Charlie's Holdings, Inc.: Form 10-Q for the period ended Jun 30, 2023

The following discussion of the financial condition and results of operations of Charlie’s Holdings, Inc. should be read in conjunction with the financial statements and the notes to those statements appearing elsewhere in this Quarterly Report on Form 10-Q (this “Report”) and without audited financial statements and other information presented in our Annual Report on Form 10-K for the year ended December 31, 2022 (the “2022 Annual Report”). Some of the information contained in this discussion and analysis or set forth elsewhere in this Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. Such forward-looking statements are subject to a number of risks, uncertainties, assumptions and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by the forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and elsewhere in this Report, and in our other filings with the Securities and Exchange Commission (“SEC”), including particularly matters set forth under Part I, Item 1A (Risk Factors) of the 2022 Annual Report. Furthermore, such forward-looking statements speak only as of the date of this Report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

As used in this Report, unless otherwise stated or the context otherwise requires, references to the “Company”, “we”, “us”, “our”, or similar references mean Charlie’s Holdings, Inc., its subsidiaries and consolidated variable interest entity on a consolidated basis.

Overview

The Company’s objective is to become a leader in three broad product categories: (i) non-combustible nicotine-related products, (ii) alternative alkaloid vapor products, and (iii) hemp-derived vapor and edible products. Through our Charlie’s subsidiary, we formulate, market, and distribute premium, nicotine-based and alternative alkaloid vapor products. Charlie’s products are produced through contract manufacturers for sale through select distributors, specialty retailers, and third-party online resellers throughout the United States, as well as in more than 80 countries worldwide. Charlie’s primary international markets include the United Kingdom, Italy, Spain, New Zealand, Australia, and Canada. Through Don Polly, we develop, market and distribute products containing compounds derived from hemp.

Operational Plan

Considering industry-specific hurdles, as well as the potential for future regulatory changes, management has targeted opportunities for growth and has adopted the following operational plan.

Priority 1: In 2022, we initiated a plan and began to invest substantial time and resources to develop various proprietary products and new technologies in order to achieve competitive advantages in the vapor and alternative products marketplace. In conjunction with internal and external research and development resources, we have endeavored to identify a nicotine substitute (“Metatine™”) to be used in lieu of tobacco-based and synthetically derived nicotine. We believe adult consumers will enjoy Metatine vapor products in much the same way that they enjoy traditional vapor products. However, because Metatine is not made or derived from tobacco, and because Metatine does not consist of or contain nicotine from any source, the FDA's Center for Tobacco Products does not have jurisdiction to regulate Metatine. Accordingly, if the Company is successful utilizing Metatine in the development of a viable commercial product, such a product would allow us additional flexibility in offering both flavored and non-flavored vapor products to adult consumers looking to transition away from traditional combustible and smokeless tobacco products.

In September 2023 the Company plans to begin shipping its new Metatine disposable vape products, under the “SPREE BAR™” brand name. We believe that our transition to the SPREE BAR product line will give Charlie's an extraordinary opportunity to capture significant sales and market share in the vapor products marketplace in 2024 and beyond.

• SPREE BAR, with Metatine, is indistinguishable from a conventional disposable vape; SPREE BAR provides adult consumers with the same cerebral satisfaction that typical nicotine disposables provide, but without nicotine.
• As a disposable pod system - with a reusable battery - 6,000-puff SPREE BAR flavor pods have a retail price that is LESS THAN HALF that of the industry-leading 5,500-puff disposables.
• Because Metatine is not made or derived from tobacco, and because Metatine does not consist of or contain nicotine from any source, SPREE BAR is not subject to FDA Pre-Market Tobacco Application ("PMTA") requirements.

As of the date of this writing, before receiving any finished product from our Chinese manufacturers, we have awarded Master Distributor and Distributor contracts to six large customers. As part of these agreements, we have accepted purchase orders, and corresponding 50% up-front deposits, for each distributor’s initial order. It is our plan to sign additional Master Distributor agreements with as many as ten new SPREE BAR Distributors before the end of 2023. Given the novelty of the product, its compelling value in the marketplace as a disposable pod system (with a reusable battery), and its very significant regulatory advantages, SPREE BAR represents the single largest, most important commercial opportunity in Charlie's history.

