AI Financial Corp: Form 10-Q for the period ended Sep 30, 2023

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Dollars stated in thousands, except per–share amounts.

Forward-Looking and Cautionary Statements

This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of the federal securities laws, including Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which involve risks and uncertainties. You can identify forward-looking statements because they contain words such as ‘‘believes,’’ ‘‘expects,’’ ‘‘may,’’ ‘‘will,’’ ‘‘should,’’ ‘‘seeks,’’ ‘‘approximately,’’ ‘‘intends,’’ ‘‘plans,’’ ‘‘estimates’’ or ‘‘anticipates’’ or similar expressions that concern our strategy, plans or intentions. Any statements we make relating to our future operations, performance and results, and anticipated liquidity are forward-looking statements. All forward-looking statements are subject to risks and uncertainties that may change at any time, and, therefore, our actual results may differ materially from those we expected. We derive most of our forward-looking statements from our operating budgets and forecasts, which are based upon many detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the impact of known factors, and, of course, it is impossible for us to anticipate all factors that could affect our actual results. Important factors that could cause actual results to differ materially from our expectations, including, without limitation, in conjunction with the forward-looking statements included in this Form 10-Q, are disclosed in “Item 1-Business, Item 1A – Risk Factors” of our Form 10-K and Part II, Item 1A of this Form 10-Q.

We undertake no obligation to publicly update or revise any forward-looking statement as a result of new information, future events or otherwise, except as otherwise required by law. Our MD&A should be read in conjunction with our Form 10-K (including the information presented therein under the caption Risk Factors), together with our Quarterly Reports on Forms 10-Q and other publicly available information. All amounts herein are unaudited.

Overview

We are focused on finding treatments for conditions that cause severe pain and bringing to market drugs with non-addictive pain-relieving properties. In addition, through our now-sold subsidiaries ARCA Recycling, Connexx, and ARCA Canada, we were engaged in the business of recycling major household appliances in North America by providing turnkey appliance recycling and replacement services for utilities and other sponsors of energy efficiency programs. Also, through our now-sold GeoTraq Inc. subsidiary, we were engaged in the development and design of wireless transceiver modules with technology that provides LBS directly from global Mobile IoT networks.

During the periods disclosed in this Quarterly Report, we operated three reportable segments:

• Biotechnology: Our biotechnology segment is focused on finding treatments for conditions that cause severe pain and bringing to market drugs with non-addictive pain-relieving properties.
• Recycling: Our recycling segment is a turnkey appliance recycling program. We receive fees charged for recycling, replacement and additional services for utility energy efficiency programs and have established 18 Regional Processing Centers (“RPCs”) for this segment throughout the United States and Canada. On March 9, 2023, we entered into a Stock Purchase Agreement, retroactive to March 1, 2023, with VM7 Corporation, a Delaware corporation, under which the Buyer agreed to acquire all of the outstanding equity interests of our recycling segment. Consequently, the results for this segment are reported as discontinued operations for the 13 and 39 weeks ended September 30, 2023 and October 1, 2022.
• Technology: We suspended all operations for GeoTraq, and, on May 24, 2022, sold substantially all of its assets. The results for this segment are reported as discontinued operations for the 13 and 39 weeks ended September 30, 2023 and October 1, 2022.

For the Thirteen Weeks Ended September 30, 2023 and October 1, 2022

Results of Operations

The following table sets forth certain statement of operations items and as a percentage of revenue, for the periods indicated (in $000’s):

The following tables set forth revenues for key product and service categories, percentages of total revenue and gross profits earned by key product and service categories and gross profit percent as compared to revenues for each key product category indicated (in $000’s):

Revenue

Revenue decreased by approximately $8.6 million for the 13 weeks ended September 30, 2023, as compared to the 13 weeks ended October 1, 2022. The decrease is due to the disposition of our recycling segment as of March 1, 2023.

Cost of Revenue

Cost of revenue decreased by approximately $7.6 million for the 13 weeks ended September 30, 2023, as compared to the 13 weeks ended October 1, 2022. The decrease is due the disposition of our recycling segment as of March 1, 2023.

Selling, General and Administrative Expense

Selling, general and administrative expenses increased by approximately $153,000, or 25%, for the 13 weeks ended September 30, 2023, as compared to the 13 weeks ended October 1, 2022, primarily due to increased amortization costs relating to the Soin intangibles. This increase relates only to continuing operations.

