AeroGrow International, Inc. (the(collectively, the “Company,”" “AeroGrow,” “we,” “our,”“our” or “us”) was formed as a Nevada corporation onin March 25, 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 sevennine 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 .com retail outlets, catalogue and direct-to-consumer sales primarily in the United States and Canada, as well as selected countries in Europe, Asia and Australia.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 SeptemberJune 30, 2016,2017, the results of operations for the three and six months ended SeptemberJune 30, 20162017 and 2015,2016, and the cash flows for the sixthree months ended SeptemberJune 30, 20162017 and 2015.2016. The results of operations for the three and six months ended SeptemberJune 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 offrom October through January.  Furthermore, during the six-monththree-month period ended SeptemberJune 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, however, to address the seasonal nature of our working capital needs, increase the scale of our business and provide a cash reserve against contingencies.  There can be no assurance we will be able to raise this additional capital.

 

The preparation of financial statements in conformity with 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 potential common stock equivalents (e.g., convertible securities, options, and warrants) as if itsuch 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.  Employee stock options to purchase approximately 656,000 shares of common stock were outstanding and warrants to purchase approximately 432,000 shares of common stock were outstanding but wereSecurities not included in the computation of diluted net income per shareEPS because the effect of including such sharesto do so would have been anti-dilutive inwere 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 SeptemberJune 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 SeptemberJune 30, 2017 and 2016, one customer, Amazon.com, represented 23.0% and 35.8%, respectively, of the Company’s net revenue.

As of June 30, 2017, the Company had three customers, Amazon.com, Sur La TableBed, Bath & Beyond and Ace Hardware, whichAmazon.ca, that represented 33.3%26.5%, 20.1%16.3% and 16.8%15.8% of net revenue,the Company’s outstanding accounts receivable, respectively.  For the three months ended September 30, 2015,As of March 31, 2017, the Company had one customer,three customers, Amazon.com, Amazon.uk and Amazon.ca, which represented 42.4%33.9%, 14.3% and 11.0%, respectively, of the Company’s net revenue. For the six months ended September 30, 2016, theoutstanding accounts receivable.  The Company had one customer, Amazon.combelieves that represented 34.6% of the Company’s net revenue. For the six months ended September 30, 2015, the Company had had one customer, Amazon.com that represented 40.1% of the Company’s net revenue.all receivables from these customers are collectible.

For the three months ended SeptemberJune 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 $3.6 million, representing 233.2%$300,000.  The purchase of cost of revenue, as we ramp up inventory levels for the holiday season. For the three months ended September 30, 2015, the Company purchased inventories and other inventory-related items from four suppliers totaling $2.2 million, $315,000, $167,000is dependent on timing of purchases for our highly seasonal business and $149,000, representing 206.2%, 29.1%, 15.4% and 13.7% of cost of revenue, respectively. For the six months ended September 30, 2016, the Company purchased inventories and other inventory-related items from one supplier totaling $4.1 million, representing 142.3% of cost of revenue. For the six months ended September 30, 2015, the Company purchased inventories and other inventory-related items from one supplier totaling $2.6 million, representing 43.3% of cost of revenue.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, third-party labortransportation/shipping and weather/natural disaster risks.  Although the Company believes alternate sources of manufacturing could be obtained, these risksthe risk of an interruption in product sourcing could have an adverse impact on our 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.

 

 

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 SeptemberJune 30, 20162017 and March 31, 20162017 due to the relatively short-term nature of these instruments. 