The Company has also begun to develop intellectual property around technologies designed to prevent youth access to nicotine vapor products. Edward Carmines, Ph.D., a member of Charlie’s Board of Directors and an accomplished scientist and regulatory affairs expert, is spearheading Charlie's development of patented "age-gating technology" for both Charlie's and potential licensees of the Company. Currently, there is a need for age-gated product technologies that can satisfy or accommodate concerns the FDA has related to under-age youth access in the ENDS market. If our age-gated e-cigarettes-in-development are recognized as "products of merit" by the FDA, Charlie's e-cigarettes could emerge among the select minority of flavored nicotine disposables able to be sold legally in the $7 billion U.S. vapor products market.

Underlining the importance of Charlie’s work with age-gating technology is an initiative taken by JUUL Labs, one of the largest competitors in our industry. In July JUUL announced that it has submitted a PMTA with the FDA for a new e-cigarette device that also included information on novel, data-driven technologies to restrict underage access. JUUL’s chief product officer explained, “With our next-generation platform, we have designed a technological solution for two public-health problems: improving adult-smoker switching from combustible cigarettes and restricting underage access to vapor products...” Similar to the age-gating technology under development at Charlie’s, the JUUL device includes a mobile and web-based app that enables age-verification technology, including device-locking, and real-time product information and usage insights for age-verified consumers with industry-leading data-privacy protections.

Rounding out the Company’s research and development initiatives are Charlie’s efforts to expand and enhance the PINWEEL product line. PINWEEL is Charlie’s alternative cannabis brand that contains only cannabinoids derived from the hemp plant. Since our PINWEEL product line contains only cannabinoids made from 100% hemp extract, we are able to legally manufacture, distribute and sell to consumers in the United States. As a result of the Agriculture Improvement Act (the “Farm Bill”), ratified and signed into law in December 2018, cannabis containing less than 0.3% Delta 9-THC is legally classified as hemp and is thus legal under federal law. Accordingly, with the objective of developing an array of new purpose-driven alternative cannabis products that offer adult consumers an enjoyable alternative to alcohol and traditional cannabis products, the Company continues to develop new PINWEEL vapor products, edibles, and other novel products.

Priority 2: In November 2022, we successfully launched our PINWEEL brand of alternative cannabis products. In the second half of 2023, we plan to increase sales and marketing efforts of our PINWEEL product line, including ingestibles and disposable vapor devices. We feel there is a significant upside in the hemp-derived products space, and we have begun to shift our focus in this business to the burgeoning “alternative cannabis” market for products containing live resin blends of hemp-derived cannabinoids. These product categories have grown rapidly, as they offer consumers a range of benefits across varying potencies and product formats. Alternative cannabis products contain only cannabinoids that are derived from the hemp plant, are not subject to the Controlled Substances Act and are legal throughout most of the United States. Further, alternative cannabis products are not currently subject to FDA review.

Priority 3: With a new focus on the SPREE BAR product line and on the Master Distributors with whom we have awarded SPREE BAR distribution agreements, we will cost-effectively expand and strategically refocus our sales team. An expanded sales team will more effectively manage key customer relationships across a larger number of reps, mitigating concentration risks and assuring adequate coverage. The sales team is organized into two groups, each with a specific mandate for targeting customers. One group will focus on direct-to-retail (smoke shops, chain stores, adult beverage/liquor stores, gas stations, and grocery stores) with the goal of acquiring 1,000 new customer accounts in 2023. The second group will focus on satisfying the requirements of mega-distributors (McLane, Coremark, HT Hackney, Eby-Brown) in order to sell into the nation’s largest chain store accounts. Additionally, to broaden our footprint with customers and to minimize order size variability, sales reps will rebalance their product sales mix, placing enhanced focus on alternative cannabis and legacy e-liquid products.

Priority 4: In order to mitigate FDA regulatory risk in the domestic market and to capture what management continues to believe is a significant commercial opportunity, we have dedicated additional resources to efforts focused on growing our market share internationally. Presently, approximately 17% of our vapor product sales come from the international market and we are well positioned to increase sales in countries where we already have presence and, in additional overseas markets, as we have already built an international distribution platform. To facilitate this plan, we recently hired an Account Executive who is dedicated to driving our efforts in international expansion. Further, in late 2023 and throughout 2024 we plan to build-out a dedicated international team, including country managers and marketing coordinators, to market and sell a suite of custom-made products to new and existing international customers.

