Liqtech International Inc: Form 10-Q for the period ended Sep 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.

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 September 30, 2022 and 2021:

Revenue

Revenue for the three months ended September 30, 2022, was $3,305,534 compared to $4,142,954 for the same period in 2021, representing a decrease of $837,420, or 20%. The decrease was particularly attributed to a reduction in deliveries of water treatment systems of $708,503 and a decrease in Plastics revenue of $190,389 amid general market uncertainty exacerbated by the European energy crisis, partly offset by an increase in Ceramics revenue of $151,924 due to increased sales of membranes and large-scale DPF deliveries for the Asian market.

Gross Profit

Gross profit for the three months ended September 30, 2022, was $107,279 compared to gross profit of $196,222 for the same period in 2021, representing a decrease of $88,943. The decrease was mainly caused by the continued negative impact from rising input cost inflation associated with the production of our silicon carbide products, including increases in electricity, raw material prices, labor, freight and logistic services. The gross profit in the third quarter was further impacted by adjustments for excess and obsolete inventory in a period with changing market fundamentals, resulting in write-downs of select items and implementation of revised standard cost calculations. The negative impact was partly offset by deliveries of high-margin Ceramics membranes and increased aftermarket sales during the quarter. Included in the gross profit was depreciation of $436,257 and $473,327 for the three months ended September 30, 2022 and 2021, respectively.

Expenses

Total operating expenses for the three months ended September 30, 2022 were $2,387,295, representing a decrease of $419,149, or 15%, compared to $2,806,444 for the same period in 2021, mainly reflecting the cost reduction, restructuring, and reorganization efforts implemented in 2022.

Selling expenses for the three months ended September 30, 2022 were $676,420 compared to $1,205,849 for the same period in 2021, representing a decrease of $529,429, or 44%. This decline was the result of, organizational streamlining that included a reduction in headcounts of seven compared to same period in 2021, partly offset by increased marketing and travel activities following the easing of COVID-19 restrictions.

General and administrative expenses for the three months ended September 30, 2022, were $1,429,315 compared to $1,102,772 for the same period in 2021, representing an increase of $326,543, or 30%. Included in general and administrative expenses was increased non-cash compensation of $254,592 related to onboarding of new CFO, CEO, and interim CEO agreement, and increased employee expenses related to onboarding of key staff, partly offset by a decrease in legal expenses.

The following is a summary of non-cash compensation:

Research and development expenses for the three months ended September 30, 2022, were $283,524 compared to $497,823 for the same period in 2021, representing a decrease of $214,299, or 43%. The decrease represents a reduction in the number of external development projects along with efficiencies and saving achieved through the streamlining and centralization of the R&D function.

Restructuring costs for the three months ended September 30, 2022, were $(1,964) compared to $0 for the same period in 2021, representing additional restructuring costs for the completion of the restructuring program announced in the second quarter (see Note 3), offset by the continued appreciation of the USD against EUR and DKK.

Other Income (Expenses)

Other Income for the three months ended September 30, 2022, was $514,059 compared to Other Expenses of $309,425 for the comparable period in 2021, representing a positive variance of $823,484. The change was mainly related to a decrease in interest expenses and amortization discount of $414,835, explained by the refinancing of the Convertible Note in the second quarter of 2022 with the new $6 million Senior Promissory Note and gain on currency transactions of $410,107.

Net Loss

Net loss for the three months ended September 30, 2022, was $1,752,664 compared to $2,903,956 for the comparable period in 2021, representing a decrease in net loss of $1,151,292, supported by the intensified cost reduction efforts, gain on currency transactions, and the benefits from the refinancing of the Convertible Note.

Comparison of the Nine Months Ended September 30, 2022 and September 30, 2021

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

Revenue

Revenue for the nine months ended September 30, 2022, was $11,961,062 compared to $12,157,394 for the same period in 2021, representing a decrease of $196,332, or 1.6%. The decrease was mainly driven by increased Plastics revenue of $153,517 and Ceramics revenue of $104,088, offset by the continued appreciation of the USD against the EUR due to revenue denominated in DKK or EUR, coupled with lower share of completed development projects of $245,098 and reduced Water revenue of $208,840.

Gross Profit

Gross profit for the nine months ended September 30, 2022, was $500,960 compared to gross profit of $631,547 for the same period in 2021, representing a decrease of $130,587. The change reflects reduced profitability within the Plastics and Ceramics businesses due to unfavorable mix, further exacerbated by continued input cost inflation and the European energy crisis. Proactive measures such as price increases and power price surcharges have been launched by the company to defend profitability. Included in the gross profit was depreciation of $1,406,003 and $1,440,382, for the nine months ended September 30, 2022 and 2021, respectively.

