$PHOT Releases Form 10-Q

Forward-looking statements in this report reflect the good-faith judgment of our management and the statements are based on facts and factors as we currently know them. Forward-looking statements are subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, but are not limited to, those discussed below as well as those discussed elsewhere in this report (including in Part II, Item 1A (Risk Factors)). Readers are urged not to place undue reliance on these forward-looking statements because they speak only as of the date of this report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report.

OVERVIEW

Our goal of becoming the nation’s largest cultivation facility service provider for the production of organics, herbs and greens and plant-based medicines has not changed. Our mission is to best serve more cultivators in the design, build-out and expansion of their facilities with products of high quality, exceptional value and competitive price. Through a nationwide network of local representatives, regional centers and its e-Commerce team, GrowLife provides essential goods and services including media (i.e., farming soil), industry-leading hydroponics equipment, plant nutrients, and thousands more products to specialty grow operations starting with 17 states. GrowLife is headquartered in Seattle, Washington and was founded in 2012 with the Closing of the Agreement and Plan of Merger with SGT Merger Corporation.

Starting in June 2014 we focused on cost reductions without compromising revenue growth has been our focus. The primary reduction in operating costs came from streamlining non-profitable personnel, lowering expenses by replacing the Woodland Hills, California headquarters with that of Seattle, Washington that serves more people at a lower cost, closing the unprofitable Peabody, Massachusetts superstore, and relocated the Greners eCommerce operation from Santa Rosa, California to Colorado. The eCommerce fulfillment is being temporarily served from the Boulder, Colorado store until the new Denver facility is set up. Additional cost reductions were made by reducing full-time employees from 46 to 26 and adding direct sales people to provide greater customer coverage. Finally, Phototron warehousing with $4,313 rent was replaced with storage units of about 1/3 the cost. While transition costs are still being paid out, the repurposing of company resources has resulted in an estimated 60% operating cost savings and allows for greater market reach and efficiencies.

However, the challenges of operating a public company under the strains gray market trading and lawsuits, that are in negotiations, as well as limited access to investment capital kept the company lean. We also chose to convert about three month’s of inventory into cash. This reduced our inventory level from $1.8 million to $800,000 and lowered our gross margins to (8%). This conscientious decision was made to help us transition through this period. As for our $1.9 million expenses, there were approximately $880,000 in non-recurring/non-cash stock expenses, which resulted in net cash expenses at approximately $1 million for the three months ended September 30, 2014.

We remain focused on hiring the best people that are knowledgeable in using the most progressive growing technologies that fit our customer’s needs. Whether they are small-scale local cultivation facilities or large-scale regional cultivators, our customer service team recommends smart medium, cost-effective lighting and ventilation, and the right nutrients that are best suited for the crop objective. Our knowledge layer is strategic for the evolution of the indoor growing industry. Unlike an outdoor superstore, GrowLife serves the specialty cultivation business as indoor crops are designed to deliver multiple grow cycles with greater quality and yield not available in outdoor agriculture. Technologies will be available to provide our customers with a way to further tune their ordering process and crop development using their own experience.

Products

Our products are as follows:

GrowLife provides essential supplies and services including media (i.e., farming soil), industry-leading hydroponics equipment, power-efficient lighting, plant nutrients, and thousands more products to specialty cultivation facilities. We offer more than 3,000 products to cultivators through direct sales, stores and our e-Commerce site. GrowLife is also pilot testing a new brand of third party products, GrowLife eco,that provides a set of lower carbon footprint products that reduce operating cultivator operating costs. The GrowLife eco products are sold through both GrowLife outlets and other non-GrowLife retailers across the country. This line includes the exclusive distribution of VegaMatrix, a leading veganics plant nutrient line for specialty crops including plant-based medicines. The result of this pilot program is expected to provide greater market coverage of the GrowLife brand and increase gross margins.

Over the last four decades Phototron has provided a self-contained growing environment for a single plant. The cost of individually producing each Phototron unit, as well as the decrease in demand for a $500+ growing unit, has resulted in the Company’s decision to design and develop alternative products better suited for today’s market. When the time is right the Phototron products that best fit the needs of the customer using its trusted brand will be introduced.