Recent Developments

New Executive Employment Agreement. On June 15, 2023, the Company entered into a new employment agreement with Ryan Stump (the “New Agreement”). Pursuant to the New Agreement, Mr. Stump will earn a base salary of $300,000 per year and serve as Chief Operating Officer for a term of two years, renewable on an annual basis unless earlier terminated by the Company or Mr. Stump. In the event that Mr. Stump is terminated by the Company without Cause (as defined therein) or for Good Reason (as defined therein), he will be entitled to receive his base salary and benefits for a period of one year. In the event of a change in control, all unvested equity awards will immediately vest. Notwithstanding his contracted annual salary, to cut costs during a time when the Company is striving to launch the SPREE BAR line, Mr. Stump has elected to reduce his current compensation to the rate of $225,000 annually. As a point of reference, all the Company’s other executives have also elected to reduce their current compensation. It is anticipated that, after the launch of SPREE BAR, executive base salaries will revert to their previous levels.

New Director. At the Company’s Annual Meeting of Stockholders, the Company’s stockholders appointed Michael D. King as a director. Mr. King is the Founder and current Chief Executive Officer of OEM Solutions, a private company that has developed a supply network in Asia with world-class manufacturing companies that offer a wide variety of custom-made medical products, scientific instruments, consumer products, and food service devices. Operating OEM Solutions has been Mr. King’s sole occupation and employment for the past 22 years. From 1998 until 2001, Mr. King worked as a Sales Representative at Allied Enterprises in Pittsburgh, Pennsylvania. From 1991 through 1998, Mr. King worked for the Ford Motor Company in the Finance Department as an analyst and eventually supervisor. Mr. King graduated with a Master of Business Administration degree from the State University of New York at Buffalo in 1991.

Risks and Uncertainties and Ability to Continue as a Going Concern

The Company operates in an environment that is subject to rapid changes and developments in laws and regulations that could have a significant impact on the Company’s ability to sell its products. Beginning in September 2019, certain states temporarily banned the sale of flavored e-cigarettes, and several states and municipalities are considering implementing similar restrictions. Federal, state, and local governmental bodies across the United States have indicated that flavored e-cigarette liquid, vaporization products and certain other consumption accessories may become subject to new laws and regulations at the federal, state, and local levels. In addition, in June 2022, the FDA announced a plan to reduce nicotine levels in cigarettes to minimally or non-addictive levels. The application of any new laws or regulations that may be adopted in the future, at a federal, state, or local level, directly or indirectly implicating nicotine, flavored e-cigarette liquid, and other electronic nicotine delivery system (“ENDS”) products, could significantly limit the Company’s ability to sell such products, result in additional compliance expenses, and/or require the Company to change its labeling and/or methods of distribution. Any ban of the sale of flavored e-cigarettes directly limits the markets in which the Company may sell its products. In the event the prevalence of such bans and/or changes in laws and regulations increase across the United States, or internationally, the Company’s business, results of operations, and financial condition could be adversely impacted. In addition, the Company is presently seeking to obtain marketing authorization for certain of its tobacco-derived nicotine e-liquid products. The Company’s applications were submitted in September 2020 on a timely basis, which if approved, will allow the Company to continue to sell its approved products in the United States. Beginning in August 2021, the FDA began issuing Marketing Denial Orders (“MDO”) for ENDS products that lack evidence to demonstrate that permitting the marketing of such products would be appropriate for the protection of the public health. The Company has not received an MDO for any of its submissions; however, there is no assurance that regulatory approval to sell our products will be granted or that we would be able to raise additional financing if required, which could have a significant impact on our sales. On March 15, 2022, a new rider to the Federal Food, Drug and Cosmetic Act was passed granting the FDA authority over synthetic nicotine. These regulations make the Company’s synthetic nicotine products subject to the same FDA rules as tobacco-derived nicotine products. As such, the Company was required to file a PMTA for its existing synthetic nicotine products marketed under the Pacha brands by May 14, 2022 or be subject to FDA enforcement. The Company filed new PMTAs, for its synthetic Pacha products on May 13, 2022, prior to the May 14, 2022 deadline. On November 3, 2022, FDA accepted for scientific review certain of our PMTAs for synthetic nicotine products and, on November 4, 2022, FDA refused to accept certain other PMTAs for these products, rendering the latter products subject to FDA enforcement. The Company submitted an administrative appeal with FDA regarding its refusal to accept certain of the PMTAs, and has resubmitted PMTAs for, and continues to sell, the affected synthetic nicotine products while the administrative appeal process is pending. There can be no guarantee that FDA will grant our administrative appeal, and the FDA may bring an enforcement action against our synthetic nicotine products for lack of premarket authorization and/or issue an MDO to our pending applications at any time. More generally, FDA’s regulatory initiatives and enforcement priorities regarding ENDS products are unpredictable and continue to evolve, and we cannot predict whether FDA’s priorities and review of our premarket submissions will impact our products to a greater degree than our competitors in the industry. In the event the FDA denies our PMTAs, we would be required to remove products and cease selling them.