Expenses

Total operating expenses for the nine months ended September 30, 2022, were $10,708,216, representing an increase of $2,095,650, or 24%, compared to $8,612,566 for the same period in 2021, mainly driven by restructuring costs of $1,786,863 recognized in the second quarter of 2022.

Selling expenses for the nine months ended September 30, 2022, were $2,932,881 compared to $3,417,933 for the same period in 2021, representing a decrease of $485,052, or 14%. The decrease is explained by the cost reduction and reorganization efforts initiated in 2022, and more specifically headcounts reductions and organization streamlining, partly offset by increased costs associated with intensified direct sales efforts, consulting service engagements, direct marketing activities, and bad debt provisions.

General and administrative expenses for the nine months ended September 30, 2022, were $4,611,375 compared to $3,824,574 for the same period in 2021, representing an increase of $786,801, or 21%. The increase was mainly caused by increased headcount and costs associated with the China capacity expansion, recruitment of key employees, and general legal and audit costs. Also included in general and administrative expenses for the period was increased cost associated with the recent CEO transition that included increased non-cash compensation of $782,361 for the nine months ended September 30, 2022, compared to $354,983 in the same period in 2021.

The following is a summary of non-cash compensation:

Research and development expenses for the nine months ended September 30, 2022, were $1,377,097 compared to $1,370,059 for the same period in 2021, representing an increase of $7,038, or 0.5%.

Restructuring costs for the nine months ended September 30, 2022, were $1,786,863 compared to $0 for the same period in 2021. The restructuring program was executed in the second quarter (See Note 3).

Other Income (Expense)

Other Expense for the nine months ended September 30, 2022, was $1,841,165 compared to $528,124 for the comparable period in 2021, representing a negative variance of $1,313,040.

The variance was mainly related to the early repayment of the Convertible Note issued in April 2021, reflecting the full recognition of the repayment premium and amortization cost in the second quarter of 2022. Further, the period was impacted by a lower gain on currency transactions of $144,090, partly offset by the receipt of COVID-19 grants in the Danish entities and gain on lease terminations.

Net Loss

Net loss for the nine months ended September 30, 2022, was $12,006,147 compared to $8,461,493 for the comparable period in 2021, representing an unfavorable variance in net loss of $3,544,653.

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

Liquidity and Capital Resources

Based on the continued, and more recently increased market volatility and geopolitical unrest pertaining to the Russia and Ukraine conflict, European energy crisis and highly inflationary environment, and macro-economic uncertainty, 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 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 improve 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 weakening 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 a global recession or structural shift in regulation or demand for its products across its core end 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 September 30, 2022, the Company had cash of $17,605,377 and net working capital of $23,306,125, 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 $12,106,867 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 EUR 1,350,000 (approximately $1,315,000). 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 was 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 was 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 was 100.6749 shares of Common Stock per $1,000 of principal amount of the Note. The conversion rate was 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.

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 was 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. Beginning on March 1, 2022, the Company paid the first monthly installments of $840,000 in cash, totaling $3,360,000.

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.

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

Nine months ended September 30, 2022 compared to nine months ended September 30, 2021

Cash used in operating activities for the nine months ended September 30, 2022 of $11,482,936 represents a decrease of $7,074,845 compared to $4,408,091 for the nine months ended September 30, 2021. For the nine months ended September 30, 2022, the result is mainly explained by the net loss for the period of $12,006,147 adjusted for depreciation and other non-cash-related items of $5,153,301. Changes in assets and liabilities include increased Accounts receivable of $1,262,577 and net Contract assets/liabilities of $650,497, with the latter caused by the delivery of a water treatment system in the second quarter of 2022 with an extended service, commissioning, and payment schedule running until August 2025. The increase in prepaid expenses and other current assets of $1,497,612 is related to prepayments on production equipment. Furthermore, accounts payable increased by $212,304 and accrued expenses decreased by $1,028,428 due to repayment of COVID-19 loans provided by the Danish government.

Net cash used in investing activities was $791,881 for the nine months ended September 30, 2022, compared to $1,252,741 for the nine months ended September 30, 2021, representing a decrease of $460,860.

Cash provided from financing activities was $13,359,415 for the nine months ended September 30, 2022 compared to $13,995,807 for the nine months ended September 30, 2021, representing a decrease of $636,392. For the nine-month period ended September 30, 2022, the change is mainly explained by the equity capital raise in the second quarter, generating net proceeds of $24,418,612 from the issuance of common stock and prefunded warrants, combined with the $6,000,000 proceeds from the issuance of the new Senior Promissory Notes, and 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, along with the reserve for excess and obsolescence, 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

None.

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 September 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.