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AeroGrow International, Inc. (collectively, the “Company," “AeroGrow,” “we,” “our” or “us”) was formed as a Nevada corporation in March 2002. The Company’s principal business is developing, marketing, and distributing advanced indoor aeroponic garden systems designed and priced to appeal to the consumer gardening, cooking and small indoor appliance markets worldwide.  The Company manufactures, distributes and markets nine different models of its AeroGarden systems in multiple colors, as well as over 40 varieties of seed pod kits and a full line of accessory products through multiple channels including retail distribution via online retail outlets and brick and mortar storefronts, and online retail outlets, catalogue and direct-to-consumer sales primarily in the United States and Canada.

The unaudited interim financial statements of the Company included herein have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim reporting including the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. These condensed statements do not include all disclosures required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for annual audited financial statements and should be read in conjunction with the Company’s audited financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2016,2017, as filed with the SEC on June 15, 2016.26, 2017.

In the opinion of management, the accompanying unaudited interim financial statements reflect all adjustments, including normal recurring adjustments, necessary to present fairly the financial position of the Company at June 30, 2016,2017, the results of operations for the three months ended June 30, 20162017 and 2015,2016, and the cash flows for the three months ended June 30, 20162017 and 2015.2016. The results of operations for the three months ended June 30, 20162017 are not necessarily indicative of the expected results of operations for the full year or any future period. In this regard, the Company’s business is highly seasonal, with approximately 70.9%65.7% of revenues in the fiscal year ended March 31, 20162017 (“Fiscal 2016”2017”) occurring in the four consecutive calendar months from October through January.  Furthermore, during the three-month period ended June 30, 2016,2017, the Company has further expanded its distribution channelchannels and invested in necessary overhead in anticipation of the peak sales season.  The balance sheet as of March 31, 20162017 is derived from the Company’s audited financial statements.

Sources of funding to meet prospective cash requirements include the Company’s existing cash balances, cash flow from operations, and borrowings under the Company’s debt arrangements.  We may need to seek additional debt or equity capital;capital, however, to provide a cash reserve against contingencies, address the seasonal nature of our working capital needs, and to enable us to invest further in trying to increase the scale of our business.business and provide a cash reserve against contingencies.  There can be no assurance we will be able to raise this additional capital.  See Note 9 for subsequent events.

 

The preparation of financial statements in conformity U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  It is reasonably possible that a change in the Company’s estimates could occur in the near term as additional or new information becomes available.

The Company computes net income (loss) per share of common stock in accordance with Accounting Standards Codification (“ASC”) 260.  ASC 260 requires companies with complex capital structures to present basic and diluted earnings per share (“EPS”).  Basic EPS is measured as the income or loss available to common stockholders divided by the weighted average shares of common stock outstanding for the period. Diluted EPS is similar to basic EPS, but presents the dilutive effect on a per share basis of common stock equivalents (e.g., convertible securities, options, and warrants) as if such securities had been converted into common stock at the beginning of the periods presented. Potential shares of common stock that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from the calculation of diluted EPS.  For the three months ended June 30, 2016 and 2015, the Company had 3.1 million (including preferred stock), and 3.1 million shares, respectively, of securities that could potentially dilute basic EPS in the future that wereSecurities not included in the computation of diluted EPS because to do so would have been anti-dilutive were employee stock options to purchase 175,000 shares and warrants to purchase 2,000 shares of common stock for the periods presented.period ended June 30, 2017 and employee stock options to purchase 656,000 shares and warrants to purchase 3,093,000 shares for the three months ended June 30, 2016.

ASC 825-10-50-20 requires disclosure of significant concentrations of credit risk regardless of the degree of such risk.  Financial instruments

The Company maintains cash depository accounts with significant credit risk include cash deposits.financial institutions.  The amount on deposit with oneseveral financial institutioninstitutions exceeded the $250,000 federally insured limit as of June 30, 2016.  However, management believes that the2017.  The Company has not historically incurred any losses related to these deposits.  The financial institution isinstitutions are highly rated, financially sound and the risk of loss is minimal.

For the three months ended June 30, 20162017 and 2015,2016, one customer, Amazon.com, represented 35.8%23.0% and 38.5%35.8%, respectively, of the Company’s net revenue.

For the three months ended June 30, 2017, the Company purchased inventories and other inventory-related items from one supplier totaling $1.7 million. For the three months ended June 30, 2016, the Company purchased inventories and other inventory-related items from one supplier totaling $300,000, representing 35.0%$300,000.  The purchase of cost of revenue. For the three months ended June 30, 2015, the Company purchased inventories and other inventory-related items from one supplier totaling $344,000, representing 31.5%is dependent on timing of cost of revenue. purchases for our highly seasonal business and payment terms with our suppliers.

The Company’s primary contract manufacturers are located in China.  As a result, the Company may be subject to political, currency, regulatory, transportation/shipping and weather/natural disaster risks.  Although the Company believes alternate sources of manufacturing could be obtained, the risk of an interruption in product sourcing could have an adverse impact on operations.

The Company follows the guidance in ASC 820, Fair Value Measurements and Disclosures (“ASC 820”), as it relates to the fair value of its financial assets and liabilities. ASC 820 provides for a standard definition of fair value to be used in new and existing pronouncements. This guidance requires disclosure of fair value information about certain financial instruments (insurance contracts, real estate, goodwill and taxes are excluded) for which it is practicable to estimate such values, whether or not these instruments are included in the balance sheet at fair value. The fair values presented for certain financial instruments are estimates, which, in many cases, may differ significantly from the amounts that could be realized upon immediate liquidation.