The Stealth Grow Technology Corp. subsidiary has effectively transitioned from expensive LED lighting systems to leveraging its popular brand on private label commodity products such as lights, fans, hoods and tents. The Company’s experience gained from selling the LED lighting technology showed us that while power consumption is low, the limited range of low-powered light is not effective for long-stemmed plants. Yet, the Stealth Grow brand is well recognized among commercial growers. As a result, it has found strong brand appeal to an audience seeking basic products for private cultivation.

Markets

Our markets are as follows:

GrowLife serves a new, yet sophisticated community of commercial and urban cultivators growing specialty crops including organics, greens and plant-based medicines. Unlike the traditional agricultural industry, these cultivators use innovative indoor growing techniques to produce specialty crops in highly controlled environments. This enables them to produce crops at higher yields without having to compromise quality – regardless of the season or weather and drought conditions.

Indoor growing techniques have primarily been used to cultivate plant-based medicines. Plant-based medicines often require high-degree of regulation and controls including government compliance, security, and crop consistency, making indoor growing techniques a preferred method. Cultivators of plant-based medicines often make a significant investment to design and build-out their facilities. They look to work with companies such as GrowLife who understand their specific needs, and can help mitigate risks that could jeopardize their crops.

An industry report from ArcView indicates that plant-based medicines are the fastest-growing market in the U.S., and conservatively predicts the market could be worth more than $10 billion within five years. Several industry pundits including Dr. Sanjay Gupta of CNN believe that plant-based medicines may even displace prescription pain medication by providing patients with a safer, more affordable alternative.

Indoor growing techniques, however, are not limited to plant-based medicines. Vertical farms producing organic fruits and vegetables are beginning to emerge in the market due to a rising shortage of farmland, and environmental vulnerabilities including drought, other severe weather conditions and insect pests. Indoor growing techniques enables cultivators to grow crops all-year-round in urban areas, and take up less ground while minimizing environmental risks. Indoor growing techniques typically require a more significant upfront investment to design and build-out these facilities, than traditional farmlands. If new innovations lower the costs for indoor growing, and the costs to operate traditional farmlands continue to rise, then indoor growing techniques may be a compelling alternative for the broader agricultural industry.

Key Partners

Our key customers varying by state and are expected to be more defined as the company moves from its retail walk-in purchasing sales strategy to serving cultivation facilities directly and under predictable purchasing contracts.

Our key suppliers include distributors such as HydroFarm, Rambridge Wholesale and Sunlight Supply to product specific suppliers such as PureLife Veganix, Solis-Tek and CAN USA. All the products purchased and resold are applicable to indoor growing for organics, greens, and plant-based medicines.

Our Competition

Our key competitors include Way To Grow, Cultivate Colorado and many local product resellers of hydroponic equipment.

Intellectual Property and Proprietary Rights

Our intellectual property consists of brands and their related trademarks and websites, customer lists and affiliations, product know-how and technology, and marketing intangibles.

Our other intellectual property is primarily in the form of trademarks and domain names. We also hold rights to more than 30 website addresses related to our business including websites that are actively used in our day-to-day business such as www.growlifeinc.com, www.stealthgrow.com, www.greners.com, and www.urbangardensupplies.com.

We have a policy of entering into confidentiality and non-disclosure agreements with our employees and some of our vendors and customers as necessary.

Government Regulation

Currently, there are over twenty states plus the District of Columbia that have laws and/or regulation that recognize in one form or another legitimate medical uses for cannabis and consumer use of cannabis in connection with medical treatment. About a dozen other states are considering legislation to similar effect. As of the date of this writing, the policy and regulations of the Federal government and its agencies is that cannabis has no medical benefit and a range of activities including cultivation and use of cannabis for personal use is prohibited on the basis of federal law and may or may not be permitted on the basis of state law. Active enforcement of the current federal regulatory position on cannabis on a regional or national basis may directly and adversely affect the willingness of customers of GrowLife to invest in or buy products from GrowLife. Active enforcement of the current federal regulatory position on cannabis may thus indirectly and adversely affect revenues and profits of the GrowLife companies.