In the second half of 2023 the Company plans to launch new disposable vape products, under the “SPREE BAR™” brand, that the Company expects will (i) replace most of its legacy products and (ii) become the single largest, most important commercial opportunity in Charlie's history. The Company and its attorneys believe SPREE BAR products are not subject to FDA review. Based on the information provided by the Company’s contracted chemical suppliers and its consultants, the proprietary Metatine™ (patented in the United States and in China by the Company’s chemical supplier) in the Company’s SPREE BAR products does not meet the definition of nicotine set forth in 21 U.S.C. § 387(12) and therefore its products containing Metatine, as their active ingredient, are not subject to regulation as “tobacco products” under 21 U.S.C. § 321(rr). Further, according to information provided by the Company’s chemists, the other ingredients in the Company’s SPREE BAR vape liquid are not made or derived from tobacco, nor do they contain nicotine from any source. The documentary support for these facts, including a Certificate of Analysis (COA) for the Metatine used in the Company’s SPREE BAR products, corroborates these conclusions. However, should any of these understandings be incorrect, the Company’s position on Metatine not qualifying as a “tobacco product” would need to be revisited. Further, should Congress bestow regulatory control over Metatine to the FDA, or should the FDA deem Metatine disposable vape devices “tobacco products” despite the facts that Metatine is not a salt or complex of nicotine, and is not itself derived from nicotine or tobacco, SPREE BAR products might then be subject to the FDA tobacco requirements, including, but not limited to, the requirement that all newly deemed tobacco products obtain premarket authorization before entering the U.S. market. If this were to happen, the FDA could bring an enforcement action against our Metatine products for lack of premarket authorization. More generally, FDA’s regulatory initiatives and enforcement authority regarding our products are unpredictable and continue to evolve and we cannot predict whether FDA’s priorities and/or potential jurisdiction over our products will require us to remove our products from the market and to cease selling them.

As discussed below, our financial statements and working capital raise substantial doubt about the Company’s ability to continue as a going concern. Our financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. See Liquidity and Capital Resources below for additional information.

Results of Operations for the Three Months Ended June 30, 2023 Compared to the Three Months Ended June 30, 2022

Regarding results from operations for the quarter ended June 30, 2023, we generated revenue of approximately $3,970,000, as compared to revenue of $7,397,000 for the three months ended June 30, 2022. This $3,427,000 decrease in revenue was due primarily to a $3,594,000 decrease in sales of our nicotine-based vapor products, offset by a $167,000 increase in sales of our hemp-derived products.

We generated net income for the three months ended June 30, 2023, of approximately $32,000 as compared to net loss of approximately $636,000 for the three months ended June 30, 2022. The net income for the three months ended June 30, 2023 includes a non-cash gain in fair value of derivative liabilities of $185,000 compared to a non-cash gain in fair value of derivative liabilities of $12,000 during the three months ended June 30, 2022.

A review of the three-month period ended June 30, 2023, follows:

($ in thousands)

Revenue

Revenue for the three months ended June 30, 2023, decreased by approximately $3,427,000 or 46.3%, to approximately $3,970,000, as compared to approximately $7,397,000 for same period in 2022 due to a $3,594,000 decrease in sales of our nicotine-based vapor products, offset by a $167,000 increase in sales of our hemp-derived products. The decrease in our nicotine-based vapor product sales was primarily driven by decreased sales of our Pacha Disposable line as well as periodic, voluntary stockouts of our e-liquid products. Pacha Disposables became Charlie’s first-ever entrant into the rapidly expanding, disposable e-cigarette market and offer adult users a variety of premium flavors containing synthetic nicotine (not derived from tobacco) in a compact, discrete format. Despite a strong performance during its initial launch, this category has faced challenges including increased competition from low-priced Chinese products, the requirement for synthetic nicotine products to obtain marketing authorization from the FDA, as well as continued uncertainty surrounding the FDA’s issuance of MDO’s and Refuse-to-File designations. The FDA enhanced enforcement efforts during the quarter, including the periodic halting of shipments into U.S. shipping ports which caused supply chain issues and further marketplace unrest. Voluntary stockouts of e-liquid products were the result of diverting working capital to the launch of our new Spree Bar line of nicotine substitute vapor products.

