$VPCO Form 10-K

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following management’s discussion and analysis of financial condition and results of operations should be read in conjunction with our audited consolidated financial statements and related notes thereto included elsewhere in this report.

Executive Overview

The Company designs, markets, and distributes electronic cigarettes, vaporizers, e-liquids and accessories, under the emagine vaporTM, Krave�, VaporX�, Hookah Stix�, and Fifty-One� (also known as Smoke 51) brands. “Vaporizers” and “Electronic cigarettes” or “e-cigarettes,” are battery-powered products that enable users to inhale nicotine vapor without smoke, tar, ash, or carbon monoxide. Electronic cigarettes look like traditional cigarettes and, regardless of their construction, are comprised of three functional components: (i) a mouthpiece, which is a small plastic cartridge that contains a liquid nicotine solution; (ii) a heating element that vaporizes the liquid nicotine so that it can be inhaled; and (iii) the electronics, which include: a lithium-ion battery, an airflow sensor, a microchip controller and an LED, which illuminates to indicate use.

The Company participates directly in the highly competitive and fragmented vaporizer and e-cigarette market, but also faces competition from big tobacco companies. Vaporizers and electronic cigarettes are relatively new products and the Company is continually working to introduce its products and brands to customers. The Company believes increased investment in marketing and advertising programs is critical to increasing product and brand awareness and that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value and benefits vaporizers and electronic cigarettes have to offer over traditional tobacco burning cigarettes.

The Company’s business strategy leverages its ability to design market and develop vaporizers and e-cigarettes and to bring those products to market through its multiple distribution channels. The Company sells its products through its company owned retail kiosks, retail stores, online stores, to retail channels through its direct sales force, and through third-party wholesalers, retailers, and value-added resellers.

Critical Accounting Policies and Estimates

This discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in conformity with 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 net revenue and expenses during the reporting periods. Actual results could differ from those estimates. These estimates and assumptions include allowances, reserves and write-downs of receivables and inventories, stock-based payment arrangements, deferred taxes and related valuation allowances. Certain of our estimates could be affected by external conditions, including those unique to our industry, and general economic conditions. It is possible that these external factors could have an effect on our estimates that could cause actual results to differ from our estimates. The Company re-evaluates all of its accounting estimates at least quarterly based on these conditions and records adjustments when necessary.

Revenue Recognition

Net sales consist primarily of revenue from the sale of vaporizers, electronic cigarettes, e-liquids, replacement cartridges, components and related accessories. We recognize revenue from product sales when the persuasive evidence of an arrangement exists, selling price has been fixed and determined, delivery has occurred and collectability is reasonably assured. Product sales and shipping revenues, net of promotional discounts, rebates, and return allowances, are recorded when the products are shipped and title passes to customers. Retail items sold to customers are made pursuant to sales contracts that generally provide for transfer of both title and risk of loss upon our delivery to the carrier. Customer allowances and product returns, which reduce product revenue by our best estimate of these expected allowances and product returns, are estimated using historical experience. Revenue from product sales and services rendered is recorded net of sales taxes.

Accounts Receivable

Accounts receivable, net are stated at the amount the Company expects to collect. The Company provides a provision for allowances that includes returns, allowances and doubtful accounts equal to the estimated uncollectible amounts. The Company estimates its provision for allowances based on historical collection experience and a review of the current status of trade accounts receivable. It is reasonably possible that the Company’s estimate of the provision for allowances will change.

Inventories

Inventories are stated at the lower of cost (determined by the first-in, first-out method) or market. If the cost of the inventories exceeds their market value, provisions are recorded to write down excess inventory to its net realizable value. The Company’s inventories consist primarily of merchandise available for resale.

Stock-Based Compensation

We account for stock-based compensation under Accounting Standard Codification Topic (“ASC”) 718, “Compensation-Stock Compensation” (“ASC 718”). These standards define a fair value based method of accounting for stock-based compensation. In accordance with ASC 718, the cost of stock-based compensation is measured at the grant date based on the value of the award and is recognized over the vesting period. The value of the stock-based award is determined using the Black-Scholes-Merton valuation model, whereby compensation cost is the estimated fair value of the award as determined by the valuation model at the grant date or other measurement date. The resulting amount is charged to expense on the straight-line basis over the period in which we expect to receive the benefit, which is generally the vesting period.