All this being said, many reports show that the majority of the American public is in favor of making medical cannabis available as a controlled substance to those patients who need it. The need and consumption will then require cultivators to continue to provide safe and compliant crops to consumers. The cultivators will then need to build facilities and use consumable products, which GrowLife provides.

Employees

During the three months ended September 30, 2014, we held our manpower count from at 26 by leveraging all our manpower across many areas. All company operations are continually reviewed for growth opportunities and direct sales along with GrowLife eco, a premium line of eco-friendly products, is enabling the Company to expand its coverage in a cost-effective manner.

As of November 10, 2014, we had one full-time employee and three consultants at our Seattle, Washington office. Marco Hegyi, our President, is based in Seattle, Washington. Mark E. Scott, our consulting CFO, is based out of in Seattle, Washington and Atlanta, Georgia. In addition, we have 26 employees located throughout the United States who operate our e-commerce, direct sales and retail businesses. None of our employees is subject to a collective bargaining agreement or represented by a trade or labor union. We believe that we have a good relationship with our employees.

KEY MARKET PRIORITIES

Demand for indoor growing equipment is currently high due to legalization of plant-based medicines, primarily Cannabis, which is mainly due to equipment purchases for build-out and repeated consumables. This demand is projected to continue to grow as a result of the supporting state laws in 20+ states and the District of Columbia. Continued innovation in more efficient build-out technologies along with larger and consolidated cultivation facilities will further expand market demand for GrowLife products and services.

We expect for the market to continue to segment into urban farmers serving groups of individuals, community cultivators, and large-scale cultivation facilities across the states. Each segment will be optimized to different distribution channels that GrowLife currently provides. Our volume purchasing will allow us to obtain the best prices and maximize both our revenues and gross margins.

The nature of the industry’s inefficiencies due to the lack of interstate commerce imposed by the Federal government have segmented the market opportunities by state laws, population and demand. Currently, Colorado laws and population demand make it the most progressive and top market in the industry. GrowLife has elected to have two major retail stores in Boulder and Vail, direct sales team and centralized our national eCommerce operations in Denver. We are currently expanding into seventeen states using both direct sales of exclusive supplier contracts and GrowLife eco products to other hydroponic retailers.

STRATEGY

Our goal is to become the nation’s largest cultivation facility service provider for the production of organics, herbs and greens and plant-based medicines. We intend to achieve our goal by implementing the following strategies:

? engage with cultivation facilities and secure exclusive supplier contracts;

? focus on build-out and consumable supplies for all indoor growing facilities;

? establish a multi-channel sales network throughout the continental United States;

? assemble the most knowledgeable staff and leadership team; and

? review opportunities and acquire additional products and services that are essential to our customers and deliver high-margins.

THE COMPANY’S COMMON STOCK

Our common stock trades on the OTCQB Exchange under the symbol “PHOT.” While the company is currently without a market maker, its stock does trade directly between buyers and sellers on the grey sheets.

PRIMARY RISKS AND UNCERTAINTIES

We are exposed to various risks related to legal proceedings, our need for additional financing, the sale of significant numbers of our shares, the potential adjustment in the exercise price of our convertible debentures and a volatile market price for our common stock. These risks and uncertainties are discussed in more detail below in Part II, Item 1A.

RESULTS OF OPERATIONS

The following table presents certain consolidated statement of operations
information and presentation of that data as a percentage of change from
period-to-period.

(dollars in thousands)

                                                 Three Months Ended September 30,
                                        2014          2013        $ Variance      % Variance
Net revenue                           $   2,105     $  1,313     $        792            60.3 %
Cost of goods sold                        2,284        1,051            1,233          -117.3 %
Gross profit                               (179 )        262             (441 )        -168.3 %
General and administrative expenses       1,923        1,290              633           -49.1 %
Operating loss                           (2,102 )     (1,028 )         (1,074 )        -104.5 %
Other income (expense):
Change in fair value of derivative       (6,949 )         67           (7,016 )      -10471.6 %
Loss on extinguishment of debt                -         (750 )            750           100.0 %
Interest expense, net                   (28,715 )       (130 )        (28,585 )      -21988.5 %
Other income                                  -           36              (36 )        -100.0 %
Total other (expense)                   (35,664 )       (777 )        (34,887 )       -4490.0 %
(Loss) before income taxes              (37,766 )     (1,805 )        (35,961 )       -1992.3 %
Income taxes - current benefit                -            -                -             0.0 %
Net (loss)                            $ (37,766 )   $ (1,805 )   $    (35,961 )       -1992.3 %