The increase in sales for our hemp-derived business was directly related to a steady increase in market share for our PINWEEL brand of hemp-derived cannabinoid products. The hemp-derived products market is currently experiencing a confluence of challenges including an influx of low-cost brands, potential for regulatory challenges in the third quarter as well as a rapid product development cycle which requires corporate agility and swift market penetration; however, we continue to believe that this category offers significant short- and medium-term growth potential for our Company and will place enhanced focus on growing this segment as a portion of overall sales.

Cost of Revenue

Cost of revenue, which consists of direct costs of materials, direct labor, third party subcontractor services, and other overhead costs decreased by approximately $2,679,000 or 58.8%, to approximately $1,879,000 or 47.3% of revenue, for the three months ended June 30, 2023, as compared to approximately $4,558,000, or 61.6% of revenue, for the same period in 2022. This cost, as a percent of revenue, decreased significantly due to a more favorable sales mix of our e-liquid products as well as a reduction in provision for inventory obsolescence related to certain of our nicotine and alternative cannabis disposable products.

General and Administrative Expenses

For the three months ended June 30, 2023, total general and administrative expenses decreased by approximately $95,000 to $1,775,000 as compared to approximately $1,870,000 for the same period in 2022. This change was primarily due to decreases of $91,000 in provision for bad debt, $85,000 in depreciation expense and approximately $101,000 in other general and administrative expenses. The decrease in provision for bad debt was primarily the result of lower sales activity during the period. The decrease in depreciation expense was primarily due to the permanent closure of our Denver, Colorado office and warehouse. The reduction in other general and administrative costs primarily consisted of decreased occupancy costs resulting from an overall reduced office and warehouse footprint and lower merchant fees resulting from lower sales activity. These reductions were offset by increases of $112,000 in professional fees as well as $70,000 in payroll and benefits costs. Professional fees increased due to higher costs necessary to complete our 2022 audit. Payroll and benefits costs increased due to Employee Retention Credits (“ERCs”) received during 2022, in conjunction with the Infrastructure Investment and Jobs Act which was enacted in November 2021. Excluding the effect of ERCs, payroll and benefits costs decreased significantly as the result of staff consolidation, elective executive salary reductions and a reduced bonus accrual for the period.

Sales and Marketing Expense

For the three months ended June 30, 2023, total sales and marketing expense decreased by approximately $468,000 to approximately $319,000 as compared to approximately $787,000 for the same period in 2022, which was primarily due to reduced marketing and commission costs during the period. Digital marketing, use of promotional materials and tradeshow costs were all adjusted for weaker anticipated sales activity during the quarter ended June 30, 2023. Our commission costs, included in sales and marketing expense, was also lower during the period due to lower sales during the period.

Research and Development Expense

For the three months ended June 30, 2023, total research and development costs decreased by approximately $705,000 to approximately $39,000 as compared to approximately $744,000for the same period in 2022, which was primarily due to costs associated with the development of new technologies and product formats.

(Loss) Income from Operations

We incurred a loss from operations of approximately $42,000 for the three months ended June 30, 2023, compared to a loss of approximately $562,000for the three months ended June 30, 2022, due primarily to a significant decrease in sales. We also incurred certain non-cash, general and administrative expenses during the period including a $37,000 expense related to stock-based compensation. Net loss is determined by adjusting loss from operations by the following items:

• Change in Fair Value of Derivative Liabilities. For the three months ended June 30, 2023, the gain in fair value of derivative liabilities was $185,000, compared to a gain in fair value of derivative liabilities of $12,000 for the three months ended June 30, 2022. The derivative liability is associated with the issuance of the Investor Warrants and the Placement Agent Warrants (as defined in Note 3 of this Report) in connection with the Share Exchange. The gain for the quarter ended June 30, 2023, reflects the effect of the decrease in stock price as of June 30, 2023, compared to March 31, 2023. Due to the limited supply of shares currently freely trading, our stock price may experience volatility and therefore considerable fluctuations in the value of our warrant derivative liability in the future. We had 40,337,693 warrants outstanding as of June 30, 2023.
• Interest Expense. For the three months ended June 30, 2023 and 2022, we recorded interest expense related to notes payable of $111,000 and $91,000, respectively. The increase was primarily due to amortization of debt discount associated with the future receivable sale financing, and contractual interest associated with April 2022 and August 2022 promissory notes.

Net (Loss) Income

For the three months ended June 30, 2023, we had net income of $32,000 as compared to a net loss of $636,000 for the same period in 2022.

