $8,655,528 compared to $8,014,440 for the same period in 2021, representing an increase of $641,088, or 8%. The increase was particularly attributed to an increase in sales of liquid filters and water treatment systems of $499,661, and engineered plastic products of $343,906, partly offset by lower share of completed development projects of $153,125 and Ceramics products of $49,355 due to lower share of direct membrane sales and the continued negative impact from the USD appreciation against the EURO and DKK.

Gross Profit

Gross profit for the six months ended June 30, 2022, was $393,681 compared to gross profit of $435,325 for the same period in 2021, representing a decrease of $41,644. The decrease in gross profit was mainly caused by reduced profitability from the Ceramics business due to unfavorable mix further exacerbated by continued input cost inflation and the negative impact from the USD appreciation, but also the delivery of a significant water treatment system at comparatively lower margin during the second quarter with subsequent service and commissioning revenue expected to elevate the full project margin. This was partly offset by continued resilient contribution from both the sale of plastics components, systems spare-parts, and general commission activities during the period. Included in the gross profit was depreciation of $969,746 and $967,055, for the six months ended June 30, 2022, and 2021, respectively.

Expenses

Total operating expenses for the six months ended June 30, 2022 were $8,320,921, representing an increase of $2,514,799, or 43%, compared to $5,806,122 for the same period in 2021, mainly driven by the second quarter restructuring costs of $1,788,827.

Selling expenses for the six months ended June 30, 2022 of $2,256,461 compared to $2,212,084 for the same period in 2021, representing an increase of $44,377, or 2%. The current increase was a combination of increased costs associated with intensified direct sales efforts, consulting service engagements, and direct marketing activities during the period, combined with a bad debt provision booked in the second quarter.

General and administrative expenses for the six months ended June 30, 2022, were $3,182,060 compared to $2,721,802 for the same period in 2021, representing an increase of $460,258, or 17%. The increase was mainly driven by increased headcounts and continued spend associated with the China capacity expansion in the first quarter. Included in general and administrative expenses for the period was also increased cost associated with recent management changes as well as and non-cash compensation of $400,250 and $227,464 for the six months ended June 30, 2022, and 2021, respectively.

The following is a summary of non-cash compensation:

Research and development expenses for the six months ended June 30, 2022, were $1,093,573 compared to $872,236 for the same period in 2021, representing an increase of $221,337, or 25%. The increase represents the completion of several development projects during the period.

Restructuring costs for the six months ended June 30, 2022, were $1,788,827 compared to $0 for the same period in 2021. The restructuring program was executed in the second quarter.

Other Income (Expenses)

Other Income (Expenses) for the six months ended June 30, 2022, was $(2,355,244) compared to $(218,699) for the comparable period in 2021, representing a negative variance of $2,136,525. The variance was mainly related to the Convertible including interest and cost related to the repayment with a combined expense of $1,968,152 compared to the same period in 2021. Further, the period was negatively impacted by loss on currency transactions of $266,209 compared to a gain in the same period last year of $287,988, due to a less favorable DKK/USD exchange rate, partly offset by the receipt of COVID-19 grants in the Danish entities.

Net Loss

Net loss for the six months ended June 30, 2022, was $(10,253,483) compared to $(5,557,537) for the comparable period in 2021, representing an increase in net loss of $4,695,946.

This change was primarily attributable to the operating losses for the period, second quarter restructuring charges, and refinancing cost related to the repayment of the Convertible Note.

Liquidity and Capital Resources

Based on the prolonged negative effects of the global pandemic, continued market volatility and geopolitical unrest pertaining to the Russia and Ukraine conflict, the Company is unable to predict the full impact this will have on our long-term financial condition, results of operations, liquidity, and cash flows. The Company has planned and executed on decisive measures in the first half of 2022 to help safeguard the business and its financial position by reducing cost, headcount, and overall capex commitments, which together with the successful completion of the $26.45 million public offering of common stock and pre-funded warrants, substantially improves the near-term liquidity position of the Company.

