ROX Castle Brands Inc

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Our objective is to continue building Castle Brands into a profitable international spirits company, with a distinctive portfolio of premium and super premium spirits brands. To achieve this, we continue to seek to:

Recent Developments

Craft Beverage Modernization and Tax Reform Act of 2017

We recognized a $1.0 million reduction in excise taxes in the fiscal year ended March 31, 2019 due to changes to excise tax rates resulting from the enactment of the Craft Beverage Modernization and Tax Reform Act of 2017. The amount resulted in a $1.0 million increase in our gross margin for our full fiscal year ended March 31, 2019. We expect to recognize a similar benefit in our 2020 fiscal year.

Operations overview

We generate revenue through the sale of our products to our network of wholesale distributors or, in control states, state-operated agencies, which, in turn, distribute our products to retail outlets. In the U.S., our sales price per case includes excise tax and import duties, which are also reflected as a corresponding increase in our cost of sales. Most of our international sales are sold “in bond”, with the excise taxes paid by our customers upon shipment, thereby resulting in lower relative revenue as well as a lower relative cost of sales, although some of our United Kingdom sales are sold “tax paid”, as in the U.S. The difference between sales and net sales principally reflects adjustments for various distributor incentives.

Our gross profit is determined by the prices at which we sell our products, our ability to control our cost of sales, the relative mix of our case sales by brand and geography and the impact of foreign currency fluctuations. Our cost of sales is principally driven by our cost of procurement, bottling and packaging, which differs by brand, as well as freight and warehousing costs. We purchase certain products, such as Goslings rums and ginger beer, Pallini liqueurs, Arran whiskeys, and Gozio amaretto, as finished goods. For other products, such as Jefferson’s bourbons, we purchase the components, including the distilled spirits, bottles and packaging materials, and have arrangements with third parties for bottling and packaging. Our U.S. sales typically have a higher absolute gross margin than in other markets, as sales prices per case are generally higher in the U.S.

Selling expense principally includes advertising and marketing expenditures and compensation paid to our marketing and sales personnel. Our selling expense, as a percentage of sales and per case, is higher than that of our competitors because of our brand development costs, level of marketing expenditures and established sales force versus our relatively small base of case sales and sales volumes. However, we believe that maintaining an infrastructure capable of supporting future growth is the correct long-term approach for us.

While we expect the absolute level of selling expense to increase in the coming years, we expect selling expense as a percentage of revenues and on a per case basis to decline or remain constant, as our volumes expand and our sales team sells a larger number of brands.

General and administrative expense relates to corporate and administrative functions that support our operations and includes administrative payroll, occupancy and related expenses and professional services. We expect general and administrative expense in fiscal 2020 to be higher than fiscal 2019 due to costs associated with increased infrastructure to support our growth. However, we expect our general and administrative expense as a percentage of sales to decline due to economies of scale.

We expect to increase our case sales in the U.S. and internationally over the next several years through organic growth, and through the introduction of product line extensions, acquisitions and distribution agreements. We will seek to maintain liquidity and manage our working capital and overall capital resources during this period of anticipated growth to achieve our long-term objectives, although there is no assurance that we will be able to do so.

We continue to believe the following industry trends will create growth opportunities for us, including:

Our growth strategy is based upon growing existing brands, partnering with other brands and acquiring smaller and emerging brands. To identify potential partner and acquisition candidates we plan to rely on our management’s industry experience and our extensive network of industry contacts. We also plan to maintain and grow our U.S. and international distribution channels so that we are more attractive to spirits companies who are looking for a route to market for their products. We expect to compete for foreign and small private and family-owned spirits brands by offering flexible and creative structures, which present an alternative to the larger spirits companies.

We intend to finance any future brand acquisitions through a combination of our available cash resources, third party financing and, in appropriate circumstances, the further issuance of equity and/or debt securities. Acquiring additional brands could have a significant effect on our financial position, and could cause substantial fluctuations in our quarterly and yearly operating results. Also, the pursuit of acquisitions and other new business relationships may require significant management attention. We may not be able to successfully identify attractive acquisition candidates, obtain financing on favorable terms or complete these types of transactions in a timely manner and on terms acceptable to us, if at all.

Financial performance overview

The following table provides information regarding our spirits case sales for the periods presented based on nine-liter equivalent cases, which is a standard spirits industry metric (table excludes related non-alcoholic beverage products):

The following table provides information regarding our case sales of related non-alcoholic beverage products, which primarily consists of Goslings Stormy Ginger Beer, for the periods presented:

Critical accounting policies and estimates

A number of estimates and assumptions affect our reported amounts of assets and liabilities, amounts of sales and expenses and disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate these estimates and assumptions based on historical experience and other factors and circumstances. We believe our estimates and assumptions are reasonable under the circumstances; however, actual results may differ from these estimates.

We believe that the estimates and assumptions discussed below are most important to the portrayal of our financial condition and results of operations in that they require our most difficult, subjective or complex judgments and form the basis for the accounting policies deemed to be most critical to our operations.

Revenue recognition

We recognize revenue from product sales when the product is shipped to a customer (generally a distributor), title and risk of loss has passed to the customer under the terms of sale (FOB shipping point) and collection is reasonably assured. We do not offer a right of return but will accept returns if we shipped the wrong product or wrong quantity. Revenue is not recognized on shipments to control states in the U.S. until such time as the product is sold through to the retail channel.