Income Taxes

The Company uses the asset and liability method of accounting for income taxes in accordance with ASC 740, “Income Taxes” (“ASC 740.”) Under this method, income tax expense is recognized as the amount of: (i) taxes payable or refundable for the current year and (ii) future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. A valuation allowance is provided to reduce the deferred tax assets reported if based on the weight of available evidence it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Convertible Debt Instruments

The Company accounts for convertible debt instruments when the Company has determined that the embedded conversion options should not be bifurcated from their host instruments in accordance with ASC 470-20 “Debt with Conversion and Other Options”. The Company records, when necessary, discounts to convertible notes for the intrinsic value of conversion options embedded in debt instruments based upon the differences between the fair value of the underlying common stock at the commitment date of the note transaction and the effective conversion price embedded in the note. The Company amortizes the respective debt discount over the term of the notes, using the straight-line method, which approximates the effective interest method.

Other Contingencies

In the ordinary course of business, we are involved in legal proceedings regarding contractual and employment relationships, product liability claims, trademark rights, and a variety of other matters. We record contingent liabilities resulting from claims against us, including related legal costs, when a loss is assessed to be probable and the amount of the loss is reasonably estimable. Assessing probability of loss and estimating probable losses requires analysis of multiple factors, including, in some cases, judgments about the potential actions of third party claimants and courts. Recorded contingent liabilities are based on the best information available and actual losses in any future period are inherently uncertain. If future adjustments to estimated probable future losses or actual losses exceed our recorded liability for such claims, we would record additional charges as other (income) expense, net during the period in which the actual loss or change in estimate occurred. In addition to contingent liabilities recorded for probable losses, we disclose contingent liabilities when there is a reasonable possibility that the ultimate loss will materially exceed the recorded liability. Currently, we do not believe that any of our pending legal proceedings or claims will have a material impact on our financial position or results of operations.

The information contained under Results of Operations and Liquidity and Capital Resources reflects only Vapor during the years ended December 31, 2013 and 2014 and does not reflect the same information for Vaporin.

Results of Operations for the Year Ended December 31, 2014 Compared to the Year Ended December 31, 2013

Net sales for the year ended December 31, 2014 and 2013 were $15,279,860 and $25,990,227, respectively, a decrease of $10,710,367 or approximately 41.2%. The decrease in sales is primarily attributable to decreased sales of our television direct marketing campaign for our Alternacig� brand, a decrease in sales of our on-line stores and distributor inventory buildup in the e-cigarette category that existed in 2013 and continued during 2014. This is a result of the increasing prevalence of vaporizers, tanks and open system vapor products that are dramatically marginalizing the e-cigarette category and increased our customer returns of e-cigarette products. We have increased our purchases of vaporizers, tanks and open system vapor products as we shift our inventory mix to align with products in high customer demand. Sales were also negatively impacted by new national competitors’ launches of their own branded products during the second quarter of 2014. Due to low conversion rates of our Alternacig� and VaporX� branded direct marketing campaign, we limited the direct marketing campaign, resulting in lower sales of direct marketing products. In addition, sales decreased due to certain wholesale and distribution customers selling off their current inventory of electronic cigarette products so they can switch to e-vapor products. During the second half of 2014 we introduced several new e-vapor products under the Vapor X brand, including premium USA manufactured e-liquids. We anticipate that the demand for e-vapor products will continue to increase, as users want products that have more advanced technology with higher performance and longer battery life. During the fourth quarter of 2014 we opened eight new emagine vaporTM retail kiosks to expand our distribution channels for vaporizer and e-cigarette products. In addition we are altering our product mix to include more e-vapor products e-liquids and vaporizer accessories and transitioning our customer base to these favorable demand products.

Cost of goods sold for the year ended December 31, 2014 and 2013 was $14,497,254 and $16,300,333, respectively, a decrease of $1,803,077, or approximately 11.1%. The decrease is primarily due to the overall decrease in sales, offset by write downs of $1,834,619 for obsolete and slow moving inventory that primarily consisted of e-cigarettes. As customers complete the migration to vaporizers, tanks and open vaporizer systems, our sales incentives should decrease.