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants.  ASC 820 also provides a hierarchy for determining fair value, which emphasizes the use of observable market data whenever available. The three broad levels defined by the hierarchy are as follows, with the highest priority given to Level 1 as these are the most reliable, and the lowest priority given to Level 3.

 

Level 1 – Quoted prices in active markets for identical assets.

Level 2 – Quoted prices for similar assets in active markets, quoted prices for identical or similar assets in markets that are not active, or other inputs that are observable or can be corroborated by observable market data, including model-derived valuations.

 

Level 3 – Unobservable inputs that are supported by little or no market activity.

The carrying value of financial instruments including cash, receivables and accounts payable and accrued expenses, approximates their fair value at June 30, 20162017 and March 31, 20162017 due to the relatively short-term nature of these instruments. 

 

The Company sells its products to retailers and directly to consumers. Consumer transactions are primarily paid by credit card. Retailer sales terms vary by customer, but generally range from net 30 days to net 60 days.days, while direct-to-consumer transactions are primarily paid by credit card.  Accounts receivable are reported at net realizable value and net of the allowance for doubtful accounts. The Company uses the allowance method to account for uncollectible accounts receivable. The Company's allowance estimate is based on a review of the current status of trade accounts receivable, which resulted in an allowance of $9,000$10,000 and $14,000$20,000 at June 30, 20162017 and March 31, 2016,2017, respectively.

 

In conjunction with the Company’s processing of credit card transactions for its direct-to-consumer sales activities and as security with respect to the Company’s performance for credit card refunds and charge backs, the Company is required to maintain a cash reserve with Litle and Company, the Company’s credit card processor. This reserve is equal to 5% of the credit card sales processed during the previous six months. As of June 30, 20162017 and March 31, 2016,2017, the balance in this reserve account was $148,000$176,000 and $232,000,$258,000, respectively.

The Company expenses all production costs related to advertising, including print, television, and radio advertisements when the advertisement has been broadcast or otherwise distributed.  In contrast, the Company records media and marketing costs related to its direct-to-consumer advertisements, inclusive of postage and printing costs incurred in conjunction with mailings of direct-response catalogues, and related direct-response advertising costs, in accordance with ASC 340-20 Capitalized Advertising Costs.  As prescribed by ASC 340-20-25, direct-to-consumer advertising costs incurred are reported as assets and should be amortized over the estimated period of the benefits, based on the proportion of current period revenue from the advertisement to probable future revenue.  

As the Company has continued to expand its retail distribution channel, the Company has expanded its advertising to include online gateway and portal advertising, as well as placement in third party catalogues.

 

 

As of June 30, 20162017 and March 31, 2016,2017, the Company deferred $4,000 and $24,000, respectively, related to such media and advertising costs which include the catalogue cost described above.  The costs are included inwithin the prepaid“prepaid expenses and otherother” line of the balance sheet.

Inventories are valued at the lower of cost, determined on the basis of standard costing, which approximates the first-in, first-out method, or net realizable value.  When the Company is the manufacturer, raw materials, labor and manufacturing overhead are included in inventory costs. The Company records the raw materials at delivered cost. Standard labor and manufacturing overhead costs are applied to the finished goods based on normal production capacity.  A majority of the Company’s products are manufactured overseas and are recorded at standard cost, which includes product costs for purchased and manufactured products, and freight and transportation costs for inbound freight from manufacturers. Inventory values at June 30, 2017 and March 31, 2017 were as follows:

 

The Company determines an inventory obsolescence reserve based on management’s historical experience and establishes reserves against inventory according to the age of the product. As of June 30, 20162017 and March 31, 2016,2017, the Company had reserved $285,000$346,000 and $362,000 for inventory obsolescence.obsolescence, respectively.  The inventory values are shown net of these reserves.

 

The Company recognizes revenue from product sales, net of estimated returns, when persuasive evidence of a sale exists, including the following; (i) a product is shipped under an agreement with a customer; (ii) the risk of loss and title has passed to the customer; (iii) the fee is fixed or determinable; and (iv) collection of the resulting receivable is reasonably assured.

The Company records estimated reductions to revenue for customer and distributor programs and incentive offerings, including promotions, rebates, and other volume-based incentives.  Certain incentive programs require the Company to estimate the number of customers who will actually redeem the incentive based on historical industry experience. As of June 30, 20162017 and March 31, 2016,2017, the Company had accrued $89,000$202,000 and $151,000,$304,000, respectively, as itsan estimate for the foregoing deductions and allowances.  These expenses are included inallowances within the accrued expenses“accrued expenses” line of the balance sheets.

The Company records warranty liabilities at the time of sale for the estimated costs that may be incurred under its basic warranty program. The specific warranty terms and conditions vary depending upon the product sold, but generally include technical support, repair parts, and labor for periods up to one year. Factors that affect the Company’s warranty liability include the number of installed units currently under warranty, historical and anticipated rates of warranty claims on those units, and cost per claim to satisfy the Company’s warranty obligation.  Based upon the foregoing, the Company has recorded a provision for potential future warranty costs of $112,000$117,000 and $117,000$125,000 as of June 30, 20162017 and March 31, 2016,2017, respectively.

The Company reserves for known and potential returns from customers and associated refunds or credits related to such returns based upon historical experience. In certain cases, retailer customers are provided a fixed allowance, usually in the 1% to 2% range, to cover returned goods and this allowance is deducted from payments made to us by such customers. As of June 30, 20162017 and March 31, 2016,2017, the Company has recorded a reserve for customer returns of $48,000$73,000 and $197,000,$175,000, respectively.