Furthermore, in June the Company completed the refinancing of its $15 million Convertible Note due in 2023, partly funded by the issuance of the new $6 million Senior Promissory Notes due in June 2024 along with the proceeds from the public offering. The Senior Promissory Notes are interest-free, with full redemption after 24 months.

Based on current projections, which are subject to significant uncertainties, including the duration and severity of global macroeconomic issues, commodity volatility, and continued global supply chain disruptions, the Company believes the cash on hand, as well as ongoing cash generated from operations, will be sufficient to cover its capital requirements and committed investments for the next 12 months.

Continued market uncertainty and reduced order intake caused by global macroeconomic conditions, recession, or a resurgence of the COVID-19 pandemic, however, could unfavorably impact the Company’s ability to generate positive cash flow and thereby significantly reduce the profitability and liquidity position.

While the Company anticipates that its proactive measures will be sufficient to protect and fund the business over the coming 12 months, the Company cannot predict the specific duration and severity of the unfavorable market dynamics that may adversely affect the business as a result of these global economic issues and associated supply chain disruptions. In the future, the Company may experience reduced or changed demand for its products and services, especially if there is global recession or structural shift in regulation or demand for its products across its core markets.

The Company has historically satisfied its capital and liquidity requirements through offerings of equity instruments, internally generated cash from operations and our available lines of credit. On June 30, 2022, the Company had cash of $19,695,722 and net working capital of $25,884,809, and on December 31, 2021, the Company had cash of $17,489,380 and net working capital of $11,199,258. The increase in working capital of $14,685,551 compared to December 31, 2021 is mainly a result of the capital raise and repayment of the Convertible Note.

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 EUR1,750,000 (approximately $1,820,000). The credit line is secured by a cash deposit.

Convertible Note

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 (the “Note”) due on October 1, 2023 and 80,000 shares of common stock, $0.001 par value (“Common Stock”), for an aggregate purchase price of $15.0 million upon the satisfaction of the closing conditions set forth in the Securities Purchase Agreement. The Closing occurred on April 8, 2021, and the Company issued to the Investor the securities in connection with the Closing.

The Note is a senior, unsecured obligation of the Company, payable at 112% of the principal amount at maturity (October 1, 2023) or earlier upon redemption or repurchase as set forth in the Note. The Note is convertible into shares of Common Stock pursuant to the terms of the Note, in part or in whole, from time to time, at the election of the Investor. The initial conversion rate is 100.6749 shares of Common Stock per $1,000 of principal amount of the Note. The conversion rate is subject to anti-dilution adjustments including for stock dividends, splits and combinations; issuances of options, warrants or similar rights; spin-offs and distributions of property; cash dividends or distributions; and tender or exchange offers, in each case as further described in and pursuant to the terms of the Note.

The Note has interest payable quarterly beginning on June 1, 2021 at a rate of 5% per annum. The number of shares issuable if the Company elects to pay interest in shares of Common Stock shall be based on the Market Price.

The Company may provide written notice to the Holder electing to convert the entire Principal Amount of the Note if (1) the Daily VWAP per share of Common Stock exceeds one hundred and seventy-five percent (175%) of the Conversion Price on each of twelve (12) consecutive VWAP Trading Days beginning after September 24, 2021; and (2) the Equity Conditions are satisfied on each of such twelve (12) consecutive VWAP Trading Days.

Beginning on March 1, 2022, and on the first day of each calendar month thereafter, at the election of the Investor or Holder, if applicable, the Company shall be required to redeem $840,000 of the amounts due under the Note in cash or Common Stock at 90% of the lesser of (i) the volume-weighted average price (“VWAP”) of the Common Stock on the trading day immediately preceding the payment date and (ii) the average of the lowest three (3) VWAPs over the 10 trading days immediately preceding the payment date, which shall in no case be less than the floor price of $1.75 per share. On March 1, 2022, the Company paid the first installment of $840,000 in cash.