Our gross margins decreased to 5.1% from 37.3% primarily due to write downs of $1,834,619 for obsolete and slow moving inventory, increase in sales returns, discounts, incentives and allowances that primarily resulted from the customer demand shift from e-cigarettes to e-vapor products.

Selling, general and administrative expenses for the year ended December 31, 2014 and 2013 were $11,126,759 and $6,464,969, respectively, an increase of $4,661,790 or approximately 72.1%. The increase is primarily attributable to increases in non-cash stock compensation expense of $1,631,340 primarily attributable to the consulting agreement with Knight Global Services, professional fees of $3,281,388 due to implementing the corporate actions we agreed to take in connection with the private placement of common stock we completed in October 2013, including registering the shares for resale with the SEC, reincorporating in the State of Delaware from the State of Nevada, effecting the 1-for-5 reverse stock split of our common stock and uplisting to the NASDAQ Capital Market, costs of $576,138 incurred in connection with the initiation and termination of the previously contemplated acquisition of International Vapor Group, Inc.’s online, wholesale and retail operations, consulting and recruiting fees of $882,590 related to the development of the emagine vaporTM retail kiosk and store distribution channel, and costs incurred in connection with the merger of Vaporin, Inc. We also incurred additional filing and listing fees related to our uplisting to The NASDAQ Capital Market, business insurance due to the increases in coverage limits and increases in travel due to increased presence at trade shows and conferences, net of decreased personnel costs attributable to decreased payroll net of the accrued severance related to the resignation of our former Chief Executive Officer, merchant card processing fees due to lower transaction volumes.

Advertising expense for the years ended December 31, 2014 and 2013 was $2,374,329 and $2,264,807, respectively, an increase of $109,522 or 4.8%. As a percentage of sales advertising expense increased to 15.5% for the year ended December 31, 2014 from 8.7% for the year ended December 31, 2013. During the year ended December 31, 2014, we decreased our Internet advertising and television direct marketing campaign for our Alternacig brand, increased our print advertising programs, participation at trade shows, initiated several new marketing campaigns in which we sponsored several music concerts and we continued various other advertising campaigns.

Other expense for the years ended December 31, 2014 and 2013 was $366,433 and $683,558, respectively, a decrease of $317,125. Included in other expense is interest expense which was $348,975 and $383,981, for the years ended December 31, 2014 and 2013 respectively, a decrease of $35,006 or 9.1%. The decrease was attributable to lower amounts of outstanding debt throughout 2014 compared to 2013. In addition, the Company incurred an induced conversion expense during the year ended December 31, 2013 of $299,577 related to the reduction in the conversion price for the $350,000 Senior Convertible Notes and $75,000 Senior Convertible Notes in order to induce the holders to convert the notes. Such inducement did not reoccur in 2014.

Income tax expense (benefit) for the years ended December 31, 2014 and 2013 was $767,333 and $(524,791), respectively, an increase of $1,292,124 or 246.2%. The Company determined, based on the weight of the available evidence, that a valuation allowance of $5,695,446 (or 100% of the Company’s net deferred tax assets) is required at December 31, 2014, which is the cause of the significant increase in income tax expense compared to the year ended December 31, 2013. At December 31, 2013, the Company had determined that a valuation allowance against its net deferred tax assets was not necessary and recorded an income tax benefit.

Net (loss) income for the years ended December 31, 2014 and 2013 was $(13,852,249) and $801,352, respectively, a decrease of $14,653,601 as a result of the items discussed above.

Liquidity and Capital Resources

Our net cash used in operating activities was $6,291,027 and $4,120,152 for the years ended December 31, 2014 and 2013, respectively, an increase of $2,170,875. Our net cash used in operating activities for the year ended December 31, 2014 resulted primarily from our net losses, purchases of new inventories to meet future customer demand, and changes in accounts receivable, prepaid expenses, accounts payable, accrued expenses and due from merchant credit card processor, which are attributable to our efforts to accommodate anticipated future sales growth.

Our net cash used in investing activities was $1,987,505 and $14,779 for the years ended December 31, 2014 and 2013, respectively. Our net cash used in investing activities for the year ended December 31, 2014 resulted primarily from entering into loans receivable with International Vapor Group, Inc. and Vaporin and for purchases of property and equipment utilized in connection with the opening of eight retail kiosks.