Interest Income, net

Interest income, net, increased by approximately $348,000 for the 13 weeks ended September 30, 2023, as compared to the 13 weeks ended October 1, 2022 primarily due to the accretion of discount in connection with the promissory note with SPYR and receivable from VM7 (see Note 18), as well as interest recorded on the note with SPYR.

Unrealized Loss on Marketable Securities

Unrealized loss on marketable securities decreased by approximately $3,000 for the 13 weeks ended September 30, 2023, as compared to the 13 weeks ended October 1, 2022. An unrealized gain or loss on marketable securities is recorded to mark to fair value securities received in connection to the sale of GeoTraq.

Segment Performance

We report our business in the following segments: Biotechnology and discontinued operations. We expect revenues and profits for our biotechnology segment to be driven by the development of pharmaceuticals that treat the root cause of pain but are non-opioid painkillers. We include Corporate expenses within the Biotechnology segment. As discussed above, we sold our Technology segment, GeoTraq, during the fiscal year ended December 31, 2022, and our Recycling segment in March 2023, and detail those results as discontinued operations below.

Operating loss by operating segment, is defined as loss before net interest expense, other income and expense, provision for income taxes ($000’s).

Biotechnology Segment

Our biotechnology segment incurred expenses of approximately $764,000 and $611,000 related to employee costs and professional services related to research, and corporate services, as well as amortization of the Soin intangibles for the 13 weeks ended September 30, 2023 and the 13 weeks ended October 1, 2022, respectively.

Discontinued Operations

Discontinued operations consists of our Recycling segment, which was disposed of effective March 1, 2023, and our Technology segment, which was disposed of during May 2022. Revenue for the 13 weeks ended September 30, 2023, decreased by approximately $8.6 million as compared to the prior year period, which was due to the disposition of our Recycling segment as of March 1, 2023.

Operating loss for the 13 weeks ended September 30, 2023, decreased by approximately $1.2 million as compared to the prior year period. The increase is due to the disposition of our Recycling segment as of March 1, 2023.

For the Thirty-Nine Weeks Ended September 30, 2023 and October 1, 2022

Results of Operations

The following table sets forth certain statement of operations items and as a percentage of revenue, for the periods indicated (in $000’s):

30

The following tables set forth revenues for key product and service categories, percentages of total revenue and gross profits earned by key product and service categories and gross profit percent as compared to revenues for each key product category indicated (in $000’s):

Revenue

Revenue decreased by approximately $25.0 million, or 86.7%, for the 39 weeks ended September 30, 2023, as compared to the 39 weeks ended October 1, 2022. The decrease is due to the disposition of our recycling segment as of March 1, 2023.

Cost of Revenue

Cost of revenue decreased by approximately $19.9 million for the 39 weeks ended September 30, 2023, as compared to the 39 weeks ended October 1, 2022. The decrease is due the disposition of our recycling segment as of March 1, 2023.

Selling, General and Administrative Expense

Selling, general and administrative expenses increased by approximately $973,000, or 50.0%, for the 39 weeks ended September 30, 2023, as compared to the 39 weeks ended October 1, 2022, primarily due to increased amortization costs relating to the Soin intangibles. This increase relates only to continuing operations.

Interest Income, net

Interest income, net increased by approximately $1.0 million for the 39 weeks ended September 30, 2023, as compared to the 39 weeks ended October 1, 2022 primarily due to the accretion of discount in connection with the promissory note with SPYR and receivable from VM7 (see Note 18), as well as interest recorded on the note with SPYR.

Unrealized Loss on Marketable Securities

Unrealized loss on marketable securities decreased by approximately $132,000 for the 39 weeks ended September 30, 2023, as compared to the 39 weeks ended October 1, 2022. An unrealized gain or loss on marketable securities is recorded to mark to fair value securities received in connection to the sale of GeoTraq.

Segment Performance

We report our business in the following segments: Biotechnology and discontinued operations. We expect revenues and profits for our biotechnology segment to be driven by the development of pharmaceuticals that treat the root cause of pain but are non-opioid painkillers. We include Corporate expenses within the Biotechnology segment. As discussed above, we sold our Technology segment, GeoTraq, during the fiscal year ended December 31, 2022, and our Recycling segment in March 2023, and detail those results as discontinued operations below.