Results of Operations for the Six Months Ended June 30, 2023 Compared to the Six Months Ended June 30, 2022

Regarding results from operations for the six months ended June 30, 2023, we generated revenue of approximately $8,000,000, as compared to revenue of $15,471,000 for the six months ended June 30, 2022. This $7,471,000 decrease in revenue was due primarily to a $6,680,000 decrease in sales of our nicotine-based vapor products, as well as a $791,000 decrease in sales of our hemp-derived products.

We generated a net loss for the six months ended June 30, 2023, of approximately $1,358,000 as compared to a net income of approximately $70,000 for the six months ended June 30, 2022. The net loss for the six months ended June 30, 2023 includes a non-cash gain in fair value of derivative liabilities of $408,000 compared to a non-cash gain in fair value of derivative liabilities of $352,000during the six months ended June 30, 2022.

A review of the six-month period ended June 30, 2023, follows:

($ in thousands)

Revenue

Revenue for the six months ended June 30, 2023, decreased by approximately $7,471,000 or 48.3%, to approximately $8,000,000,as compared to approximately $15,471,000 for same period in 2022, primarily due to a $6,680,000 decrease in sales of our nicotine-based vapor products, as well as a $791,000 decrease in sales of our hemp-derived products. The decrease in our nicotine-based vapor product sales was primarily driven by decreased sales of our Pacha Disposable line and periodic stockouts of our e-liquid line of products. Pacha Disposables became Charlie’s first-ever entrant into the rapidly expanding, disposable e-cigarette market and offer adult users a variety of premium flavors containing synthetic nicotine (not derived from tobacco) in a compact, discrete format. Despite a strong performance during its initial launch, this category has faced challenges including increased competition from low-priced Chinese products, the requirement for synthetic nicotine products to obtain marketing authorization from the FDA, as well as continued uncertainty surrounding the FDA’s issuance of MDO’s and Refuse-to-File designations. The FDA enhanced enforcement efforts during the period, including the periodic halting of shipments into U.S. shipping ports which caused supply chain issues and further marketplace unrest. Voluntary stockouts of e-liquid products during the second quarter were the result of diverting working capital to the launch of our new Spree Bar line of nicotine substitute vapor products.

The decrease in sales for our hemp-derived business was directly related to an eight-week pause in manufacturing, and a subsequent lack of inventory, when the Company changed some of the ingredients in its PINWEEL products in order to avoid compounds that were newly deemed “controlled substances.” However, inventory was restored during the second quarter, resulting in a modest rise in sales. The hemp-derived products market is currently experiencing a confluence of challenges including an influx of low-cost brands, as well as a rapid product development cycle which requires corporate agility and swift market penetration; however, we continue to believe that this category offers significant short- and medium-term growth potential for our Company and will place enhanced focus on growing this segment as a portion of overall sales.

Cost of Revenue

Cost of revenue, which consists of direct costs of materials, direct labor, third party subcontractor services, and other overhead costs decreased by approximately $3,974,000 or 44.2%, to approximately $5,018,000 or 62.7% of revenue, for the six months ended June 30, 2023, as compared to approximately $8,992,000, or 58.1% of revenue, for the same period in 2022. This cost, as a percent of revenue, increased significantly due to an increase of approximately $199,000 in our provision for inventory obsolescence during the period related to certain of our nicotine and alternative cannabis disposable products. The increased provision for inventory obsolescence was mostly the result of compressed product lifecycles in both the nicotine disposable and alternative cannabis product categories.

General and Administrative Expenses

For the six months ended June 30, 2023, total general and administrative expenses decreased by approximately $666,000 to $3,763,000 as compared to approximately $4,429,000 for the same period in 2022. This change was primarily due to decreases of $397,000 in payroll and benefits, $108,000 in depreciation expense and approximately $234,000 in other general and administrative expenses. The decrease in payroll and benefits was primarily the result of staff consolidation, elective executive salary reductions and a reduced bonus accrual for the period. During the six months ended June 30, 2023, our depreciation expense decreased due to the permanent closure of our Denver, Colorado facilities. The decrease in other general and administrative expenses was primarily due to lower merchant account fees and a reduced bad debt provision resulting from softened sales activity during the period. These decreases were offset primarily by a $73,000 increase in professional fees resulting from higher costs in relation to our 2022 audit.