Our net cash provided by financing activities was $2,269,481 and $10,528,738 for the years ended December 31, 2014 and 2013, respectively, a decrease of $8,259,256. These financing activities relate to the Company’s sale of $1,250,000 Senior Convertible Notes entered into in November 2014, $1,000,000 Loan Payable to Related Party entered into in December 2014, and the $1,000,000 Term Loan entered into in September 2014 and proceeds from the exercise of stock options net of principal repayments under the $750,000 and $1,000,000 Term Loans and principle repayments of capital lease obligations.

Our financial statements for the year ended December 31, 2014 indicate there is substantial doubt about our ability to continue as a going concern as we require additional equity and/or debt financing to continue our operations. We must ultimately generate sufficient cash flow to meet our obligations on a timely basis, attain profitability in our business operations and be able to fund our long term business development and growth plans. Our business will require significant amounts of capital to sustain operations and make the investments we need to execute our longer-term business plan. Our liquidity and capital resources have decreased as a result of the net operating loss of $13,852,249 that we incurred during the year ended December 31, 2014. At December 31, 2014 our accumulated deficit amounted to $15,231,903. At December 31, 2014, we had working capital of $127,874 compared to $11,657,615 at December 31, 2013, a decrease of $11,529,741. On March 4, 2015, we and institutional and individual accredited investors entered in a securities purchase pursuant to which we sold in a $3.5 million private placement ($2.9 million net proceeds received) 3,432,314 shares of common stock and warrants to purchase up to 2,735,132 shares of our common stock. In addition, the Merger with Vaporin also provides an additional financing to occur subsequent to the closing of the Merger for up to $25 million of our common stock and warrants subject to us complying with financial covenants and performance-based metrics.

In the ordinary course of our business, we enter in to purchase orders for components and finished goods, which may or may not require vendor deposits and may or may not be cancellable by either party. At December 31, 2014 and 2013, we had $319,563 and $782,363 in vendor deposits, respectively, which are included in prepaid expenses on the consolidated balance sheets included elsewhere in this report. At December 31, 2014 and 2013, we do not have any material financial guarantees or other contractual commitments that are reasonably likely to have an adverse effect on liquidity.

As of March 30, 2015, we had approximately $2 million of cash on hand. Our existing liquidity is not sufficient to fund our operations, anticipated capital expenditures, working capital and other financing requirements for the foreseeable future. We believe we will need to raise additional debt or equity financing to maintain and expand the business. Any equity financing or the issuance of equity equivalents including convertible debt could be dilutive to our shareholders. If either such additional capital is not available on terms acceptable to us or at all then we may need to curtail our operations and/or take additional measures to conserve and manage our liquidity and capital resources, any of which would have a material adverse effect on our business, results of operations and financial condition.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

Seasonality

We do not consider our business to be seasonal.

Commitments and Contingencies

We are subject to the legal proceedings described in “Item 3. Legal Proceedings” of this report. We believe that any ultimate liability resulting from such legal proceedings will not have a material adverse effect on our business, results of operations or financial condition.

Inflation and Changing Prices

Neither inflation nor changing prices for the years ended December 31, 2014 and 2013 had a material impact on our operations.

Recent Accounting Policies

The Financial Accounting Standards Board, the Emerging Issues Task Force and the SEC have issued certain accounting standards, updates and regulations as of December 31, 2014 that will become effective in subsequent periods; however, management of the Company does not believe that any of those standards, updates or regulations would have significantly affected the Company’s financial accounting measures or disclosures had they been in effect during 2014 or 2013, and it does not believe that any of them will have a significant impact on the Company’s consolidated financial statements at the time they become effective.

Risk Factors

Various portions of this report contain forward-looking statements that involve risks and uncertainties. Actual results, performance or achievements could differ materially from those anticipated in these forward-looking statements as a result of certain risk factors, including those set forth below and elsewhere in this report. These risk factors are not presented in the order of importance or probability of occurrence. For purposes of these risk factors, the term “electronic cigarettes” is deemed to include “vaporizers.”