Accounts receivable

We record trade accounts receivable at net realizable value. This value includes an appropriate allowance for estimated uncollectible accounts to reflect any loss anticipated on the trade accounts receivable balances and charged to the allowance for doubtful accounts. We calculate this allowance based on our history of write-offs, level of past due accounts based on contractual terms of the receivables and our relationships with, and economic status of, our customers.

Inventory valuation

Our inventory, which consists of distilled spirits, non-beverage alcohol products, dry good raw materials (bottles, cans, labels and caps), packaging, excise taxes, freight and finished goods, is valued at the lower of cost or net realizable value, using the weighted average cost method. We assess the valuation of our inventories and reduce the carrying value of those inventories that are obsolete or in excess of our forecasted usage to their estimated realizable value. We estimate the net realizable value of such inventories based on analyses and assumptions including, but not limited to, historical usage, future demand and market requirements. Reduction to the carrying value of inventories is recorded in cost of goods sold.

Goodwill and other intangible assets

At each of March 31, 2019 and 2018, we had $0.5 million of goodwill that arose from acquisitions. Goodwill represents the excess of purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets of businesses acquired. Intangible assets with indefinite lives consist primarily of rights, trademarks, trade names and formulations. We are required to analyze our goodwill and other intangible assets with indefinite lives for impairment on an annual basis as well as when events and circumstances indicate that an impairment may have occurred. In testing goodwill for impairment, we have the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the estimated fair value of a reporting unit is less than its carrying amount. If we elect to perform a qualitative assessment and determine that an impairment is more likely than not, we are then required to perform a quantitative impairment test, otherwise no further analysis is required. We may also elect not to perform the qualitative assessment and, instead, proceed direct to the quantitative impairment test. Under the goodwill qualitative assessment, various events and circumstances that would affect the estimated fair value of a reporting unit are identified, including, but not limited to: prior years’ impairment testing results, budget to actual results, Company-specific facts and circumstances, industry developments, and the economic environment.

Under the goodwill two-step quantitative impairment test we evaluate the recoverability of goodwill and indefinite lived intangible assets at the reporting unit level. In the first step the fair value for the reporting unit is compared to its book value, including goodwill. If the fair value of the reporting unit is less than the book value, a second step is performed which compares the implied fair value of the reporting unit’s goodwill to the book value of the goodwill. The fair value for the goodwill is determined based on the difference between the fair values of the reporting units and the net fair values of the identifiable assets and liabilities of such reporting units. If the fair value of the goodwill is less than the book value, the difference is recognized as an impairment.

Under the goodwill qualitative assessment at March 31, 2019 and 2018, various events and circumstances that would affect the estimated fair value of each reporting unit were identified, including, but not limited to: prior years’ impairment testing results, budget to actual results, Company-specific facts and circumstances, industry developments, and the economic environment. Based on this assessment, we determined that no quantitative assessment was required. We did not record any impairment on goodwill or other intangible assets for fiscal 2019, 2018 or 2017.

Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to the estimated residual values and reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We are required to amortize intangible assets with estimable useful lives over their respective estimated useful lives to the estimated residual values and to review intangible assets with estimable useful lives for impairment in accordance with the Financial Accounting Standards Board Accounting Standards Codification (“ASC”) 310, “Accounting for the Impairment or Disposal of Long-lived Assets.”

Stock-based awards

We follow current authoritative guidance regarding stock-based compensation, which requires all share-based payments, including grants of stock options and restricted stock, to be recognized in the income statement as an operating expense, based on their fair values on the grant date. Stock-based compensation was $2.0 million, $2.0 million and $1.6 million for fiscal 2019, 2018 and 2017, respectively. We use the Black-Scholes option-pricing model to estimate the fair value of options granted. The assumptions used in valuing the options granted during fiscal 2017 are included in note 12 to our accompanying consolidated financial statements.

Fair value of financial instruments

ASC 825, “Financial Instruments”, defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties and requires disclosure of the fair value of certain financial instruments. We believe that there is no material difference between the fair value and the reported amounts of financial instruments in the balance sheets due to the short-term maturity of these instruments, or with respect to the debt, as compared to the current borrowing rates available to us.

Results of operations

The following table sets forth, for the periods indicated, the percentage of net sales of certain items in our consolidated financial statements.

The following is a reconciliation of net loss attributable to common shareholders to EBITDA, as adjusted:

Earnings before interest, taxes, depreciation and amortization, or EBITDA, adjusted for allowances for doubtful accounts and obsolete inventory, stock-based compensation expense, transaction fees, other expense (income), net, income from equity investment in non-consolidated affiliate, foreign exchange loss (income) and net income attributable to noncontrolling interests is a key metric we use in evaluating our financial performance. EBITDA, as adjusted, is considered a non-GAAP financial measure as defined by Regulation G promulgated by the SEC under the Securities Act of 1933, as amended. We consider EBITDA, as adjusted, important in evaluating our performance on a consistent basis across various periods. Due to the significance of non-cash and non-recurring items, EBITDA, as adjusted, enables our Board of Directors and management to monitor and evaluate the business on a consistent basis. We use EBITDA, as adjusted, as a primary measure, among others, to analyze and evaluate financial and strategic planning decisions regarding future operating investments and allocation of capital resources. We believe that EBITDA, as adjusted, eliminates items that are not indicative of our core operating performance or are based on management’s estimates, such as allowance accounts, are due to changes in valuation, such as the effects of changes in foreign exchange or do not involve a cash outlay, such as stock-based compensation expense and in the quarter ended December 31, 2018, a one-time $1.0 million charge to professional fees. Our presentation of EBITDA, as adjusted, should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items or by non-cash items, such as stock-based compensation, which is expected to remain a key element in our long-term incentive compensation program. EBITDA, as adjusted, should be considered in addition to, rather than as a substitute for, income from operations, net income and cash flows from operating activities.