In February 2016, the FASB issued Accounting Standards Update (“ASU”)ASU 2016-02, “Leases.” The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement.  The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The adoption of this ASU is expected to result in all operating leases being capitalized and a current and long-term liability recorded in the Company’s financial statements.

In August 2015, the FASB issued ASU 2015-14 which updated (toto defer the effective date by one year)year of previously issued ASU 2014-09, "Revenue“Revenue from Contracts with Customers,"” which amended revenue recognition guidance to clarify the principles for recognizing revenue from contracts with customers.  The guidance requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services.  The guidance also requires expanded disclosures relating to the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Additionally, qualitative and quantitative disclosures are required about customer contracts, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract.   This accounting guidance is effective for the Company beginning in the first quarter of fiscal year 20182019 using one of two prescribed retrospective methods.  Early adoption is permitted but not permitted.before annual periods beginning after December 15, 2016.  We have not yet selected a transition method nor have we determinedand are currently in the effectearly stages of evaluating the standardimpact of adoption of this ASU on our ongoingconsolidated financial reporting.statements and disclosures. 

In July 2015, the FASB issued ASU 2015-11, “Simplifying the Measurement of Inventory.” Under this ASU, inventory will be measured at the “lower of cost and net realizable value” and options that currently exist for “market value” will be eliminated. The ASU defines net realizable value as the “estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.” No other changes were made to the current guidance on inventory measurement. ASU 2015-11 is effective for interim and annual periods beginning after December 15, 2016. Early application is permitted and should be applied prospectively. Management has early adopted ASU 2015-11 and notesnoted no material impact on the Company'sCompany’s financial position or results of operations. 

In August 2014, the FASB issued ASU 2014-15, “Presentation of Financial Statements – Going Concern: Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” which requires management to evaluate whether there are conditions and events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the financial statements are issued. This ASU is effective for annual periods ending after December 15, 2016 and interim periods within annual periods beginning after December 15, 2016. The adoption of this ASU isdid not expected to have a material impact on the Company’s financial statements. 

 

Refer to the Company’s Annual Report on Form 10-K for the year ended March 31, 2016, as filed with the SEC on June 15, 2016 for a detailed discussion on our previously outstanding Notes Payable, Long Term Debt and Current Portion – Long Term Debt.  The following are the changes to our Notes Payable, Long Term Debt and Current Portion – Long Term Debt for the periods presented.

As of June 30, 20162017 and March 31, 2016,2017, the outstanding balance of the Company’s note payable and debt, including accrued interest, is as follows:

 

 

The Company and Scotts Miracle-Gro also agreed to enter an Intellectual Property Sale Agreement, a Technology License Agreement, a Brand License Agreement, and a Supply Chain Services Agreement.  The Intellectual Property Sale Agreement and the Technology License constitute an agreement of sales of future revenues.  Since the Company received cash from Scotts Miracle-Gro and agreed to pay for a defined period a specified percentage of revenue, and because the Company has significant involvement in the generation of its revenue, the excess paid over net book value is classified as debt and is being amortized under the effective interest method.  As of June 30, 20162017 and March 31, 2016,2017, a liability of $149,000$107,000 and $160,000,$117,000, respectively, was recorded on the balance sheets for the Intellectual Property Sale Agreement.  As of June 30, 20162017 and March 31, 2016, a2017, the accrued liability of $727,000 and $579,000, respectively, was recorded on the balance sheets for the Technology Licensing Agreement.Agreement at $1.51 per share is fair valued at period end and recorded as stock dividend to be distributed and amounts to $725,000 and $935,000, respectively.  The accrued liability for the Brand License Agreement at $1.51 per share is fair valued at period end and recorded as stock dividend to be distributed and amounts to $1.1$1.3 million and $905,000$1.6 million of the stock dividend to be distributed as of June 30, 20162017 and March 31, 2016,2017, respectively.

 

On April 22, 2013, the Company entered into a Securities Purchase Agreement with SMG Growing Media, Inc., a wholly owned subsidiary of Scotts Miracle-Gro.Miracle-Gro (NYSE: “SMG”), a worldwide marketer of branded consumer lawn and garden products.  Pursuant to the Securities Purchase Agreement, Scotts Miracle-Gro acquired 2.6 million2,649,007 shares of the Company’s Series B Convertible Preferred Stock, par value $0.001 per share (the “Series“Series B Preferred Stock”), and (ii) a warrant to purchase shares of the Company’s common stock (the “Warrant,” as described in greater detail below) for an aggregate purchase price of $4.0 million.  The Securities Purchase Agreement, Certificates of Designations for the Series B Preferred Stock, Form of Warrant, Indemnification Agreement, Investor’s Rights Agreement and Voting Agreement have been filed as exhibits to a Current Report on Form 8-K that was filed with the SEC on April 23, 2013.  After deducting offering expenses, including commissions and expenses paid to the Company’s advisor, net cash proceeds to the Company totaled to $3.8 million.  The Company used $950,000 of the net proceeds to repay “in full” (with concessions) the Promissory Note due to Main Power, who was a former suppliersupplier.   The Company used the remaining net proceeds for working capital and general corporate purposes.  On November 29, 2016 Scotts Miracle-Gro fully exercised the Warrant and upon exercise of product.   the Warrant the Series B Preferred Stock converted into shares of common stock.

The Series B Convertible Preferred Stock iswas convertible into 2.6 million2,649,007 shares of the Company’s common stock ($4.0 million divided by a conversion price of $1.51 per share).  The Series B Convertible Preferred Stock bearsbore a cumulative annual dividend of 8.0%, payable in shares of the Company’s common stock at a conversion price of $1.51 per share (subject to customary anti-dilution rights, as described in the Series B Convertible Preferred Stock Certificates of Designations).  The Series B Convertible Preferred Stock doesdid not have a liquidation preference and iswas entitled to vote on an “as-converted” basis with the common stock.  The stock dividend accruesaccrued from day to day and iswas payable in shares of our common stock within thirty days after the end of each fiscal year end financials are completed.end.  The stock dividend issuable iswas recorded at the fair market value of our common stock at the end of each quarter in the equity section of the balance sheet.  The corresponding charge iswas recorded below net income to arrive at net income available to common stockholders.shareholders. The Series B Convertible Preferred Stock automatically convertsconverted into the Company’s common stock: (i) upon the affirmative election of the holders of at least a majority of the then outstanding shares of the Series B Convertible Preferred Stock voting together as a single class on an as-if-converted to common stock basis; or (ii) if, at the date of exercise in whole or in part of the Warrant, the holder (or holders) of the Series B Convertible Preferred Stock own 50.1% of the issued and the Company’s then-outstanding common stock of the Company, giving effect to the issuance of shares of common stock in connection with the conversion of the Series B Convertible Preferred Stock and such exercise of the Warrant.  By its terms, the Series B Preferred Stock automatically converted into the Company’s common stock on November 29, 2016, when Scotts Miracle-Gro exercised the Warrant.

 

The foregoing description of the Securities Purchase Agreement, the Certificates of Designations for the Series B Convertible Preferred Stock, the Warrant, and the resulting transaction is only a summary, does not purport to be complete, and is qualified in its entirety by reference to the full text of the applicable documents, each of which was included as an exhibit to the Company’s Current Report on Form 8-K, as filed with the SEC on April 23, 2013. The Warrantwarrant on the Series B Convertible Preferred Stock was accounted for as a liability at its estimated fair value of $1.1 million and $644,000 as of June 30, 2016 and March 31, 2016, respectively.value.  The derivative warrant liability will bewas re-measured to fair value, on a recurring basis, at the end of each reporting period until it is exercised or expireswas exercised.  The Company accounted for the warrant as a liability and measured the value of the warrant using athe Monte Carlo simulation model.

 

In conjunction with the private offering described above, the Company and Scotts Miracle-Gro also agreed to enter an Intellectual Property Sale Agreement, a Technology License Agreement, a Brand License Agreement, and a Supply Chain Services Agreement.  The Intellectual Property Sale Agreement and the Technology License constitute an agreement of sales of future revenues.  For more details regarding these agreements, please refer to Note 3 “Scotts Miracle-Gro Transactions” to the financial statements included in the Company’s Annual Report on Form 10-K, as filed with the SEC on June 15, 2016.  See also Note 9 for subsequent events.26, 2017. 

 

For the three months ended June 30, 2017 and June 30, 2016, the Company did not grant any options to purchase the Company’s common stock under the Company’s 2005 Equity Compensation Plan (the “2005 Plan”) and no new options will be granted under this plan until a new plan is adopted. For the three months ended June 30, 2015, the Company did not grant any options to purchase the Company’s common stock under the 2005 Plan.

During the three months ended June 30, 2017 and June 30, 2016, no options to purchase shares of common stock were cancelled or expired, and no shares of common stock were issued upon exercise of outstanding stock options under the 2005 Plan.  During the three months ended June 30, 2015, no options to purchase shares of common stock were cancelled or expired, and no shares of common stock were issued upon exercise of outstanding stock options under the 2005 Plan.

 

As of June 30, 2016,2017, the Company had grantedno unvested outstanding options to purchase 100,000 shares of the Company’s common stock that are unvested and that will result in $92,000 ofno additional compensation expense in future periods if fully vested.  

Information regarding all stock options outstanding under the 2005 Plan as of June 30, 20162017 is as follows:

 

 

The aggregate intrinsic value in the preceding table represents the difference between the Company’s closing stock price and the exercise price of each in-the-money option on the last trading day of the period presented, which was June 30, 2016.2017.

 

 

The Company follows the guidance in ASC 740, Accounting for Uncertainty in Income Taxes (“ASC 740”) which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements.  This interpretation defines the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements.

Deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts at the end of each period, based on enacted laws and statutory rates applicable to the periods in which the differences are expected to affect taxable income.  Any liability for actual taxes to taxing authorities is recorded as income tax liability. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  A valuation allowance is established against such assets where management is unable to conclude more likely than not that such asset will be realized. As of June 30, 20162017 and March 31, 2016,2017, the Company recognized a valuation allowance equal to 100% of the net deferred tax asset balance and the Company has no unrecognized tax benefits related to uncertain tax positions.

 

See Note 6 “Related Party Transactions” of Form 10-K for the year ended March 31, 2016,2017, as filed with the SEC on June 15, 201626, 2017 for a detailed discussion of related party transactions. Additionally, see Note 9 “Subsequent Events” to our financial statements for discussion related to debt and equity transactions involving our officers, directors and 5% or greater shareholders.  

 

 

A summary of the Company’s common stock warrant activity for the period from April 1, 20162017 through June 30, 20162017 is presented below:

 

As of June 30, 2016,2017, the Company had the following outstanding warrants to purchase its common stock:

 

As discussed in Note 4 the Company also issued a warrant that entitles, but does not obligate Scotts Miracle-Gro to purchase a number of shares of common stock that, on a fully diluted basis, constitute 80% of the Company’s outstanding capital stock.  The warrant on the Series B Convertible Preferred Stock was accounted for as a liability at its estimated fair value.  The warrant liability will be re-measured to fair value at the end of each reporting period until it is exercised or expires.  The tables above, exclude the warrant issued to Scotts Miracle-Gro because the warrant is not issuable in any certain number of shares, as discussed above.  In June 2016, representatives of Scotts Miracle-Gro informed our management team and our Board of Directors of its intent to exercise some or all of the Warrant prior to December 31, 2016.

The discussion contained herein is for the three months ended June 30, 20162017 and June 30, 2015.2016.  The following discussion should be read in conjunction with the financial statements of AeroGrow International, Inc. (the “Company,” “AeroGrow,” “we,” “our,” or “us,”) and the notes to the financial statements included elsewhere in this Quarterly Report on Form 10-Q for the period ended June 30, 20162017 (this “Quarterly Report”). The following discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), including statements that include words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “may,” “will,” or similar expressions that are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements include, but are not limited to, statements regarding our intent, belief, or current expectations regarding our strategies, plans, and objectives, our product release schedules, our ability to design, develop, manufacture, and market products, the ability of our products to achieve or maintain commercial acceptance, our ability to obtain financing and/or generate cash flow sufficient to fund our future operations, and our ability to continue as a going concern. Such statements are not guarantees of future performance and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Factors that could cause or contribute to the differences are discussed in this Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Item 1A. “Risk Factors” of our Annual Report on Form 10-K for the year ended March 31, 2016.2017.  Except as required by applicable law or regulation, we undertake no obligation to revise or update any forward-looking statements contained in this Quarterly Report. The information contained in this Quarterly Report is not a complete description of our business or the risks associated with an investment in our common stock. Each reader should carefully review and consider the various disclosures we made in this Quarterly Report and in our other filings with the U.S. Securities and Exchange Commission (“SEC”).

AeroGrow International, Inc. was formed as a Nevada corporation in March 2002. The Company’s principal business is developing, marketing, and distributing advanced indoor aeroponic garden systems designed and priced to appeal to the consumer gardening, cooking and small indoor appliance markets worldwide.  The Company’s principal activities from its formation through March 2006 consisted of product research and development, market research, business planning, and raising the capital necessary to fund these activities. In December 2005, the Company commenced initial production of its AeroGarden system and, in March 2006, began shipping these systems to retail and catalogue customers. The Company manufactures, distributes and markets nine different models of its AeroGarden systems in multiple colors, as well as over 40 varieties of seed pod kits and a full line of accessory products through multiple channels including retail distribution, catalogue and direct-to-consumer sales primarily in the United States and Canada, as well as selected countries in Europe.

In April 2013, we entered into a Securities Purchase Agreement and strategic alliance with a wholly owned subsidiary of The Scotts Miracle-Gro Company (collectively with its subsidiary, “Scotts Miracle-Gro”). Pursuant to the Securities Purchase Agreement, we issued (i) 2.6 million shares of Series B Convertible Preferred Stock, par value $0.001 per share (the “Series B Preferred Stock); and (ii) a warrant to purchase shares of our common stock for an aggregate purchase price of $4.0 million.  In addition, as part of the strategic alliance, we entered into several other agreements with Scotts Miracle-Gro, including: (i) an Intellectual Property Sale Agreement; (ii) a Technology Licensing Agreement; (iii) a Brand License Agreement; and (iv) a Supply Chain Management Agreement. As described above in Note 9 to the condensed financial statements, certain of these agreements were amended on July 15, 2016.

Pursuant to the Intellectual Property Agreement, we agreed to sell all intellectual property associated with our hydroponic products (the “Hydroponic IP”), other than the AeroGrow and AeroGarden trademarks, free and clear of all encumbrances, to Scotts Miracle-Gro for $500,000.  Scotts Miracle-Gro has the right to use the AeroGrow and AeroGarden trademarks in connection with the sale of products incorporating the Hydroponic IP.  In addition to the working capital infusion of approximately $4.5 million from the Securities Purchase Agreement and Intellectual Property Sale Agreement, as amended, the strategic alliance affords us the use of the globally recognized and highly trusted Miracle-Gro brand name.  We believe that the strategic alliance also gives Scotts Miracle-Gro an entry into the burgeoning indoor gardening market, while providing AeroGrow a broad base of support in marketing, distribution, supply chain logistics, R&D, and sourcing.  We intend to useused our strategic alliance with Scotts Miracle-Gro to re-establish our presence in the retail and international sales channels.

For the three months ended June 30, 2016,2017, we generated $2.2$2.5 million of total revenue, an increase of 37.4%14.2%, or $586,000,$307,000, relative to the same period in the prior year.  Retail sales increased by 56.2%2.8% to $948,000$974,000 primarily due to the continued sales into the housewares channel and growing enthusiasm about new gardens that were first introduced in the prior year.  Direct-to-consumer sales increased 18.6%24.8%, to $1.1$1.4 million, reflecting increased sales due to more visibility and continued momentum from our general advertising and marketing campaign.  

For the three months ended June 30, 2016,2017, total dollar sales AeroGarden salesunits increased by 30.5%22.7% from the prior year period and seed pod kit and accessory sales increased by 42.7%6.2% over prior year period.  AeroGarden sales represented 62.5%67.1% of total revenue, as compared to 65.8%62.5% in the prior year period.  This percentage decrease,increase, on a product line basis, was attributable to existing andgrowth in the direct-to-consumer channel which typically results in new customers purchasing AeroGardens before seed pod kits and accessories.  Seed pod kit and accessory sales increased as a percent of the total to 36.2% from 34.9% in the prior year period as a result of more AeroGarderns being introduced to the market in the prior periods.accessories.   Sales of seed pod kits increased from 27,00037,000 to 37,000,46,000 units, primarily as a result of the increased size of our active customer database due toas new customers who have entered the AeroGrow franchise.

OneThe Company continues to spend advertising dollars in efforts to strategically build market awareness based on effectiveness of initiatives implemented in the prior year. For Fiscal 2018, we intend to expand consumer awareness of the company’s key strategic initiatives for Fiscal 2016 has been to increase the generalAeroGrow brand and category awareness of our products in the minds of targeted consumers.product line.  As a result, during the three months ended June 30, 2016,2017, we incurred $282,000$267,000 of advertising expenses to support our direct-to-consumer and retail channels, a $132,000$15,000 or 87.4%5.4% year-over-year increasedecrease compared to the same period in Fiscal 2016.2017. These expenditures were divided as follows:

 

Our gross marginprofit for the three months ended June 30, 20162017 was 39.1%33.4%, updown from 30.6%39.1% in the prior year period, as our sales momentum continued from the last two quarters of the prior year as our general brand awareness campaign continuedprimarily due to drive sales.  During the quarter, we experienced higher margins associated with ourchanges in customer and product costs as we focused on driving efficiencies in our supply chain costsmix and improved pricing strategies. In the prior year, we also experienced some additional costs related to our in-store customers, including in-store sales tests, which were not duplicated this year.tests.  We also incurred one-time fees in establishing new customers and additional shipping costs for international and direct-to-consumer sales.

In aggregate, our total operating expenses increased 4.1%3.6%, or $59,000,$54,000, year-over-year, principally because we spent more in anticipation of future growth.  Gross spending increased in the following areas:

These increases were partially offset by offset by decreases of $113,000$42,000 in a variety of other areas, including legal expenses, new product testing and certifications, investor relations and an IT consultantreimbursable consulting fees based on agreements with Scotts Miracle-Gro which was replaced by an employee.began in July 2016.  As a result of efforts to drive growth and increase sales, our operating loss was $653,000$728,000 for the three months ended June 30, 2016,2017, as compared to an operating loss of $957,000$653,000 in the prior year period.

Net other expenseincome for the three months ended June 30, 20162017 totaled $474,000,$39,000, as compared to net other expense of $264,000$474,000 in the prior year period.  The current year other income is attributable to interest income, other income from consulting related revenue, and foreign exchange gains.  In both periods,the prior year period, net other expense iswas primarily attributable to non-cash expenses relating to the fair value revaluation of the warrant held by Scotts Miracle-Gro.  

Net loss for the three months ended June 30, 20162017 was $1.1 million,$689,000, as compared to the $1.2$1.1 million loss a year earlier.  The net loss reflected the increased sales revenue, decreased operating expenses as a percentage of revenue and marginsthe elimination of fair value changes associated with the Scotts Miracle-Gro warrant liability offset by increasesdecreases in operating expenses.margins.   

The following table sets forth, as a percentage of sales, our financial results for the three months ended June 30, 20162017 and the three months ended June 30, 2015:2016:

 

For the three months ended June 30, 2016,2017, revenue totaled $2.2$2.5 million, a year-over-year increase of 37.4%14.2% or $587,000,$307,000, from the three months ended June 30, 2015.2016.

Direct-to-consumer sales for the three months ended June 30, 20162017 totaled $1.1$1.4 million, an increase of $180,000,$283,000, or 18.6%24.8%, from the prior year period.  TheThis increase in direct-to-consumer channels was caused by thepricing strategies to drive direct-to-consumer sales during our non-peak season, follow-on direct sales to customers that have previously purchased an AeroGarden, and continued momentum from general brand awareness campaigns that began in the last two quarters of the prior year, an increased visibility of our product in the marketplace and improved pricing strategies on new gardens.campaigns.

  

Sales to retailer customers for the three months ended June 30, 20162017 totaled $948,000,$974,000, up $341,000,$26,000, or 56.2%2.8%, principally reflecting relatively small organic growth in our growth into ourexisting retail accounts namely Amazon.com.  In the prior year, we were in the processand tests of establishingseveral other retail sales channels that are still in place in the current quarter which include our housewares customers.  In the current year, our sales were due to organic growth.accounts.  International sales increased $66,000 as we beganremained consistent at $63,000 in comparison to sales testing in Europe which has no comparable amount in the prior year quarter.as we continue to understand the trends that impact the international market.

Our products consist of AeroGardens, and seed pod kits and accessories.  A summary of the sales of these two product categories for the three months ended June 30, 20162017 and June 30, 20152016 is as follows:

 

AeroGarden sales increased $315,000,$305,000, or 30.5%22.7%, from the prior year period, reflecting increased sales from our retail and international channels, and increased sales of gardens, primarily in our Direct-to-Consumer channel.  The increase in seed pod kit and accessory sales, which increased by $233,000,$49,000, or 42.7%6.2%, principally reflects the prior period focus on acquiring new AeroGarden customers, who have historically purchased seed pod kits and accessories after purchasing and using new AeroGardens, partially offset by a decrease in light bulb sales as the demand for AeroGardens with LED lighting increases.  For the three months ended June 30, 2016,2017, sales of seed pod kits and accessories represented 36.2%33.7% of total revenue, as compared to 34.9%36.2% in the prior year period.  Other revenue, which is comprised primarily of grow club revenue, shipping revenue, accruals and deductions, increaseddecreased as a percent of total revenue to 1.3%(0.8)% from (0.6)%1.3% in the prior year period, primarily due to decreasesincreases in revenue deductions for sales allowances and discounts for in-store retail accounts.