Sales and Marketing Expense

For the six months ended June 30, 2023, total sales and marketing expense decreased by approximately $803,000, or 53.9%, to approximately $687,000 as compared to approximately $1,490,000 for the same period in 2022, which was primarily due to reduced marketing and commission costs during the period. Digital marketing, use of promotional materials and tradeshow costs were all adjusted for weaker anticipated sales activity during the quarter ended June 30, 2023. Our commission cost, included in sales and marketing expense, was lower due to significantly lower sales during the period.

Research and Development Expense

For the six months ended June 30, 2023, total research and development costs decreased by approximately $664,000, 88.0%, to approximately $91,000 as compared to approximately $755,000 for the same period in 2022, which was primarily due to costs associated with the development of new technologies and product formats.

(Loss) Income from Operations

We incurred a loss from operations of approximately $1,559,000 for the six months ended June 30, 2023, compared to an operating loss of approximately $195,000 for the six months ended June 30, 2022, due primarily to a decrease in sales. We also incurred certain non-cash, general and administrative expenses during the period including an $82,000 expense related to stock-based compensation. Net loss is determined by adjusting loss from operations by the following items:

• Change in Fair Value of Derivative Liabilities. For the six months ended June 30, 2023, the gain in fair value of derivative liabilities was $408,000, compared to a gain in fair value of derivative liabilities of $352,000 for the six months ended June 30, 2022. The derivative liability is associated with the issuance of the Investor Warrants and the Placement Agent Warrants (as defined in Note 3 of this Report) in connection with the Share Exchange. The gain for the quarter ended June 30, 2023, reflects the effect of the decrease in stock price as of June 30, 2023, compared to December 31, 2022. Due to the limited supply of shares currently freely trading, our stock price may experience volatility and therefore considerable fluctuations in the value of our warrant derivative liability in the future. We had 40,337,693 warrants outstanding as of June 30, 2023.
• Interest Expense. For the six months ended June 30, 2023 and 2022, we recorded interest expense related to notes payable of $242,000 and $92,000, respectively. The increase was primarily due to amortization of debt discount associated with the future receivable sale financing, and contractual interest associated with April 2022 and August 2022 promissory notes.
• Debt extinguishment gain. For the six months ended June 30, 2023 and 2022, we recorded a debt extinguishment gain of $35,000 and $0, respectively. The gain resulted from a modification to the promissory note issued to Michael King, a significant shareholder, which extended the maturity date to March 2025.

Net (Loss) Income

For the six months ended June 30, 2023, we incurred a net loss of $1,358,000 as compared to net income of $70,000 for the same period in 2022.

Liquidity and Capital Resources

As of June 30, 2023, we had working capital of approximately $792,000, which consisted of current assets of approximately $4,349,000 and current liabilities of approximately $3,557,000, as compared to working capital of approximately $1,067,000 at December 31, 2022. The current liabilities include approximately $2,450,000 of accounts payable and accrued expenses, notes payable of $115,000 which was net of a $2,000 debt discount, note payable from a related party of $300,000, approximately $73,000 of deferred revenue associated with product shipped but not yet received by customers, approximately $398,000 of current lease liabilities, and $221,000 of derivative liability associated with the Investor Warrants and Placement Agent Warrants (the derivative liability of $221,000 is included in determining working capital of $792,000 but is not expected to use any cash to ultimately satisfy the liability).

On January 19, 2023 the Company entered into a future receivables sale agreement (“Receivables Financing” or “Receivables Financing Agreement”) with Austin Business Finance (“Austin Purchaser”) by which Austin Purchaser purchases from the Company, its future accounts and contract rights arising from the sale of goods or rendition of services to the Company’s customers. The purchase price, as defined by the Receivables Financing Agreement, was $650,000 which was paid to the Company on January 19, 2023, net of a 3% origination fee. The Receivables Financing Agreement requires twenty-six equal payments of $29,500 to be paid weekly for a total repayment of $760,500 over the term of the agreement. During the six months ended June 30, 2023, the Company made approximately $644,000 in cash payments. As of June 30, 2023, the outstanding principal under the Receivables Financing Agreement was approximately $117,000.

Our cash and cash equivalents balance at June 30, 2023 was approximately $343,000.

For the six months ended June 30, 2023, net cash provided by operating activities was approximately $124,000, resulting from a net loss of $1,358,000, offset by a change in operating assets and liabilities of $1,364,000 and net non-cash activity of $118,000. For the six months ended June 30, 2022, net cash used in operating activities was approximately $1,276,000, resulting from a net income of $70,0000, offset by a $352,000 of change in fair value of derivative liabilities and $1,654,000 of changes in our operating assets and liabilities.