Risks Relating to Our Business

We have and may continue to experience liquidity and capital resources constraints because of our significant past operating losses; the report of our independent registered public accounting firm contains an explanatory paragraph that expresses substantial doubt about our inability to continue as a going concern.

Our liquidity and capital resources have decreased significantly as a result of the net operating losses we incurred during the year ended December 31, 2014. Although we completed a Private Placement and received net proceeds of $2,941,960 on March 4, 2015 and have taken other actions to manage our cash on hand and working capital and increase cash flows from operating and financing activities, there is no assurance we will have sufficient liquidity and capital resources to fund our business. At December 31, 2014, we had working capital of $127,874 compared to $11,657,615 at December 31, 2013, a decrease of $11,529,741. Our financial statements for the year ended December 31, 2014 indicate there is substantial doubt about our ability to continue as a going concern as we require additional equity and/or debt financing to continue our operations. We must ultimately generate sufficient cash flow to meet our obligations on a timely basis, attain profitability in our business operations, and be able to fund our long term business development and growth plans. Our business will require significant amounts of capital to sustain operations and make the investments we need to execute our longer-term business plan. Our existing liquidity is not sufficient to fund our operations, anticipated capital expenditures, working capital and other financing requirements for the foreseeable future. We will need to seek and obtain additional debt or equity financing, especially if we continue to experience liquidity and capital resources constraints, or because of continuing operating losses from our existing business, or greater than anticipated capital needs to integrate Vaporin, or our new retail kiosks and stores do not perform as anticipated, or greater than anticipated sales growth, or greater than anticipated capital needs to expand our new retail kiosk and store operations or otherwise or any combination of the foregoing. Any equity financing on the issuance of equity equivalents including convertible debt could be dilutive to our shareholders. If either such additional capital is not available on terms acceptable to us or at all then we may need to curtail its operations and/or take additional measures to conserve and manage our liquidity and capital resources, any of which would have a material adverse effect on our business, results of operations and financial condition.

We have incurred losses in the past and cannot assure you that we will achieve or maintain profitable operations.

As of December 31, 2014, we had an accumulated deficit of $15,231,903. Our accumulated deficit is primarily due to, among other reasons, the establishment of our business infrastructure and operations, stock-based compensation expenses and increases in our marketing expenditures to grow sales of our electronic cigarettes. For the year ended December 31, 2014, we had a net loss of $13,852,249 compared to net income of $801,352 for the year ended December 31, 2013. There is no assurance we will have sufficient liquidity and capital resources available to fund our business. Our liquidity and capital resources have decreased significantly as a result of the net operating losses we incurred during the year ended December 31, 2014. We cannot assure you that we will be able to generate operating profits in the future on a sustainable basis or at all as we continue to expand our infrastructure, open additional retail stores, further develop our marketing efforts and otherwise implement our growth initiatives.

Our seven years of operating history in an evolving business, makes it difficult to accurately predict our future sales and appropriately budget our expenses.

We acquired Smoke Anywhere USA, Inc., a distributor of electronic cigarettes, on November 5, 2009. Smoke Anywhere USA, Inc. commenced its business in March 2008. Because we have only seven years of operating history, and our business is still evolving, it is difficult to accurately predict our future sales and appropriately budget our expenses. Additionally, our operations will be subject to risks inherent in the establishment of a developing new business, including, among other things, efficiently deploying our capital, costs or difficulties relating to the integration of the merger with Vaporin, developing our products, opening retail stores, developing and implementing our marketing campaigns and strategies and developing brand awareness and acceptance of our products. Our ability to generate future sales will be dependent on a number of factors, many of which are beyond our control, including the pricing of competing products, overall demand for our products, changes in consumer preferences, market competition and government regulation. We are currently evaluating the expansion of our staffing, advertising campaigns and operational expenditures in anticipation of future sales growth. If our sales do not increase as anticipated, we could incur significant losses due to our higher infrastructure expense levels if we are not able to decrease our advertising and operating expenses in a timely manner to offset any shortfall in future sales.

The potential regulation of electronic cigarettes by the United States Food and Drug Administration may materially adversely affect our business.

On April 24, 2014, the FDA released proposed rules that would extend its regulatory authority to electronic cigarettes and certain other tobacco products under the Family Smoking Prevention and Tobacco Control Act. We are in the