Operating loss by operating segment, is defined as loss before net interest expense, other income and expense, provision for income taxes ($000’s).

Liquidity and Capital Resources

Overview

As of September 30, 2023, our cash on hand was $413,000. We intend to fund operations by using cash on hand, monthly revenues from the sale of our Subsidiaries, and funds received from approved ERC’s. We intend to raise funds to support future development of JAN 123 and JAN 101 either through capital raises or structured arrangements.

Our ability to continue as a going concern is dependent upon the success of future capital raises or structured settlements to fund the required testing to obtain FDA approval of JAN 123 and JAN 101, as well as to fund our day-to-day operations. The accompanying financial statements do not include any adjustments that might be necessary should we be unable to continue as a going concern. While we will actively pursue these additional sources of financing, management cannot make any assurances that such financing will be secured.

Cash Flows

During the 39 weeks ended September 30, 2023, cash provided by operations was approximately $1.9 million, compared to cash used in operations of approximately $2.4 million during the 39 weeks ended October 1, 2022. Cash provided by discontinued operations during the 39 weeks ended September 30, 2023 was approximately $2.3 million, while cash used in continuing operations was approximately $2.7 million. The increase in cash was primarily due to results of operations as discussed above.

Cash used in investing activities was approximately $156,000 and $950,000, respectively, for the 39 weeks ended September 30, 2023 and the 39 weeks ended October 1, 2022. Cash used in investing activities for the 39 weeks ended September 30, 2023 was all associated with discontinued operations and was related to purchases of property and equipment. Cash used in investing activities for the 39 weeks ended October 1, 2022 was all associated with discontinued operations and related to purchases of property and equipment and intangibles.

Cash used in financing activities was approximately $1.4 million for the 39 weeks ended September 30, 2023. Cash used in financing activities from discontinued operations for the 39 weeks ended September 30, 2023 was approximately $2.2 million and was primarily due to the repayment of debt obligations. Cash provided by financing activities from continued operations for the 39 weeks ended September 30, 2023 was approximately $777,000 and was related to $792,000 in proceeds from equity financing and $259,000 from warrants issued, partially offset by $274,000 in debt repayments. Cash used in financing activities was approximately $3.5 million for the 39 weeks ended October 1, 2022. Cash provided by financing activities from discontinued operations for the 39 weeks ended October 1, 2022 was approximately $3.4 million, and was primarily due to proceeds from the issuance of debt. Cash provided by financing activities from continuing operations for the 39 weeks ended October 1, 2022 was $118,000 and was due to $648,000 in proceeds from issuing notes payable, partially offset by $530,000 in repayment of debt obligations.

Sources of Liquidity

We continue to face a challenging competitive environment as we continue to focus on raising capital and managing expenses. We reported a net loss of approximately $825,000 from continuing operations in for the 39 weeks ended September 30, 2023, and net income from continuing operations of approximately $2.6 million for the 39 weeks ended October 1, 2022 primarily due to a gain on litigation settlement of approximately $2.0 million, gain on reversal of a contingency loss of $637,000, and other income, net of approximately $2.0 million and interest income, net, of approximately $575,000, partially offset by an operating loss of $2.0 million and an unrealized loss on marketable securities of $646,000. Additionally, the Company has total current assets of approximately $517,000 and total current liabilities of approximately $2.5 million resulting in a net negative working capital of approximately $2.0 million. Cash provided by continuing operations was approximately $329,000.

Future Sources of Cash; Phase 2b Trials, New Acquisitions, Products, and Services

We may require additional debt financing and/or capital to finance new acquisitions, conduct our Phase IIb clinical trials, or consummate other strategic investments in our business. No assurance can be given any financing obtained may not further dilute or otherwise impair the ownership interest of our existing stockholders.

Market Risk and Impact of Inflation

Interest Rate Risk. We do not believe there is any significant risk related to interest rate fluctuations on our short and long-term fixed rate debt.

We do not hold any derivative financial instruments, nor do we hold any securities for trading or speculative purposes.

Evaluation of Disclosure Controls and Procedures

Evaluation of Disclosure control and Procedures. We carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) to ensure that information required to be disclosed in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the required time periods and is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Based upon that evaluation, our principal executive officer and principal financial officer concluded that, as of September 30, 2023, the period covered in this report, our disclosure controls and procedures were not effective because of the material weaknesses discussed below.