Fiscal 2019 compared with Fiscal 2018

Net sales. Net sales increased 6.6% to $95.8 million for the year ended March 31, 2019, as compared to $89.9 million for the prior fiscal year, primarily due to U.S. sales growth of Jefferson’s bourbons, Knappogue Castle Irish whiskey and Goslings Stormy Ginger Beer, partially offset by the impact of the release of high revenue specialty releases of our Jefferson’s bourbon in the prior fiscal year and decreases in Clontarf and Arran whiskey sales and certain of our liqueurs in the year ended March 31, 2019. We expect to continue to focus on our faster growing brands and markets, both in the U.S. and internationally, including the release of high revenue specialty releases of our Jefferson’s bourbons in future periods.

The table below presents the increase or decrease, as applicable, in case sales by spirits product category for the year ended March 31, 2019 as compared to the year ended March 31, 2018:

Our international spirits case sales as a percentage of total spirits case sales decreased to 18.5% for the year ended March 31, 2019 as compared to 19.6% for the prior fiscal year, primarily due to decreased Irish whiskey and rum sales in certain international markets resulting in part from the timing of shipments to large retailers in Ireland and Scandinavia.

The following table presents the increase in case sales of ginger beer products for the year ended March 31, 2019 as compared to the year ended March 31, 2018:

Gross profit. Gross profit increased 3.8% to $37.6 million for the year ended March 31, 2019 from $36.2 million for the prior fiscal year, while gross margin decreased to 39.2% for the year ended March 31, 2019 as compared to 40.3% for the prior fiscal year. The decrease in gross margin was primarily due to a temporary increase in aggregate costs of our bulk bourbon in the current period and to the impact of the release of high margin specialty releases of our Jefferson’s bourbon in the prior fiscal year. We expect gross margin will improve over the long-term as our lower-cost new-fill bourbon ages and becomes available for use across all of our Jefferson’s expressions. Gross profit was positively impacted by a rebate of $1.0 million on excise taxes recognized under the Craft Beverage Modernization and Tax Reform Act of 2017 in the fiscal year ended March 31, 2019, and we expect a similar benefit in our next fiscal year. The timing and amount of such future rebates remains subject to the review and approval of the U.S. Customs and Border Protection Agency. During the year ended March 31, 2019, we recorded additions to allowance for obsolete and slow-moving inventory of $0.5 million. We recorded this write-off and allowance on both raw materials and finished goods, primarily in connection with label and packaging changes made to certain brands, as well as certain cost estimates and variances. The net charge has been recorded as an increase to cost of sales in the relevant period.

Selling expense . Selling expense increased 2.7% to $22.4 million for the year ended March 31, 2019 from $21.8 million for the prior fiscal year, primarily due to a $0.8 million increase in employee costs and a $0.5 million increase in shipping costs, partially offset by a $0.6 million decrease in advertising, marketing and promotion expense related to the timing of certain sales and marketing programs, including Goslings’ sponsorship of the 35th America’s Cup, in the prior fiscal year. Selling expense as a percentage of net sales decreased to 23.3% for the year ended March 31, 2019 as compared to 24.2% for the prior fiscal year due to increased revenues in the current period.

General and administrative expense . General and administrative expense increased 16.4% to $11.0 million for the year ended March 31, 2019 from $9.4 million for the prior fiscal year, primarily due to a one-time $1.0 million increase in professional fees in the quarter ended December 31, 2018 and a $0.7 million increase in employee costs. General and administrative expense as a percentage of net sales increased to 11.4% for the year ended March 31, 2019 as compared to 10.5% for the prior fiscal year.

Depreciation and amortization. Depreciation and amortization was $0.6 million for the year ended March 31, 2019 as compared to $0.8 million for the prior fiscal year.

Income from operations . As a result of the foregoing, we had income from operations of $3.7 million for the year ended March 31, 2019 as compared to income from operations of $4.2 million for the prior fiscal year. As a result of our focus on our stronger growth markets and better performing brands, and expected growth from our existing brands, we anticipate improved results of operations in the near term as compared to prior years, although there is no assurance that we will attain such results.

Income tax benefit (expense), net. Income tax benefit (expense), net is the estimated tax expense primarily attributable to the net taxable income recorded by GCP, our 80.1% owned subsidiary, adjusted for changes in the deferred tax asset and deferred tax liability during the periods. Based on historical operating results, projected positive trend of earnings and projected future taxable income, we concluded as of March 31, 2019 that certain of our U.S. deferred tax assets are realizable on a more-likely-than-not basis. As a result, we released $9.6 million of valuation allowance, which resulted in a net income tax benefit (expense) of $9.4 million for the year ended March 31, 2019 as compared to expense of ($0.1) million in the prior fiscal year.

Our provision for income taxes consists principally of state and local taxes in amounts necessary to align our year-to-date tax provision with the effective rate that we expect to achieve for the full year.

For the year ended March 31, 2019, we recorded an income tax benefit of $9.4 million. The effective tax rate for the year ended March 31, 2019 was (1,571.08)%. The effective tax rate differs from the statutory rate of 21% as we concluded that our deferred tax assets are realizable on a more-likely-than-not basis.

We maintain a valuation allowance on Section 163(j) deferred interest carryforwards and a partial valuation allowance on certain state net operating losses. Our valuation allowance decreased by $9.6 million during fiscal 2019 as certain of our U.S. deferred tax assets became realizable on a more-likely-than-not basis as of March 31, 2019.

Foreign exchange. Foreign exchange gain for the year ended March 31, 2019 was $0.2 million as compared to a net expense of ($0.8) million for the prior fiscal year due to the net effects of fluctuations of the U.S. dollar against the Euro and its impact on our Euro-denominated intercompany balances due to our foreign subsidiaries for inventory purchases.

Interest expense, net. We had interest expense, net of ($4.6) million for the year ended March 31, 2019 as compared to ($3.8) million for the prior fiscal year due to balances outstanding under our credit facilities and long-term debt. Due to the expected borrowings under our credit facilities to finance additional purchases of aged whiskies in support of the growth of our Jefferson’s bourbons and other working capital needs, we expect interest expense, net to increase in the near term as compared to prior years, although we continue to evaluate alternative financing options.

Net income attributable to noncontrolling interests. Net income attributable to noncontrolling interests was $3.2 million for the year ended March 31, 2019 as compared to $1.1 million for the prior fiscal year, as a result of net income allocated to the 19.9% noncontrolling interests in GCP.

Net income (loss) attributable to common shareholders. As a result of the net effects of the foregoing, net income attributable to common shareholders was $5.7 million for the year ended March 31, 2019 as compared to a net loss of ($0.8) million for the prior fiscal year. Net income per common share, basic and diluted, was $0.03 per share for the year ended March 31, 2019 as compared to net loss per common share, basic and diluted, of ($0.01) per share for the year ended March 31, 2018.

EBITDA, as adjusted. EBITDA, as adjusted, improved to $7.8 million for the year ended March 31, 2019, as compared to $7.4 million for the prior fiscal year, primarily due to our increased sales and gross profit.

Fiscal 2018 compared with fiscal 2017

Net sales. Net sales increased 16.3% to $89.9 million for the year ended March 31, 2018, as compared to $77.3 million for the prior fiscal year, primarily due to U.S. sales growth of our whiskey portfolio, Goslings Stormy Ginger Beer and certain liqueur brands, partially offset by decreases in vodka and rum sales. For the year ended March 31, 2018, sales of our Goslings Stormy Ginger Beer increased 32.7% to $26.5 million. The launch of Arran whiskeys during the year ended March 31, 2018 contributed $1.2 million in sales. We continue to focus on our faster growing brands and markets, both in the U.S. and internationally.

The table below presents the increase or decrease, as applicable, in case sales by spirits product category for the year ended March 31, 2018 as compared to the year ended March 31, 2017:

Our international spirits case sales as a percentage of total spirits case sales increased to 19.6% for the year ended March 31, 2018 as compared to 18.0% for the prior fiscal year, primarily due to increased Irish whiskey and rum sales in certain international markets resulting in part from the timing of shipments to large retailers in Ireland and Scandinavia.

The following table presents the increase in case sales of ginger beer products for the year ended March 31, 2018 as compared to the year ended March 31, 2017:

Gross profit. Gross profit increased 14.2% to $36.2 million for the year ended March 31, 2018 from $31.7 million for the prior fiscal year, while gross margin decreased to 40.4% for the year ended March 31, 2018 as compared to 41.0% for the prior fiscal year. The increase in gross profit was due to increased aggregate revenue in the current period, partially offset by increased cost of sales in the current period. The small decrease in gross margin was primarily due to pricing of some of our ancillary brands. During the year ended March 31, 2018, we recorded an addition to the allowance for obsolete and slow-moving inventory of $0.4 million as compared to $0.2 million for the prior fiscal year. We recorded these write-offs and allowances on both raw materials and finished goods, primarily in connection with label and packaging changes made to certain brands, as well as certain cost estimates and variances. The net charges have been recorded as an increase to cost of sales in the relevant period.

Selling expense . Selling expense increased 8.2% to $21.8 million for the year ended March 31, 2018 from $20.1 million for the prior fiscal year, primarily due to a $1.3 million increase in advertising, marketing and promotion expense related to the timing of certain sales and marketing programs, including Goslings’ sponsorship of the 35th America’s Cup, a $0.5 million increase in shipping costs and a $0.3 million increase in commission expense from increased sales volume, partially offset by a $0.5 million decrease in employee expense. Selling expense as a percentage of net sales decreased to 24.2% for the year ended March 31, 2018 as compared to 26.0% for the prior fiscal year.

General and administrative expense. General and administrative expense increased 9.1% to $9.4 million for the year ended March 31, 2018 from $8.6 million for the prior fiscal year, primarily due to a $0.3 million increase in professional fees and a $0.5 million increase in compensation costs. General and administrative expense as a percentage of net sales decreased to 10.5% for the year ended March 31, 2018 as compared to 11.2% for the prior fiscal year.

Depreciation and amortization. Depreciation and amortization was $0.8 million for the year ended March 31, 2018 as compared to $1.0 million for the prior fiscal year.

Income from operations . As a result of the foregoing, we had income from operations of $4.2 million for the year ended March 31, 2018 as compared to $1.9 million for the prior fiscal year.

Income tax expense, net. Income tax expense, net is the estimated tax benefit or expense primarily attributable to the net taxable income recorded by GCP, our 80.1% owned subsidiary, adjusted for changes in the deferred tax asset and deferred tax liability during the periods, and was a net expense of ($0.1) million for the year ended March 31, 2018 as compared to a net expense of ($0.2) million for the prior fiscal year.

Foreign exchange (loss) gain. Foreign exchange loss for the year ended March 31, 2018 was $0.1 million as compared to a gain of $0.1 million for the prior fiscal year due to the net effects of fluctuations of the U.S. dollar against the Euro and its impact on our Euro-denominated intercompany balances due to our foreign subsidiaries for inventory purchases.

Interest expense, net. We had interest expense, net of ($3.8) million for the year ended March 31, 2018 as compared to ($1.3) million for the prior fiscal year due to balances outstanding under our credit facilities and long-term debt.

Net income attributable to noncontrolling interests. Net income attributable to noncontrolling interests was ($1.1) million for the year ended March 31, 2018 as compared to ($1.4) million for the comparable prior year period, both as a result of net income allocated to the 19.9% noncontrolling interests in GCP in the year ended March 31, 2018 and the 40.0% noncontrolling interests in GCP in the year ended March 31, 2017. The change in noncontrolling interests from our acquisition of an additional 20.1% of GCP occurred in March 2017.

Net loss attributable to common shareholders. As a result of the net effects of the foregoing, net loss attributable to common shareholders improved to ($0.8) million for the year ended March 31, 2018 as compared to ($0.9) million for the prior fiscal year. Net loss per common share, basic and diluted, was ($0.01) per share for the each of the years ended March 31, 2018 and 2017.

EBITDA, as adjusted. EBITDA, as adjusted, improved to $7.4 million for the year ended March 31, 2018, as compared to $5.2 million for the prior year, primarily as a result of our increased sales and gross profit.

Liquidity and capital resources

Overview

Since our inception, we have incurred significant net losses and have not generated positive cash flows from operations. For the year ended March 31, 2019, we had net income of $8.8 million, and used cash of $8.5 million in operating activities. As of March 31, 2019, we had cash and cash equivalents of $0.5 million and had an accumulated deficit of $144.2 million.

We believe our current cash and working capital and the availability under the Credit Facility (as defined below) will enable us to fund our losses until we achieve profitability, ensure continuity of supply of our brands, and support new brand initiatives and marketing programs through at least June 2020. We believe we can continue to meet our operating needs through additional mechanisms, if necessary, including additional or expanded debt financings, potential equity offerings and limiting or adjusting the timing of additional inventory purchases based on available resources.

We are currently negotiating the restructuring of all or a portion of our debt, including the Subordinated Note. This restructuring may consist of a combination of expanding and extending the Loan Agreement and Credit Facility with ACF, extending the term of the Subordinated Note, or other methods of paying down the debt, although there is no assurance that we will be successful in such restructuring.

Financing

We and our wholly-owned subsidiary, CB-USA, are parties to an Amended and Restated Loan and Security Agreement (as amended, the “Loan Agreement”) with ACF FinCo I LP (“ACF”), which provides for availability (subject to certain terms and conditions) of a facility (the “Credit Facility”) to provide us with working capital, including capital to finance purchases of aged whiskeys in support of the growth of our Jefferson’s whiskeys. We and CB-USA entered into four amendments to the Loan Agreement during our 2019 fiscal year which increased the maximum amount of the Credit Facility from $21.0 million to $27.0 million, including a sublimit in the maximum principal amount of $7.0 million to permit us to acquire aged whiskey inventory (the “Purchased Inventory Sublimit”) subject to certain conditions set forth in the Loan Agreement. The Credit Facility matures on July 31, 2020 (the “Maturity Date”). The monthly facility fee is 0.75% per annum of the maximum Credit Facility amount (excluding the Purchased Inventory Sublimit).

Pursuant to the Loan Agreement, we and CB-USA may borrow up to the lesser of (x) $27.0 million and (y) the sum of the borrowing base calculated in accordance with the Loan Agreement and the Purchased Inventory Sublimit. We and CB-USA may prepay the Credit Facility in whole or the Purchased Inventory Sublimit, in whole or in part, subject to certain prepayment penalties as set forth in the Loan Agreement.

ACF required as a condition to entering into an amendment to the Loan Agreement in August 2015 that ACF enter into a participation agreement with certain related parties of ours, including Frost Gamma Investments Trust, an entity affiliated with Phillip Frost, M.D., a director of ours and a principal shareholder of ours ($150,000), Mark E. Andrews, III, a director of ours and our Chairman ($50,000), Richard J. Lampen, a director of ours and our President and Chief Executive Officer ($100,000), Brian L. Heller, our General Counsel and Assistant Secretary ($42,500), and Alfred J. Small, our Senior Vice President, Chief Financial Officer, Treasurer & Secretary ($15,000), to allow for the sale of participation interests in the Purchased Inventory Sublimit and the inventory purchased with the proceeds thereof. The participation agreement provides that ACF’s commitment to fund each advance of the Purchased Inventory Sublimit shall be limited to seventy percent (70%), up to an aggregate maximum principal amount for all advances equal to $4.9 million. Under the terms of the participation agreement, the participants receive interest at the rate of 11% per annum. We are not a party to the participation agreement. However, we and CB-USA are party to a fee letter with the junior participants (including the related party junior participants) pursuant to which we and CB-USA were obligated to pay the junior participants a closing fee of $18,000 on the effective date of the amendment to the Loan Agreement and are obligated to pay a commitment fee of $18,000 on each anniversary of the effective date until the junior participants’ obligations are terminated pursuant to the participation agreement. As of March 31, 2019, we had borrowed $27.0 million of the $27.0 million then available under the Credit Facility, including $7.0 million of the $7.0 million available under the Purchased Inventory Sublimit, leaving no potential availability for working capital needs under the Credit Facility or for aged whiskey inventory purchases.

We may borrow up to the maximum amount of the Credit Facility, provided that we have a sufficient borrowing base (as defined in the Loan Agreement). The Credit Facility interest rate (other than with respect to the Purchased Inventory Sublimit) is the rate that, when annualized, is the greatest of (a) the Prime Rate plus 3.00%, (b) the LIBOR Rate plus 5.50% and (c) 6.0%. The interest rate applicable to the Purchased Inventory Sublimit is the rate, that when annualized, is the greatest of (a) the Prime Rate plus 4.25%, (b) the LIBOR Rate plus 6.75% and (c) 7.50%. Interest is payable monthly in arrears, on the first day of every month on the average daily unpaid principal amount of the Credit Facility. After the occurrence and during the continuance of any “Default” or “Event of Default” (as defined under the Loan Agreement) we are required to pay interest at a rate that is 3.25% per annum above the then applicable Credit Facility interest rate. The Loan Agreement contains EBITDA targets allowing for further interest rate reductions in the future. The Credit Facility currently bears interest at 8.0% and the Purchased Inventory Sublimit currently bears interest at 9.75%. We are required to pay down the principal balance of the Purchased Inventory Sublimit within 15 banking days from the completion of a bottling run of bourbon from our bourbon inventory stock purchased with funds borrowed under the Purchased Inventory Sublimit in an amount equal to the purchase price of such bourbon. The unpaid principal balance of the Credit Facility, all accrued and unpaid interest thereon, and all fees, costs and expenses payable in connection with the Credit Facility, are due and payable in full on the Maturity Date. In addition to closing fees, ACF receives facility fees and a collateral management fee (each as set forth in the Loan Agreement). Our obligations under the Loan Agreement are secured by the grant of a pledge and a security interest in all of our assets. The Loan Amendment also contains a fixed charge coverage ratio covenant requiring us to maintain a fixed charge coverage ratio of not less than 1.1 to 1.0.

In January 2017, we acquired $1.0 million in aged bulk bourbon purchased under the Purchased Inventory Sublimit. Certain related parties, including Frost Gamma Investments Trust ($65,406), Richard J. Lampen ($43,604), Mark E. Andrews, III ($21,802), Brian L. Heller ($18,532) and Alfred J. Small ($6,541), were junior participants in the Purchased Inventory Sublimit with respect to such purchase.

In October 2017, we acquired $1.3 million in aged bulk bourbon purchased under the Purchased Inventory Sublimit. Certain related parties, including Frost Gamma Investments Trust ($51,500), Richard J. Lampen ($34,333), Mark E. Andrews, III ($17,167), Brian L. Heller ($14,592) and Alfred J. Small ($5,150), were junior participants in the Purchased Inventory Sublimit with respect to such purchase.

In December 2017, we acquired $1.0 million in aged bulk bourbon purchased under the Purchased Inventory Sublimit. Certain related parties, including Frost Gamma Investments Trust ($45,021), Richard J. Lampen ($30,014), Mark E. Andrews, III ($15,007), Brian L. Heller ($12,756) and Alfred J. Small ($4,502), were junior participants in the Purchased Inventory Sublimit with respect to such purchase.

In April 2018, we acquired $2.0 million in aged bulk bourbon purchased under the Purchased Inventory Sublimit. Certain related parties, including Frost Gamma Investments Trust ($100,050), Richard J. Lampen ($66,700), Mark E. Andrews, III ($33,350), Brian L. Heller ($28,348) and Alfred J. Small ($10,005), were junior participants in the Purchased Inventory Sublimit with respect to such purchase.

In June 2018, we acquired $1.0 million in aged bulk bourbon under the Purchased Inventory Sublimit. Certain related parties, including Frost Gamma Investments Trust ($51,750), Richard J. Lampen ($34,500), Mark E. Andrews, III ($17,250), Brian L. Heller ($14,663), and Alfred J. Small ($5,175), were junior participants in the Purchased Inventory Sublimit with respect to such purchase.

The Loan Agreement contains standard borrower representations and warranties for asset-based borrowing and a number of reporting obligations and affirmative and negative covenants. The Loan Agreement includes negative covenants that, among other things, restrict our ability to create additional indebtedness, dispose of properties, incur liens, and make distributions or cash dividends. At March 31, 2019, we were in compliance, in all material respects, with the covenants under the Loan Agreement.

In March 2017, we issued an 11% Subordinated Note due 2019, dated March 29, 2017, in the principal amount of $20.0 million with Frost Nevada Investments Trust (the “Subordinated Note”), an entity affiliated with Phillip Frost, M.D., a director and a principal shareholder of ours. In April 2018, we entered into a first amendment to the Subordinated Note to extend the maturity date on the Subordinated Note from March 15, 2019 until September 15, 2020. No other provisions of the Subordinated Note were amended. The purpose of the Subordinated Note was to finance the GCP Share Acquisition. The Subordinated Note, as amended, bears interest quarterly at the rate of 11% per annum. The principal and interest accrued thereon is due and payable in full on September 15, 2020. All claims of the holder of the Subordinated Note to principal, interest and any other amounts owed under the Subordinated Note are subordinated in right of payment to all our indebtedness existing as of the date of the Subordinated Note. The Subordinated Note contains customary events of default and may be prepaid by us, in whole or in part, without penalty, at any time.

In December 2009, GCP issued a promissory note in the aggregate principal amount of $0.2 million to Gosling’s Export (Bermuda) Limited in exchange for credits issued on certain inventory purchases. This note matures on April 1, 2020, is payable at maturity, subject to certain acceleration events, and calls for annual interest of 5%, to be accrued and paid at maturity.

We have arranged various credit facilities aggregating €0.3 million or $0.4 million (translated at the March 31, 2019 exchange rate) with an Irish bank, including overdraft coverage, creditors’ insurance, customs and excise guaranty and a revolving credit facility. These facilities are payable on demand, continue until terminated by either party, are subject to annual review, and call for interest at the lender’s AA1 Rate minus 1.70%. We have deposited €0.3 million or $0.4 million (translated at the March 31, 2019 exchange rate) with the bank to secure these borrowings.

In October 2013, we issued an aggregate principal amount of $2.1 million of unsecured 5% convertible subordinated notes (the “Convertible Notes”). We used a portion of the proceeds to finance the acquisition of additional bourbon inventory in support of the growth of our Jefferson’s bourbon brand. The Convertible Notes matured on December 15, 2018. The Convertible Notes, and accrued but unpaid interest thereon, were convertible into shares of our common stock, par value $0.01 per share, at a conversion price of $0.90 per share. The Convertible Note purchasers included certain related parties of ours, including an affiliate of Dr. Phillip Frost ($500,000), Mark E. Andrews, III ($50,000), an affiliate of Richard J. Lampen ($50,000) and Vector Group Ltd., a more than 5% shareholder of ours, of which Richard Lampen is an executive officer, Henry Beinstein, a director of ours, is a director and Phillip Frost, M.D. is a principal shareholder ($200,000), all of whom converted the outstanding principal and interest balances of their Convertible Notes into shares of our common stock in the year ended March 31, 2018.

In the year ended March 31, 2018, certain holders of the Convertible Notes, including the related party holders described above, converted an aggregate $1,632,000 of the outstanding principal and interest balances of their Convertible Notes into 1,813,334 shares of our common stock, pursuant to the terms of the Convertible Notes.

The remaining Convertible Note of $50,000 matured and was repaid on December 15, 2018 in the normal course.

Liquidity

As of March 31, 2019, we had shareholders’ equity of $19.3 million as compared to $8.0 million at March 31, 2018. This increase in shareholders’ equity was due to the exercise of stock options and stock-based compensation expense of $2.6 million, partially offset by our $8.7 million total comprehensive income for the year ended March 31, 2019, including a $9.4 million tax benefit.

We had working capital of $49.0 million at March 31, 2019 as compared to $38.6 million at March 31, 2018, primarily due to a $10.2 million increase in inventory, a $2.0 million increase in prepaid expenses and other current assets and a $3.5 million increase in accounts receivable, which was partially offset by a $5.1 million increase in accounts payable and accrued expenses.

As of March 31, 2019, we had cash and cash equivalents of approximately $0.5 million, as compared to $0.4 million as of March 31, 2018. Changes in our cash and cash equivalents are primarily attributable to the net borrowings on our credit facilities to fund our operations and working capital needs. At March 31, 2019 and 2018, we also had approximately $0.4 million of cash restricted from withdrawal and held by a bank in Ireland as collateral for overdraft coverage, creditors’ insurance, revolving credit and other working capital purposes.

The following may materially affect our liquidity over the near-to-mid term:

● continued cash losses from operations;

● our ability to obtain additional debt or equity financing should it be required;

● an increase in working capital requirements to finance higher levels of inventories and accounts receivable;

● our ability to maintain and improve our relationships with our distributors and our routes to market;

● our ability to procure raw materials at a favorable price to support our level of sales;

● potential acquisitions of additional brands; and

● expansion into new markets and within existing markets in the U.S. and internationally.

We continue to implement sales and marketing initiatives that we expect will generate cash flows from operations in the next few years. We seek to grow our business through expansion to new markets, growth in existing markets and strengthened distributor relationships. As our brands continue to grow, our working capital requirements will increase. In particular, the growth of our Jefferson’s brands requires a significant amount of working capital relative to our other brands, as we are required to purchase and hold ever increasing amounts of aged whiskey to meet growing demand. We must purchase and hold several years’ worth of aged whiskey in inventory until such time as it is aged to our specific brand taste profiles, increasing our working capital requirements and negatively impacting cash flows.

We may also seek additional brands and agency relationships to leverage our existing distribution platform. We intend to finance any such brand acquisitions through a combination of our available cash resources, borrowings and, in appropriate circumstances, additional issuances of equity and/or debt securities. Acquiring additional brands could have a significant effect on our financial position, could materially reduce our liquidity and could cause substantial fluctuations in our quarterly and yearly operating results. We continue to control expenses, seek improvements in routes to market and contain production costs to improve cash flows.

We are currently negotiating the restructuring of all or a portion of our debt, including the Subordinated Note. This restructuring may consist of a combination of expanding and extending the Loan Agreement and Credit Facility with ACF, extending the term of the Subordinated Note, converting some or all of the debt to equity or paying down the debt with funds that may be raised from future equity offerings, although there is no assurance that we will be successful in such restructuring. If we are unable to restructure or refinance our debt, or are unable to raise equity on terms that are acceptable to us, it could have a significant effect on our financial position, could materially reduce our liquidity and could cause substantial fluctuations in our quarterly and yearly operating results.

As of March 31, 2019, we had borrowed $27.0 million of the $27.0 million then available under the Credit Facility, including $7.0 million of the $7.0 million available under the Purchased Inventory Sublimit, leaving no potential availability for working capital needs under the Credit Facility or for aged whiskey inventory purchases. As of June 12, 2019, we had repaid $2.5 million of the $27.0 million borrowed at March 31, 2019. As of June 14, 2019, we had borrowed $24.5 million of the $27.0 million then available under the amended Credit Facility, including $7.0 million of the $7.0 million available under the Purchased Inventory Sublimit, leaving $2.5 million in potential availability for working capital needs under the amended Credit Facility and $0.0 million available for aged whiskey inventory purchases. We believe our current cash and working capital and the availability under the Credit Facility will enable us to fund our losses until we achieve profitability, ensure continuity of supply of our brands, and support new brand initiatives and marketing programs through at least June 2020. We believe we can continue to meet our operating needs through additional mechanisms, if necessary, including additional or expanded debt financings, potential equity offerings and limiting or adjusting the timing of additional inventory purchases based on available resources, although we continue to evaluate alternative financing options.

Cash flows

The following table summarizes our primary sources and uses of cash during the periods presented:

Operating activities. A substantial portion of available cash has been used to fund our operating activities. In general, these cash funding requirements are based on the costs in maintaining our distribution system, our sales and marketing activities and cash required to fund the purchase of our inventories. In general, these cash outlays for inventories are only partially offset by increases in our accounts payable to our suppliers.

On average, the production cycle for our owned brands is up to three months from the time we obtain the distilled spirits and other materials needed to bottle and package our products to the time we receive products available for sale, in part due to the international nature of our business. We do not produce Goslings rums or ginger beer, Pallini liqueurs, Arran Scotch whiskeys or Gozio amaretto. Instead, we receive the finished product directly from the owners of such brands. From the time we have products available for sale, an additional two to three months may be required before we sell our inventory and collect payment from customers. Further, our inventory at March 31, 2019 included significant additional stores of aged bourbon purchased in advance of forecasted production requirements. In October 2017, we entered into a supply agreement with a bourbon distiller, which provides for the production of newly-distilled bourbon whiskey. Under this agreement, the distiller will provide us with an agreed upon amount of original proof gallons of newly-distilled bourbon whiskey, subject to certain annual adjustments. For the contract year ending December 31, 2018, we contracted to purchase approximately $3.9 million in newly distilled bourbon, all of which had been purchased as of December 31, 2018. For the contract year ending December 31, 2019, we contracted to purchase approximately $4.6 million in newly distilled bourbon, of which $1.2 million had been purchased as of March 31, 2019. We are not obligated to pay the distiller for any product not yet received. We expect to use the aged bourbon in the normal course of future sales, generating positive cash flows in future periods.

During the year ended March 31, 2019, net cash used in operating activities was $8.5 million, consisting primarily of a $10.2 million increase in inventory, a $3.5 million increase in accounts receivable, a $2.0 million increase in prepaid expenses and other current assets and a net loss of $0.6 million. These uses of cash were partially offset by a $5.0 million increase in accounts payable and accrued expenses, stock-based compensation expense of $2.0 million and depreciation and amortization expense of $0.6 million.

During the year ended March 31, 2018, net cash used in operating activities was $5.6 million, consisting primarily of a $5.8 million increase in inventory, a $2.1 million decrease in accounts payable and accrued expenses and a $1.7 million increase in accounts receivable. These uses of cash were partially offset by $0.5 million in net income, a $0.6 million increase in due to related parties, stock based compensation expense of $2.0 million, and depreciation and amortization expense of $0.8 million.

During the year ended March 31, 2017, net cash used in operating activities was $1.7 million, consisting primarily of a $4.3 million increase in inventory, a $2.1 million increase in prepaid expenses and a $1.2 million increase in accounts receivable. These uses of cash were partially offset by $0.5 million in net income, a $2.2 million increase in accounts payable and accrued expenses, stock based compensation expense of $1.6 million, a $0.8 million increase in due to related parties and depreciation and amortization expense of $1.0 million.

Investing Activities. Net cash used in investing activities was $0.3 million for the year ended March 31, 2019, representing $0.3 million used in the acquisition of fixed and intangible assets.

Net cash used in investing activities was $0.5 million for the year ended March 31, 2018, representing a $0.2 million investment in non-consolidated affiliate and $0.3 million used in the acquisition of fixed and intangible assets.

Net cash used in investing activities was $20.4 million for the year ended March 31, 2017, consisting of the $20.0 million cash consideration used in the GCP Share Acquisition, and $0.4 million used in the acquisition of fixed and intangible assets.

Financing activities. Net cash provided by financing activities for the year ended March 31, 2019 was $8.9 million, consisting primarily of $8.4 million in net proceeds from the Credit Facility and $0.6 million from the exercise of stock options and $0.1 million from the issuance of common stock under the employee stock purchase plan.

Net cash provided by financing activities for the year ended March 31, 2018 was $5.9 million, consisting primarily of $5.6 million in net borrowings on the credit facilities and $0.2 million from the exercise of stock options.

Net cash provided by financing activities for the year ended March 31, 2017 was $21.3 million, consisting of $20.0 million in proceeds from the issuance of the 11% Subordinated Note, $1.0 million in net proceeds from the Credit Facility and $0.3 million from the exercise of stock options.

Obligations and commitments

The table sets forth our contractual commitments as of March 31, 2019:

Interest payments are based on current interest rates at March 31, 2019. Debt principal and debt interest represent principal and interest to be paid on our revolving credit facility based on the balance outstanding as of March 31, 2019. Interest on the revolving credit facility is calculated using the prevailing rates as of March 31, 2019. Our estimate assumes that we will maintain the same levels of indebtedness and financial performance through the credit facility’s maturity in July 2020.