As of June 22, 2022, the Note, including accrued interests and all relevant obligations, was repaid in full, amounting to $13,446,875, allocated to principal repayment of $11,640,000 and contractual repayment premium of $1,806,875. During the quarter, the Company paid the second, third, and fourth installment, totaling $2,520,000, in cash according to the original payment schedule.

Senior Promissory Notes

On June 22, 2022, the Company issued and sold Senior Promissory Notes in an aggregate principal amount of $6.0 million (the "Notes") and issued warrants to purchase 4,250,000 shares of common stock of the Company to affiliates of Bleichroeder L.P., 21 April Fund, L.P., and 21 April Fund, Ltd. (together, the "Purchasers"), pursuant to a note and warrant purchase agreement entered into with the Purchasers.

The Notes have a term of 24 months and do not bear interest during this period. If the notes are not repaid on or before the second anniversary of issuance, however, the Notes will thereafter bear interest of 10% per annum, which will increase by 1% each month the Notes remain unpaid, up to a maximum of 16% per annum, payable monthly.

Additionally, as part of the transaction, the Company issued 230,000 warrants to the placement agent. All of the warrants issued in this transaction have an exercise price of $0.65 per share, a term of five years and are exercisable for cash at any time.

As a result, the Company recorded an initial debt discount of $664,704 based on the relative fair value of the warrants and notes issued. The Company determined the fair value of the warrants by using the Black-Scholes Option Pricing Model with the following assumptions: expected term of 2.5 years, stock price of $0.43, exercise price of $0.65, volatility of 80.8%, risk-free rate of 3.13%, and no forfeiture rate. The debt discount will be accreted according to the effective interest method over the contractual term of the note. The warrants qualified for equity classification and were reported within Additional Paid-In Capital.

Cash Flows

Six months ended June 30, 2022 compared to six months ended June 30, 2021

Cash provided by (used in) operating activities for the six months ended June 30, 2022 of $(11,032,241) represents a decrease of $10,121,981 compared to $(910,259) for the six months ended June 30, 2021. For the six months ended June 30, 2022, the result is mainly attributable to the net loss for the period of $(10,253,483) adjusted for depreciation and other non-cash-related items of $4,274,243. Changes in assets and liabilities include increased Accounts receivable of $660,578 and net Contract assets/liabilities of $1,358,363, with the latter caused by delivery of a water treatment system in Q2 2022 includes an extended payment schedule that runs until August 2025. Furthermore, Accounts payable increased by $432,337 and Accrued expenses decreased by $178,716.

Net cash used in investing activities of $229,204 for the six months ended June 30, 2022 compared to $717,232 for the six months ended June 30, 2021, representing a decrease of $488,028 due to limited delivery of production equipment during the quarter, with investments confined to the purchase of production equipment in Ballerup to relieve manufacturing bottlenecks and the continued investment in the new ERP platform, for which full implementation is anticipated in Q3 2022.

Cash provided from financing activities was $13,473,839 for the six months ended June 30, 2022 compared to $14,090,829 for the six months ended June 30, 2021, representing a decrease of $616,990. For the six-month period ended June 30, 2022, the result is mainly affected by the equity raise, generating net proceeds of $24,453,527 from the issuance of common stock and prefunded warrants, and proceeds of $6,000,000 from the issuance of the new Senior Promissory Notes, offset by the full repayment of the Convertible Note issued in April 2021 of $16,800,000.

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

For a description of subsequent events, see “Note 13 – Subsequent Events”.

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 Interim 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 Interim Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures as of June 30, 2022 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 31, 2022 for the year ended December 31, 2021.

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, Company 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 2022 by improving competencies and work processes. Further, an investment in a new ERP system has been made along with other supporting IT systems to reinforce the controls and processes of the Company. These investments are an important part of our remediation plan. Lastly, the Company has started the process of redesigning and ensuring documentation of all processes and procedures related to financial reporting to ensure the effective design and operation of process-level controls.

While management believes that the steps that have been taken and plan to take will improve the overall system of internal control over financial reporting and will remediate the identified material weaknesses, these material weaknesses cannot be considered fully 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.