For the six months ended June 30, 2023, we used approximately $38,000 cash in financing activities related to sale of future receivables for approximately $630,000 and repayment of $668,000 under the same agreement.

Substantial Doubt to Continue as a Going Concern Regarding the Legal and Regulatory Environment, Liquidity and Management’s Plan of Operation

Our consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company operates in a rapidly changing legal and regulatory environment; new laws and regulations or changes to existing laws and regulations could significantly limit the Company’s ability to sell its products, and/or result in additional costs. Additionally, the Company was required to apply for FDA approval to continue selling and marketing its products used for the vaporization of nicotine in the United States. Currently, a substantial portion of the Company’s sales are derived from products that are subject to approval by the FDA. There was a significant cost associated with the application process and there can be no assurance the FDA will approve previous and/or future application. For the six months ended June 30, 2023, the Company’s revenue declined, the Company generated a loss from operations of approximately $1,559,000, and a consolidated net loss of approximately $1,358,000 and cash provided by operations of approximately $124,000. The Company had stockholders’ equity of $424,000 at June 30, 2023. During the six months ended June 30, 2023, the Company’s working capital position decreased to $792,000 from $1,067,000, as of December 31, 2022. Considering these facts, the issuance of one or several Marketing Denial Orders ("MDOs”) from the FDA would increase the potential for inventory obsolescence and uncollectable accounts receivables and the removal of certain products for sale. These regulatory risks, as well as other industry-specific challenges and our low working capital and cash position, remain factors that raise substantial doubt about the Company’s ability to continue as a going concern.

Our plans and growth depend on our ability to increase revenues, procure cost-effective financing, and continue our business development efforts, including the expenditure of approximately $5,100,000 to date, to support our PMTA process for the Company’s submissions to the FDA. The Company has undergone cost-cutting measures including salary reductions of up to 25% for officers and certain managers and a reduction in headcount for certain departments. During 2023, we also plan to launch additional products that are not subject to FDA review or covered under the Agriculture Improvement Act (the “Farm Bill”). During 2023, the Company intends to allocate further resources and new personnel to support research and development initiatives in order to support existing, or subsequent PMTAs. The Company may require additional financing in the future to support subsequent PMTA filings, and/or in the event the FDA requests additional testing for one, or several, of the Company’s prior PMTA submissions. There can be no assurance that additional financing will be available on acceptable terms, or at all, and there can be no assurance that any such arrangement, if required or otherwise sought, would be available on terms deemed to be commercially acceptable and, in the Company’s best interests. The financial statements do not include any adjustments to the carrying amount and classification of recorded assets and liabilities should the Company be unable to continue operations. If we do not have sufficient funds to continue operations, we could be required to seek bankruptcy protection or other alternatives that would likely result in our stockholders losing some or all their investment in us.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements other than operating lease commitments.

Critical Accounting Policies

The condensed consolidated financial statements are prepared in conformity with U.S. GAAP, which require the use of estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of expense in the periods presented. We believe that the accounting estimates employed are appropriate and resulting balances are reasonable; however, due to inherent uncertainties in making estimates, actual results could differ from the original estimates, requiring adjustments to these balances in future periods. The critical accounting estimates that affect the consolidated financial statements and the judgments and assumptions used are consistent with those described under Part II, Item 7 of our Annual Report on the 2022 Annual Report.

(a) Evaluation of disclosure controls and procedures

Our management, with the participation of our President and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this Report. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Based on our evaluation, our President, the principal executive officer, and Chief Financial Officer concluded that, as of June 30, 2023, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our President and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

(b) Changes in internal control over financial reporting

There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15 of the Exchange Act that occurred during the quarter ended June 30, 2023, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Our results of operations and financial condition are subject to numerous risks and uncertainties described in the 2022 Annual Report. In addition to the other information set forth in this Report, you should carefully consider the risk factors discussed in Part 1, Item 1A, of the 2022 Annual Report and subsequent reports filed pursuant to the Exchange Act which could materially and adversely affect the Company’s business, financial condition, results of operations, and stock price. Any losses or damages we incur could have a material adverse effect on our financial results and our ability to conduct business as expected. The risks described in our 2022 Annual Report and in our subsequent reports filed pursuant to the Exchange Act are not the only risks facing the Company. Additional risks and uncertainties not presently known to management, or that management presently believes not to be material, may also result in material and adverse effects on our business, financial condition, and results of operations.