The Company has three liabilities for which theCompany’s intellectual property liability carrying value iswas determined byutilizing Level 3 inputs: (1) Notes payable – related party; (2) sale of intellectual property liability; and (3) derivative warrant liability.inputs.  As discussed below in Notes 3 and 4, each of these liabilitiesthis liability was incurred in conjunction with the Company’s strategic alliance with Scotts Miracle-Gro.  As of SeptemberJune 30, 20162017 and March 31, 2016,2017, the fair value of the Company’s note payable andCompany's sale of the intellectual property liability werewas estimated using the discounted cash flow method, which is based on expected future cash flows, discounted to present value using a discount rate of 15%.  The Company also issued a derivative 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, would constitute 80% of the Company’s outstanding capital stock.  The Company accounts for the warrant as a liability and measures the value of the warrant using the Monte Carlo simulation model as of the end of each quarterly reporting period until the warrant is exercised or expires.  As of SeptemberJune 30, 2016 and March 31, 2016, the estimated fair value of the warrant was $1.5 million and $644,000, respectively. As of September 30, 2016,2017, the Company did not have any financial assets or liabilities that were measured at fair value on a recurring basis, subsequent to initial recognition, except for the derivative warrant liability.  The table below summarizes the fair value and carry valuerecognition.   

The Company sells its products to retailers and directly to consumers. Direct-to-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’sCompany's allowance estimate is based on a review of the current status of trade accounts receivable, which resulted in an allowance of $17,000$10,000 and $14,000$20,000 at SeptemberJune 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 SeptemberJune 30, 20162017 and March 31, 2016,2017, the balance in this reserve account was $85,000$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.  TheIn contrast, the Company records media and marketing costs related to its direct-to-consumer advertisements, inclusive of related 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 areshould be amortized over the estimated period of the benefits, based on the proportion of current period revenue from the advertisement to probable future revenue.  

Advertising expense for the three and six months ended SeptemberJune 30, 20162017 and 2015June 30, 2016, were as follows:

As of SeptemberJune 30, 20162017 and March 31, 2016,2017, the Company deferred $1,000$4,000 and $24,000, respectively, related to such media and advertising costs includingwhich include the catalogue cost described above.  The costs are included inwithin the prepaid“prepaid expenses and otherother” line of the condensed balance sheets.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 as prescribed under ASC 330 Inventory Pricing.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 SeptemberJune 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 SeptemberJune 30, 20162017 and March 31, 2016,2017, the Company had accrued $105,000$202,000 and $151,000,$304,000, respectively, as an estimate for the foregoing deductions and allowances.  These expenses are included inallowances within the accrued expenses“accrued expenses” line of the condensed 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 $119,000$117,000 and $117,000$125,000 as of SeptemberJune 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 SeptemberJune 30, 20162017 and March 31, 2016,2017, the Company has recorded a reserve for customer returns of $60,000$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 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’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. 

 

The following are the changes to our Notes Payable, Long Term Debt and Current Portion – Long Term Debt for the periods presented. For a more detailed discussion on our previously outstanding Notes Payable, Long Term Debt and Current Portion – Long Term Debt, refer to 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.  The following are the changes to our Notes Payable, Long Term Debt and Current Portion – Long Term Debt for the periods presented.26, 2017.

As of SeptemberJune 30, 20162017 and March 31, 2016,2017, the outstanding balance of the Company’s notesnote 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.  BecauseSince 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 SeptemberJune 30, 20162017 and March 31, 2016,2017, a liability of $138,000$107,000 and $160,000,$117,000, respectively, was recorded on the balance sheets for the Intellectual Property Sale Agreement.  As of SeptemberJune 30, 20162017 and March 31, 2016, a2017, the accrued liability of $263,000 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 $454,000$1.3 million and $905,000$1.6 million of the stock dividend to be distributed as of SeptemberJune 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 2,649,007 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 2,649,007 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.  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 will bewas recorded below net income to arrive at net income available to common 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.

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 warrant on the Series B Convertible Preferred Stock was accounted for as a liability at its estimated fair value of $1.5 million and $644,000 as of September 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 expires.was exercised.  The Company calculatedaccounted for the warrant as a liability and measured the value of the warrant using the Monte Carlo simulation model as of the end of each quarterly reporting period until the warrant was exercised.  As of June 30, 2017 and March 31, 2017, the warrant had been exercised, and the fair value of the Warrant during the quarter ended September 30,warrant was $0. On November 29, 2016, using a 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 3 for the Term Loan with Scotts Miracle-Gro.26, 2017. 