 

Cost of revenue for the three months ended June 30, 20162017 totaled $1.3$1.6 million, an increase of $223,000,$328,000, or 20.5%25.0%, from the three months ended June 30, 2015.2016.  Cost of revenue includes product costs for purchased and manufactured products, freight costs for inbound freight from manufacturers, costs related to warehousing and the shipping of products to customers, credit card processing fees for direct sales, and duties and customs applicable to imported products.  As a percent of total revenue, cost of revenue represented 60.9%66.6% of revenue as compared to 69.4%60.9% for the quarter ended June 30, 2015.2016.  The decreaseincrease in costs as a percent of revenue reflected focus on lowering supply chainto more aggressive pricing with specific customers, test marketing with several new retailers, and one-time costs for product adjustments and pricing strategy improvements.shipping internationally.

Our gross marginprofit varies based upon the factors impacting net revenue and cost of revenue, as discussed above, as well as the mix of our revenue that comes from the retail, direct-to-consumer, and international channels.  In a direct-to-consumer sale, we recognize as revenue the full consumer purchase price for the product.  In retail and international sales, by comparison, we recognize as revenue the wholesale price that we charge to the retailer or international distributor.  Media costs associated with direct sales are included in sales and marketing expenses.  For international sales, margins are structured based on the distributor purchasing products by letter of credit or cash in advance, terms with the distributor bearing all of the marketing and distribution costs within its territory.  As a result, international sales generally have lower gross marginsprofits than domestic retail sales.  The gross marginprofit for the quarter ended June 30, 20162017 was 39.1%33.4% as compared to 30.6%39.1% for the quarter ended June 30, 2015.2016.  The increasedecrease in our gross marginprofit was primarily attributable to the increased percentagepricing pressure in our direct-to-consumer channel, customer and product mix and introduction of sales derived from gardens with higher margins, less downward pressure from carrying our product in stores, decreases in supply chain costs and improvements in our pricing strategy.into new stores.  Additionally, during the quarter we experienced lowerhigher costs as compared to the prior year for returns and allowances less adjustments provided to in-store retailers.retailers, one-time fees related to establishing new customers, additional shipping costs for international and direct-to-consumer channels.

 

Sales and marketing costs for the three months ended June 30, 20162017 totaled $820,000, as compared to $642,000 for$832,000, relatively flat with the three months ended June 30, 2015, an increase of 27.6%, or $178,000.prior year period.  Sales and marketing costs include all costs associated with the marketing, sales, operations, customer support, and sales order processing for our products, and consisted of the following:

 

Advertising expense is composed primarily of catalogue development, production, printing, and postage costs, web media expenses for search and affiliate web marketing programs, and the cost of developing and employing other forms of advertising.  Each is a key component of our integrated marketing strategy because it helps build consumer awareness and demand for our products in the retailer and direct-to-consumer sales channels.  Total advertising expense was $282,000$267,000 for the quarter ended June 30, 2016,2017, a year-over-year increasechange of 87.4%(5.4)%, or $132,000,$15,000, primarily because we participated in variousare cautiously spending on promotional programs to increase product awareness withwithin our housewaresretail channel, of retail accounts including catalogs andwhile maintaining catalogues, email campaigns, along with growth in ourand web-based advertising programs.programs for our houseware customers.

Sales and marketing personnel costs include salaries, payroll taxes, employee benefits and other payroll costs for our sales, operations, customer service, graphics and marketing departments.  For the three months ended June 30, 2016,2017, personnel costs for sales and marketing were $396,000,$429,000, up $20,000$21,000 or 5.5%5.1% from the three months ended June 30, 2015.2016.   The increase reflected changes in departmental incentive programs, specifically for bonuses and increased employee benefits and salaries. 

Other marketing expenses increased year-over-year as we continue to grow our business and increase market research and other programs, including increased travel.

General and administrative costs for the three months ended June 30, 20162017 totaled $580,000,$627,000, as compared to $665,000$564,000 for the three months ended June 30, 2015, a decrease2016, an increase of 12.7%11.1%, or $85,000.$63,000. The decreaseincrease was attributable to lower legalweb hosting, electronic data processing, network consulting fees and investor relations program expenses and a decrease in the cost of the former IT consultant who was replaced by an employee. depreciation expenses.

 

Our operating loss for the three months ended June 30, 20162017 was $653,000, a decrease$728,000, an increase of $304,000$75,000 over the $957,000$653,000 operating loss for the three months ended June 30, 2015.2016.  The decreasedincreased operating loss was attributable to higher revenuedecreased margins, several promotional events, incentive pricing strategies for direct-to-consumer sales, and higher margins, partially offset by increased operating expenses, such as advertising, to support future growth in both the retail distribution and direct-to consumer channels.retailer test pricing programs.

For the three months ended June 30, 2016,2017, we recorded a net loss of $1.1 million,$689,000, a $94,000 decrease$437,000 improvement over the $1.2$1.1 million net loss for the three months ended June 30, 2015.2016.  The decrease in the net loss reflected the increasechange in revenue coupledfair value on the Scotts Miracle-Gro warrant liability.

We report our segment information in the same way that management assesses the business and makes decision regarding the allocations of resources in accordance with increasedthe Segment Reporting Topic of the Financial Accounting Standards Board Accounting Standards Codification (ASC). We have two reportable segments. Retail and Direct-to-Consumer. Factors considered in determining our Reportable Segments include the nature of the business activities, the reports provided to the Company’s chief operating decision maker (CODM) for operating and administrative activities, available information and information that is presented to our Board of Directors.

As a result, we divide our business into two reportable segments: Direct-to-Consumer and Retail. This division of reportable segments is consistent with how the segments report to and are managed by the chief operating decision maker of the Company.  The Company evaluates performance based on the primary financial measure of contribution margin (“segment profit”). Segment profit reflects the income or loss from operations before corporate expenses, to support future revenue growth,non-operating income, net interest expense, and higher margin retail sales.income taxes.

