Digital Brands Group, Inc. quarterly report, Q2 FY2021

Digital Brands Group, Inc. — Q2 2021 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2021. The company sells apparel through the DSTLD, Bailey 44 and Harper & Jones brands, using direct-to-consumer, wholesale and showroom channels. It acquired Harper & Jones (H&J) on May 18, 2021; the period also included the company’s May IPO and a 1-for-15.625 reverse stock split.

Key financial results

Metric	Three months ended June 30, 2021	Six months ended June 30, 2021
Net revenue	$1.00 million, versus $0.66 million	$1.41 million, versus $3.24 million
Gross profit (loss)	$0.39 million, versus a loss of $0.27 million	$0.19 million, versus $1.09 million
Gross margin	39.3%; prior-year quarter was negative 40.4%	13.2%, versus 33.5%
Operating expenses	$11.24 million, versus $1.63 million	$13.38 million, versus $4.56 million
Net loss	$10.70 million, versus $2.27 million	$13.72 million, versus $4.17 million
Operating cash flow	Six-month cash used: $6.60 million, versus $2.16 million

For the six months, lower revenue was attributed mainly to COVID-19 effects on Bailey 44, partly offset by H&J. Management attributed the lower six-month gross margin to discounting and liquidation of aged inventory. The Q2 revenue and gross-profit improvement was primarily associated with H&J’s contribution and higher gross margin.

Liquidity, debt and capital

• Cash was $4.08 million at June 30, compared with $0.58 million at December 31, 2020. Current assets were $6.44 million against current liabilities of $21.60 million, a working-capital deficit of approximately $15.16 million. Total liabilities were $29.14 million.
• Financing provided $10.60 million of cash during the first half, principally from the IPO and over-allotment, while operating activities used $6.60 million. The filing reports approximately $8.6 million of net IPO proceeds and approximately $1.4 million of net proceeds from the over-allotment.
• Senior venture debt was approximately $6.0 million, bears 12.5% interest, and was scheduled to mature December 31, 2022. The company reported prior covenant defaults cured after the IPO. Other obligations included a $3.5 million Bailey acquisition promissory note bearing 12% interest, plus loan and related-party balances.
• Stockholders’ equity was $4.87 million, compared with a deficit of $5.86 million at year-end. The filing reports 11,399,594 common shares outstanding as of August 16, 2021.

Material changes and unusual items

• Operating expenses included approximately $4.0 million of stock-based compensation for the first half and a $3.05 million charge from the change in fair value of contingent consideration. These items materially contributed to the increase in reported losses.
• A $1.10 million income tax benefit was recorded following the H&J acquisition and release of a valuation allowance. H&J contributed approximately $379,000 of revenue and $158,000 of net income from acquisition through June 30.
• The H&J and Bailey acquisitions included stock-price guarantees that may require additional shares. Contingent consideration was $6.54 million at June 30; its fair-value estimate relies on significant unobservable assumptions.
• The IPO converted preferred stock and certain debt into common shares. At June 30, the company also reported 3.95 million common-stock warrants and 3.88 million stock options outstanding. In July, holders exercised 355,000 warrants for $1.62 million.

Outlook, risks and contingencies

• Going concern: The company disclosed substantial doubt about its ability to continue as a going concern, citing recurring losses, negative operating cash flow and the working-capital deficit. Management expected June 30 cash and planned measures to fund at least one year from issuance of the statements, relying on IPO funds, anticipated second-half collections and revenue, cost controls, and settlement or renegotiation of aged payables and debt. Additional financing may be needed, with no assurance it will be available; failure to obtain funding could force the company to curtail or suspend plans.
• Operating outlook: Management expected new designs and collections to be deployed in the second half of 2021. It also expected COVID-related store closures, reduced traffic, supply-chain disruption and a promotional marketplace to continue to pressure results through the remainder of 2021. No quantified revenue or earnings guidance was provided.
• Debt and liquidity risks: The senior facility is secured by company assets, contains restrictive covenants, and could be accelerated following default. The filing describes payment provisions tied to possible follow-on offerings and warns that required payments may depend on operating cash or lender agreement.
• Other risks: COVID-19 and supply-chain disruption, concentration among inventory vendors, estimated payroll-tax penalties, and several vendor and other lawsuits are disclosed. Certain trade-payable claims are recorded in accounts payable; the company disputes or is working to resolve other claims. Management did not believe the listed matters were likely to cause losses beyond recorded amounts, where stated.
• Controls: Management concluded disclosure controls were ineffective at June 30 because material weaknesses in internal control over financial reporting had not been fully remediated. Remediation included additional finance expertise, external consultants and work toward improved accounting systems and processes.

Important facts for investors to verify

• Whether cash, second-half sales plans and cost reductions are sufficient to address the substantial working-capital deficit and ongoing operating cash burn.
• Current status and terms of the senior facility, the Bailey promissory note and other debt, including payment deadlines, covenant compliance and any subsequent amendments or repayments.
• Actual sales, margins and cash contribution from H&J and the planned collections, separated from acquisition-related accounting effects.
• Potential share issuance under acquisition price guarantees, and dilution from warrants, options and other securities.
• Progress in remediating material weaknesses, and developments in vendor litigation, settlements and estimated payroll-tax penalties.