Revenue

Net revenue for the three months ended September 30, 2014 increased $792,000 to $2,105,000 as compared to $1,313,000 for the three months ended September 30, 2013. The increase was due to revenue from the retail stores acquired in our acquisition of Rocky Mountain Hydroponics and Evergreen Garden Center on June 7, 2013, $167,000 from our online hydroponics superstore, and $187,000 from our Urban Garden Supply business.

Cost of Goods Sold

Cost of sales for the three months ended September 30, 2014 increased $1,233,000 to $2,284,000 as compared to $1,051,000 for the three months ended September 30, 2013. The increase was due to increased sales, selling our products at a higher discount and the liquidation of inventory at lower margins during the three months ended September 30, 2014.

Gross margin was $(179,000) as compared to $262,000 for the three months September 30, 2013. The gross margin was (8.5%) for the three months ended September 30, 2014 as compared to 19.9% for the three months ended September 30, 2013. The decrease was due to selling our products at a higher discount and the liquidation of inventory at lower margins during the three months ended September 30, 2014.

General and Administrative Expenses

General and administrative expenses for the three months ended September 30, 2014 increased $633,000 to $1,923,000 as compared to $1,290,000 for the three months ended September 30, 2013. The increase was due to increased common stock issued for services expenses of $983,000, including $480,000 related the Severance Agreement with John Genesi and $400,000 related to banking services, offset by the following reduction in expenses, (i) rent of $62,000; (ii) public relations of $273,000; (iii) research and development of $42,000; (iv) and other general expenses of ($10,000). As part of the general and administrative expenses for the three months ended September 30, 2014, we recorded investor relation expenses of $32,000 and did not record any business development expenses.

Non-cash general and administrative expenses for the three months ended September 30, 2014 totaled $1,062,000, with (i) depreciation and amortization of $35,000; (ii) stock based compensation of $44,000 related to stock option grants issued in 2014; and (iii) increased common stock issued for services expenses of $983,000.

Other Income/ Expense

Other expense for the three months ended September 30, 2014 was $35,664,000 as compared to other expense of $777,000 for the three months ended September 30, 2013. The expenses for the three months ended September 30, 2014 included loss on change – derivative liability warrants of $6,949,000 and interest expense of $28,715,000. The loss on change- derivative liability is the non-cash change in the fair value and relates to our derivative instruments. The non-cash interest related to the amortization of the debt discount associated with our convertible notes, accrued interest expense related to our notes payable and the issuance of a 300,000,000 share warrant to CANX on July 10, 2014.

Other expense for the three months ended September 30, 2013 included interest expense of $130,000 and loss on extinguishment of debt of $750,000, offset by change in fair value of derivative of $67,000 and other income of $36,000. The non-cash interest related to the amortization of the debt discount associated with our convertible notes payable, and of accrued interest expense related to our notes payable.

Net (Loss)

Net loss for the three months ended September 30, 2014 was $37,766,000 as compared to a net loss of $1,805,000 for the three months ended September 30, 2013 for the reasons discussed above. Net income for the three months ended September 30, 2014 included non-cash expenses of $36,726,000, including (i) loss on change – derivative liability of $6,949,000; (ii) depreciation and amortization of $35,000; (iii) stock based compensation of $44,000 related to stock option grants issued to employees in 2014 and stock option grants issued to Sterling Scott, Robert Hunt and John Genesi in 2013; (iv) common stock issued for services expenses of $983,000; and (v) interest expense of $28,715,000 primarily related to the issuance of a 300,000,000 share warrant to CANX on July 10, 2014.

The net loss for the three months ended September 30, 2013 included non-cash expenses of $1,247,000 consisting gain on change – derivative liability of $67,000 and other of $3,000, offset by non-cash expenses of $1,317,000, including (i) depreciation and amortization of $38,000; (ii) common stock issued for services of $388,000; (iii) interest expense of $139,000; and (iv) loss on extinguishment of debt of $752,000.

We expect losses to continue as we implement our business plan.

The following table presents certain consolidated statement of operations information and presentation of that data as a percentage of change from period-to-period.

(dollars in thousands)

                                                  Nine Months Ended September 30,
                                        2014          2013        $ Variance      % Variance
Net revenue                           $   6,745     $  2,939     $      3,806           129.5 %
Cost of goods sold                        5,903        2,249            3,654          -162.5 %
Gross profit                                842          690              152            22.0 %
General and administrative expenses       6,684        3,546            3,138           -88.5 %
Operating loss                           (5,842 )     (2,856 )         (2,986 )        -104.6 %
Other income (expense):
Change in fair value of derivative      (20,260 )       (103 )        (20,157 )      -19569.9 %
Loss on extinguishment of debt                -         (753 )            753           100.0 %
Interest expense, net                   (63,906 )       (929 )        (62,977 )       -6779.0 %
Other income                                  -           36              (36 )        -100.0 %
Total (expense)                         (84,166 )     (1,749 )        (82,417 )       -4712.2 %
(Loss) before income taxes              (90,008 )     (4,605 )        (85,403 )       -1854.6 %
Income taxes - current benefit                -            -                -             0.0 %
Net (loss)                            $ (90,008 )   $ (4,605 )   $    (85,403 )       -1854.6 %

Revenue

Net revenue for the nine months ended September 30, 2014 increased $3,806,000 to $6,745,000 as compared to $2,939,000 for the nine months ended September 30, 2013. The increase was due to revenue from the retail stores acquired in our acquisition of Rocky Mountain Hydroponics and Evergreen Garden Center on June 7, 2013, $1,411,000 from our online hydroponics superstore, and $744,000 from our Urban Garden Supply business.

Cost of Goods Sold

Cost of sales for the nine months ended September 30, 2014 increased $3,654,000 to $5,903,000 as compared to $2,249,000 for the nine months ended September 30, 2013. The increase was due to increased sales, selling our products at a higher discount and the liquidation of inventory at lower margins during the nine months ended September 30, 2014.

Gross margin was $842,000 as compared to $690,000 for the nine months September 30, 2013.The gross margin was 12.5% for the nine months ended September 30, 2014 as compared to 23.5% for the nine months ended September 30, 2013. The decrease was due to selling our products at a higher discount and the liquidation of inventory at lower margins during the nine months ended September 30, 2014.

General and Administrative Expenses

General and administrative expenses for the nine months ended September 30, 2014 increased $3,138,000 to $6,684,000 as compared to $3,546,000 for the nine months ended September 30, 2013. The increase was due to increased payroll expenses of $846,000, increased stock based compensation of $1,847,000, increased legal expenses of $273,000 and other general expenses of $172,000. As part of the general and administrative expenses for the three months ended September 30, 2014, we recorded investor relation expenses of $575,000 and did not record any business development expenses.

The increase related to the retail stores acquired in our acquisition of Rocky Mountain Hydroponics and Evergreen Garden Center on June 7, 2013, legal expenses associated with our legal proceedings and stock based compensation related stock option grants.

Non-cash general and administrative expenses for the nine months ended September 30, 2014 totaled $3,359,000, with (i) depreciation and amortization of $107,000;
(ii) stock based compensation of $624,000 related to stock option grants issued to employees in 2014 and Sterling Scott, Robert Hunt and John Genesi in 2013; and (iii) increased common stock issued for services expenses of $2,628,000.

Other Income/ Expense

Other expense for the nine months ended September 30, 2014 was $84,166,000 as compared to other expense of $1,749,000 for the nine months ended September 30, 2013. The expenses for the nine months ended September 30, 2014 included loss on change – derivative liability warrants of $20,260,000 and interest expense of $63,879,000. The loss on change- derivative liability is the non-cash change in . . .