After adjusting the net loss for non-cash items and changes in operating assets and liabilities, the net cash providedused by operating activities totaled $517,000 for the three months ended June 30, 2017, as compared to cash provided of $69,000 for the three months ended June 30, 2016, as compared to cash used of $436,000 for the three months ended June 30, 2015.2016.  

 

Non-cash items, comprising depreciation, amortization, loss on disposal of fixed assets, bad debt allowances, and change in fair value of Scotts Miracle-Gro warrant liability, totaled to a net loss of $689,000$214,000 for the three months ended June 30, 2016,2017, as compared to a net loss of $488,000$689,000 in the prior year period.  The increase principally reflected non-cash charges arising from the change in fair value on the warrant liability in the prior year and the additional depreciation and non-cash compensation expenses. 

 

Changes in current assets provided net cash of $967,000$649,000 during the three months ended June 30, 2016,2017, principally from decreases in accounts receivable, inventory and deposit balances as we moved away from our peak season, partially offset by increases in prepaid assets.assets, inventory and deposit balances.

As of June 30, 2016,2017, the total inventory balance was $2.7$3.0 million, representing approximately 7770 days of sales activity, and 187164 days of sales activity, at the average daily rate of product cost expensed during the twelve months and three months ended June 30, 2016,2017, respectively.  The three monthsmonths’ days in inventory calculation is based on the three months of sales activity and can be greatly impacted by the seasonality of our sales, which are at their highest level during our quarter ending December 31.  The twelve monthsmonths’ days in inventory calculation is based on the twelve months of sales activity and can is less impacted by the seasonality of our salessales.

Current operating liabilities decreased $459,000$689,000 during the three months ended June 30, 2016,2017, principally because of a decrease in all operating liability accounts.  Accounts payable as of June 30, 20162017 totaled $1.6$2.0 million, representing approximately 2830 days of daily expense activity, and 5356 days of daily expense activity, at the average daily rate of expenses incurred during the twelve months and three months ended June 30, 2016,2017, respectively.

Net investment activity used $7,000$51,000 of cash in the current year period, principally because of purchases of equipment.

As of June 30, 2016,2017, we had a cash balance of $478,000,$8.2 million, of which $15,000 was restricted as collateral for various corporate obligations.  This compares to a cash balance of $1.4$8.8 million as of March 31, 2016,2017, of which $15,000 was restricted.

As of June 30, 20162017 and March 31, 2016,2017, we have no outstanding long-term debt.  However, on July 15, 2016, the Company entered into a short-term Term Loan with Scotts Miracle-Gro in the principal amount of up to $6.0 million in order to provide working capital for the upcoming peak selling season.  See Note 9 “Subsequent Events” to the condensed financial statements.

We generally require cash to:

At this time, we do not expect to enter into additional capital leases to finance major purchases.  In addition, we do not currently have any binding commitments with third parties to obtain any material amount of equity or debt financing other than the financing arrangements described in this report.

To assess our ability to fund ongoing operating requirements, we developed assumptions regarding operating cash flow.  Critical sources of funding, and key assumptions and areas of uncertainty include:

 

There are several factors that could affect our future results of operations.  These factors include, but are not limited to, the following:

 

Other than our headquarter facility lease commitment incurred in the normal course of business, we do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interest in transferred assets, and have not entered into any contracts for financial derivative such as futures, swaps, and options.

 

Our interest income is most sensitive to fluctuations in the general level of U.S. interest rates. As such, changes in U.S. interest rates affect the interest earned on our cash, cash equivalents, and short-term investments, and the value of those investments. Due to the short-term nature of our cash equivalents and investments, we have concluded that a change in interest rates does not pose a material market risk to us with respect to our interest income. As discussed above, if we acquire additional debt changes in the general level of market interest rates could impact our interest expense during the terms of future debt arrangements.

We transact business primarily in U.S. currency.  Although we purchase our products in U.S. dollars, the prices charged by our suppliers in Asia are predicated upon their cost for components, labor and overhead. Therefore, changes in the valuation of the U.S. dollar in relation to the Chinese currencies may cause our manufacturers to raise prices of our products which could reduce our profit margins.

  

In future periods, it is possible that we could be exposed to fluctuations in foreign currency exchange rates on accounts receivable from sales and net monetary assets denominated in foreign currencies and liabilities.  To date, however, virtually all of our transactions have been denominated in U.S. dollars.

 

(a) Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports filed or submitted by the Company under the Securities Exchange Act of 1934 (the “Exchange Act”), is recorded, processed, summarized, and reported, within the time periods specified in the rules and forms of the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports filed under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive and financial officer, as appropriate, to allow timely decisions regarding required disclosure.

The Company carried out an evaluation, under the supervision and with the participation of its management, including its principal executive officer and principal financial officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based upon and as of the date of that evaluation, the Company’s principal executive officer and financial officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Changes in Internal Controls

 

There were no changes in the Company’s internal controls or in other factors that could have significantly affected those controls during the three months ended June 30, 2016.2017.

 

 

None.

 

Our operations and financial results are subject to various risks and uncertainties that could adversely affect our business, results of operations, financial condition, future results, and the trading price of our common stock. In addition to the other information set forth in this Quarterly Report, you should also carefully consider the factors described in “Part I. Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended March 31, 2016,2017, which could materially affect our business, results of operations, financial condition, future results, and the trading price of our common stock.

 

None.

 

None.

 

Not applicable.