In light of the conclusion that our internal disclosure controls are ineffective as of September 30, 2023, we have applied procedures and processes as necessary to ensure the reliability of our financial reporting in regard to this annual report. Accordingly, the Company believes, based on its knowledge, that: (i) this annual report does not contain any untrue statement of a material fact or omit a material fact; and (ii) the financial statements, and other financial information included in this annual report, fairly present in all material respects our financial condition, results of operations and cash flows as of and for the periods presented in this annual report.

Management’s Report on Internal Control Over Financial Reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)). Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Our management assessed the effectiveness of our internal control over financial reporting as of September 30, 2023. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in 2013 regarding Internal Control – Integrated Framework. Based on our assessment using those criteria, our management concluded that our internal control over financial reporting was not effective as of September 30, 2023.

Management noted material weaknesses in internal control when conducting their evaluation of internal control as of September 30, 2023: (1) Insufficient information technology general controls and segregation of duties; (2) inadequate control design or lack of sufficient controls over significant accounting processes; (3) insufficient assessment of the impact of potentially significant transactions; and (4) insufficient processes and procedures related to proper recordkeeping of agreements and contracts.

These material weaknesses remained outstanding as of the filing date of this Form 10-Q and management is currently working to remedy these outstanding material weaknesses.

The Company’s management, including the Company’s CEO and CFO, do not expect that the Company’s disclosure controls and procedures or the Company’s internal control over financial reporting will prevent or detect all error and all fraud. A control system, regardless of how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system will be met. These inherent limitations include the following: judgements in decision-making can be faulty, and control and process breakdowns can occur because of simple errors or mistakes, controls can be circumvented by individuals, acting alone or in collusion with each other, or by management override, the design of any system of controls is based in part on 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, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. 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, have been detected.

Changes in Internal Control Over Financial Reporting. There were no changes in the Company’s internal control over financial reporting during the 39 weeks ended September 30, 2023 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and are not required to provide the information under this item. However, in light of the SEC Complaint, the Company provides the following additional risk factors, which supplements the risk factors previously disclosed by the Company in Part I, Item 1A, Risk Factors, of the 2022 10-K.

We are the subject of an SEC Complaint, which could divert management’s focus, result in substantial litigation expenses, and have an adverse impact on our business, reputation, financial condition, results of operations or stock price.

We are currently subject to an SEC Complaint. Refer to Note 15 to our Consolidated Financial Statements and Part II, Item 1 of this Quarterly Report for additional information regarding this specific matter. We may be subject to additional investigations, arbitration proceedings, audits, regulatory inquiries, and similar actions, including matters related to intellectual property, employment, securities laws, disclosures, tax, accounting, class action and product liability, as well as regulatory and other claims related to our business and our industry, which we refer to collectively as legal proceedings. We cannot predict the outcome of any particular proceeding, or whether ongoing investigations, will be resolved favorably or ultimately result in charges or material damages, fines or other penalties, enforcement actions, bars against serving as an officer or director, or practicing before the SEC, or civil or criminal proceedings against us or members of our senior management.

Legal proceedings in general, and securities and class action litigation and regulatory investigations in particular, can be expensive and disruptive. Our insurance may not cover all claims that may be asserted against us, and we are unable to predict how long the legal proceedings to which we are currently subject will continue. An unfavorable outcome of any legal proceeding may have an adverse impact on our business, financial condition and results of operations or our stock price. Any proceeding could negatively impact our reputation among our stakeholders. Furthermore, publicity surrounding ongoing legal proceedings, even if resolved favorably for us, could result in additional legal proceedings against us, as well as damage our image.

We may not be able to maintain compliance with the continued listing requirements of The Nasdaq Capital Market.

Our common stock is listed on The Nasdaq Capital Market. In order to maintain that listing, we must satisfy minimum financial and other requirements including, without limitation, a requirement that our closing bid price be at least $1.00 per share. If we fail to continue to meet all applicable continued listing requirements for The Nasdaq Global Market in the future and Nasdaq determines to delist our common stock, the delisting could adversely affect the market liquidity of our common stock, our ability to obtain financing to repay debt, and fund our operations.