For the three and six months ended SeptemberJune 30, 2017 and June 30, 2016, the Company did not grant any options to purchase shares ofthe Company’s common stock under the Company’s 2005 Equity Compensation Plan (the “2005 Plan”).  For the three and six months ended September 30, 2015, the Companyno new options will be granted options to purchase 212,000 shares of common stock under the 2005 Plan.this plan until a new plan is adopted. 

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

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

Information regarding all stock options outstanding under the 2005 Plan as of SeptemberJune 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 SeptemberJune 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 SeptemberJune 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.

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

 

As of SeptemberJune 30, 2016,2017, the Company had the following outstanding warrants to purchase shares of 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 and six months ended SeptemberJune 30, 20162017 and SeptemberJune 30, 2015.2016.  The following discussion should be read in conjunction with the financial statements of AeroGrow International, Inc. (the “Company,” “AeroGrow,” “we,” “AeroGrow,“our,” or “our”“us,”) and the notes to the financial statements included in Item 1 aboveelsewhere in this Quarterly Report on Form 10-Q for the period ended SeptemberJune 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 necessaryand/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 onin March 25, 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, Asia and Australia.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, “SMG” or “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.

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 allowsaffords us tothe 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 SeptemberJune 30, 2016,2017, we generated $2.5 million of total revenue, was $2.2 million, an increase of 105.5%14.2%, or $1.2 million,$307,000, relative to the same period in the prior year.  The increase wasRetail sales increased by 2.8% to $974,000 primarily due to over $700,000 of in-store retail channelthe continued sales for tests with our newly acquired retail accounts.  Additionally, we also experienced increased sales at Amazon.com and other online retailers.  This is consistent with our current strategy to build through online retailers while refocusing on in-store tests, primarily ininto the housewares channel.  We anticipate that quarterly sales results during the first six months of our fiscal year (April-September), may continue to be inconsistent as the Company tests various retail channel strategies in an effort to optimize sales and profitability throughout the year and the impact of load-in timing.  Additionally, sales in our direct-to-consumer channel also increased 46.4%, or $261,000, primarily due to growing enthusiasm about new gardens that were first introduced in the prior year with LED lighting, more color optionsyear.  Direct-to-consumer sales increased 24.8%, to our products$1.4 million, reflecting increased visibility and the growth in our active database of customers.  We believe we benefit from more visibilitycontinued momentum from our prior yeargeneral advertising and marketing campaigns and increased presence on Amazon.com and other select online retail distribution channels.campaign.  

For the three months ended SeptemberJune 30, 2016,2017, total dollar sales AeroGarden salesunits increased by 203.2%22.7% from the prior year period due to the large AeroGarden retail sales in the current year.  The prior year sales did not have a comparable retail load-in for items that will be carried in-store during the holiday season. Seedand seed pod kit and accessory sales increased by 22.9%6.2% over prior year period as our established base of AeroGardeners continues to grow.period.  AeroGarden sales represented 73.4%67.1% of total revenue, as compared to 49.7%62.5% in the prior year period.  This percentage increase, on a product line basis, was attributable to sales to expanded and newly acquired retail accountsgrowth in the current year period.  Seeddirect-to-consumer channel which typically results in new customers purchasing AeroGardens before seed pod kit and accessory sales decreasedaccessories.   Sales of seed pod kits increased from 37,000 to 46,000 units, primarily as a percentresult of the total to 33.5% from 56.0% due toincreased size of our active customer database as new customers entered the increased sales of AeroGarden this quarter.AeroGrow franchise.

DuringThe 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 AeroGrow brand and product line.  As a result, during the three months ended SeptemberJune 30, 2016,2017, we spent $150,000 inincurred $267,000 of advertising expenditures,expenses to support our direct-to-consumer and retail channels, a $17,000$15,000 or 10.2%5.4% year-over-year decrease compared to the same period ended September 30, 2015. This was primarily due to a decrease in our pay-per-click spending campaigns.  The advertisingFiscal 2017. These expenditures were divided as follows:

 

In aggregate, our total operating expenses decreased 3.9%increased 3.6%, or $54,000, year-over-year, principally as a resultbecause we spent more in anticipation of carefully managing our operating expenses in support of anticipated future growth.  Gross spending fluctuatedincreased in the following areas: