$AERO Files 10-Q

Overview

AeroGrow International, Inc. was formed as a Nevada corporation on 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 pilot production of its AeroGarden system and, in March 2006, began shipping these systems to retail and catalogue customers. The Company manufactures, distributes and markets seven 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, catalogue and direct-to-consumer sales primarily in the United States and Canada as well as selected countries in Europe, Asia and Australia.

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, the strategic alliance allows us to use 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 use our strategic alliance with Scotts Miracle-Gro to re-establish our presence in the retail and international sales channels.

Results of Operations

Three Months Ended September 30, 2014 and September 30, 2013

Summary Overview
For the three months ended September 30, 2014, total revenue of $1.7 million was up 152.5%, or $1.0 million, relative to the same period in the prior year. The increase was primarily due to a $782,000, or 526.4%, increase in sales to the retail channel due an increase in sales to existing accounts (namely Amazon and Costco.com) and to newly acquired retail accounts (namely BJ’s Wholesale Club). Sales in direct-to-consumer channels were also up by $243,000 or 46.7%, primarily due to increased marketing activity versus the prior year, an increased base of AeroGardens causing more consumers to purchase our seed pod kits and grow bulbs and due to higher stocking levels in the channel versus the prior year as we co-branded our product line with the Scotts Miracle-Gro trade name. Sales to international distributors increased by 97.0% to $13,000 in the three months ended September 30, 2014 relative to the same period in the prior year.

For the three months ended September 30, 2014, AeroGarden sales increased by 456.3% from the prior year period due to the large increase in retail sales, which were primarily garden sales. Seed pod kit and accessory sales increased by 23.6% over prior year period as our established base of AeroGardeners continues to grow. AeroGarden sales represented 70.7% of total revenue, as compared to 32.1% in the prior year period. This percentage increase, on a product line basis, was attributable to sales to newly acquired retail accounts. Seed pod kit and accessory sales decreased as a percent of the total to 29.9% from 61.2% even though overall revenue from seed pod kits and accessories increased, again due to the large increase in AeroGarden sales to retailers, which grew faster than seed pod kit sales.

During the three months ended September 30, 2014, we spent $68,000 in advertising expenditures to support our direct-to-consumer and retail channels, a $25,000 or 59.3% year-over-year increase compared to the same period ended September 30, 2013. These expenditures were divided as follows:

• Direct-to-consumer advertising increased $23,000 to $63,000 during the three months ended September 30, 2014, primarily reflecting increased spending on pay per click and digital display advertising campaigns. Efficiency, as measured by dollars of direct-to-consumer sales generated per dollar of related advertising expense continued to be strong, although the ratio decreased 8.7% to $12.19 for the three months ended September 30, 2014, as compared to $13.35 for the same period in Fiscal 2014.
•  Retail advertising increased to $5,000 from $2,000 for the three months ended September 30, 2014 and September 30, 2013, respectively.
• Media and related expenses decreased $1,000 to $0 during the three months ended September 30, 2014, reflecting the Company’s limited exposure in this channel of communication and the increased focus on driving sales with more direct advertising.

Our gross margin for the three months ended September 30, 2014 was 36.5%, down from 42.6% in the prior year period. This decline was anticipated as we shift our channel mix from higher margin direct- to-consumer and seed pod kit sales to lower margin retailers. In addition, AeroGarden sales have lower margins than seed pod kit sales, so we can expect lower margins as we ramp up sales of gardens to increase our installed base of consumers. We also increased our warranty reserves in support of significantly higher AeroGarden sales.

Other income and expense for the three months ended September 30, 2014 totaled to a net other expense of $26,000, as compared to net other expense of $20,000 in the prior year period. The net other expense in the current period includes $11,000 of non-cash income relating to the fair value revaluation of the warrant held by Scotts Miracle-Gro. For the three months ended September 30, 2013, net other expense included $12,000 of non-cash expense relating to the fair value revaluation of the warrant held by Scotts Miracle-Gro.

The net loss for the three months ended September 30, 2014 improved to $507,000, as compared to the $541,000 loss in the prior year. The decreased net loss is due to higher overall sales, which are a result of the accelerating popularity of cobranded Miracle-Gro AeroGarden products, offset by an increase in operating expenses to meet current and future demand.

The following table sets forth, as a percentage of sales, our financial results for the three months ended September 30, 2014 and the three months ended September 30, 2013:

                                        Three Months Ended September 30,
                                         2014                      2013
       Net revenue
       Direct-to-consumer                      44.8 %                    77.2 %
       Retail                                  54.5 %                    21.9 %
       International                            0.7 %                     0.9 %
       Total net revenue                      100.0 %                   100.0 %

       Cost of revenue                         63.5 %                    57.4 %
       Gross profit                            36.5 %                    42.6 %

       Operating expenses
       Research and development                 6.8 %                    12.6 %
       Sales and marketing                     28.3 %                    48.1 %
       General and administrative              29.6 %                    59.0 %
       Total operating expenses                64.7 %                   119.7 %
       Loss from operations                   (28.2 )%                  (77.1 )%

Revenue
For the three months ended September 30, 2014, revenue totaled $1.7 million, a
year-over-year increase of 152.5% or $1.0 million, from the three months ended
September 30, 2013.

                                     Three Months Ended September 30,
                                              (in thousands)
             Net Revenue                 2014                    2013
             Direct-to-consumer   $              764         $        521
             Retail                              930                  148
             International                        13                    7
             Total                $            1,707         $        676

International sales for the three months ended September 30, 2014 totaled $13,000, up $6,000 or 97.0% from the same period in the prior fiscal year. Sales in both periods principally reflect the timing of reorders from existing international distributors only and our current lack of focus on the international channel.

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 September 30, 2014 and September 30, 2013 is as follows:

                                          Three Months Ended September 30,
                                                   (in thousands)
                                           2014                      2013
      Product Revenue
      AeroGardens                     $         1,207           $           217
      Seed pod kits and accessories               511                       414
      Other                                       (11 )                      45
      Total                           $         1,707           $           676
      % of Total Revenue
      AeroGardens                                70.7 %                    32.1 %

Cost of Revenue
Cost of revenue for the three months ended September 30, 2014 totaled $1.1 million, an increase of $695,000 from the three months ended September 30, 2013, due to the increased revenue. 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 63.5% of revenue as compared to 57.4% for the quarter ended September 30, 2013. The increase in costs as a percent of revenue reflected the shift in product mix from higher margin seed kits to lower margin AeroGardens and in customer mix from higher margin direct-to-consumer customers to lower margin retailers and product mix.

Gross Margin
Our gross margin varies based upon the factors affecting 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 for the product which 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 margins than domestic retail sales. The gross margin for the quarter ended September 30, 2014 was 36.5% as compared to 42.6% for the quarter ended September 30, 2013. The decrease in our gross margin was primarily attributable to the increased percentage of sales to retailers, primarily BJ’s Wholesale Club and Amazon.com, as well as product mix, and warranty costs.

Sales and Marketing
Sales and marketing costs for the three months ended September 30, 2014 totaled
$484,000, as compared to $325,000 for the three months ended September 30, 2013,
an increase of 48.7%, or $158,000. 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:

                                    Three Months Ended September 30,
                                             (in thousands)
                                     2014                      2013
            Advertising         $            68           $            43
            Personnel                       330                       217
            Sales commissions                 3                        (6 )
            Trade shows                       -                         1
            Other                            83                        70
                                $           484           $           325

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 September 30, 2014, personnel costs for sales and marketing were $330,000, up $113,000 or 52.1% from the three months ended September 30, 2013. The increase reflected increased headcount necessary to drive what we anticipate will be increased sales to retailers and through our Direct Response channel beginning in the fall of 2014. Personnel expenses include all related payroll and equity-based compensation expenses.

Other marketing expenses increased year-over-year principally because of a public relations program and promotional items and new products that were initiated during the current year quarter.

General and Administrative
General and administrative costs for the three months ended September 30, 2014 totaled $506,000, as compared to $399,000 for the three months ended September 30, 2013, an increase of 26.7%, or $107,000. The increase is attributable to expenses associated with an investor relations program, contractor services such as IT, depreciation expense, an increase in the employee expenses such as travel and non-cash compensation.

Research and Development
Research and development costs for the quarter ended September 30, 2014 totaled $115,000, an increase of $31,000 from the quarter ended September 30, 2013. The increase reflects the support of new products development activities, including the ongoing certification and testing of the LED products, as required by our retail partners.

Operating Loss and EBITDA
Our operating loss for the three months ended September 30, 2014 was $481,000, an improvement of $40,000 from the operating loss of $521,000 for the three months ended September 30, 2013. The decreased loss reflected higher sales partially offset with higher operating expenses, as discussed in greater detail above.

                                              Three Months Ended September 30,
                                                       (in thousands)
                                                2014                    2013
   Loss from operations                    $          (481 )       $          (521 )
   Add back non-cash items:
   Depreciation                                         61                      34
   Amortization                                          -                      (1 )
   Stock based compensation                             83                      43
   Common stock warrant expense                         18                       -
   Scott's Miracle-Gro intellectual                     68                      19
   property royalty and branding license
   Total non-cash items                                230                      95
    Adjusted EBITDA                        $          (251 )       $          (426 )

Net Loss
For the three months ended September 30, 2014, we incurred a net loss of $507,000 as compared to a net loss of $541,000 for the three months ended September 30, 2013.

Six Months Ended September 30, 2014 and September 30, 2013

Summary Overview
For the six months ended September 30, 2014, total revenue of $3.4 million was up 88.4%, or $1.6 million, relative to the same period in the prior year. Sales in our direct-to-consumer channels were up, by 38.1%, or $498,000, reflecting increased size in our active customer database, new products (particularly AeroGardens with LED lighting systems), the co-branding agreement with Scotts Miracle-Gro, more available inventory, and joint marketing programs with Scotts Miracle-Gro. In addition to the direct-to-consumer increase, sales in our retail channels which were up 391.5%, or $1.2 million, primarily due to sales to newly acquired retail accounts, particularly BJ’s Wholesale Club, and existing Amazon.com and Costco.com accounts. Sales to international distributors declined by 86.5% to $23,000 in the six months ended September 30, 2014, relative to the same period in the prior year. This decline is exclusively attributable to timing of reorders from existing customers and reflects the Company’s current lack of focus on the international channel as we focus on domestic growth.

For the six months ended September 30, 2014, AeroGarden sales increased by 208.0% from the prior year period and seed pod kit and accessory sales increased by 14.7% over prior year period. AeroGarden sales represented 65.5% of total revenue, as compared to 40.1% in the prior year period. This percentage increase, on a product line basis, was attributable to existing and new . . .