DIRTT ENVIRONMENTAL SOLUTIONS LTD - Quarter Report: 2021 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2021

or

For the transition period from                        to                       

Commission file number 001-39061

DIRTT ENVIRONMENTAL SOLUTIONS LTD.

(Exact name of registrant as specified in its charter)

(Registrant’s telephone number, including area code): (403) 723-5000

Securities registered pursuant to Section 12(b) of the Exchange Act:

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes ☐ No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). ☒ Yes ☐ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☒ No

The registrant had 84,694,913 common shares outstanding as of May 3, 2021.

DIRTT ENVIRONMENTAL SOLUTIONS LTD.

FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2021

TABLE OF CONTENTS

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Cautionary Statement Regarding Forward-Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q for the quarter ended March 31, 2021 (this “Quarterly Report”) are “forward-looking statements” within the meaning of “safe harbor” provisions of the United States Private Securities Litigation Reform Act of 1995, and Section 21E of the Securities Exchange Act of 1934 as amended (the “Exchange Act”) and “forward-looking information” within the meaning of applicable Canadian securities laws. All statements, other than statements of historical fact included in this Quarterly Report, regarding our strategy, future operations, financial position, estimated revenues and losses, projected costs, prospects, plans and objectives of management are forward-looking statements. When used in this Quarterly Report, the words “anticipate,” “believe,” “expect,” “estimate,” “intend,” “plan,” “project,” “outlook,” “may,” “will,” “should,” “would,” “could,” “can,” the negatives thereof, variations thereon and other similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. Forward-looking statements are based on certain estimates, beliefs, expectations and assumptions made in light of management’s experience and perception of historical trends, current conditions and expected future developments, as well as other factors that may be appropriate.

Forward-looking statements necessarily involve unknown risks and uncertainties, which could cause actual results or outcomes to differ materially from those expressed or implied in such statements. Due to the risks, uncertainties and assumptions inherent in forward-looking information, you should not place undue reliance on forward-looking statements. Factors that could have a material adverse effect on our business, financial condition, results of operations and growth prospects include, but are not limited to, the severity and duration of the coronavirus (“COVID-19”) pandemic and related economic repercussions and other risks described under the section titled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2020, filed with the U.S. Securities and Exchange Commission (the “SEC”) and applicable securities commissions or similar regulatory authorities in Canada on February 24, 2021 (the “Annual Report on Form 10-K”), and in this Quarterly Report under “Part II, Item 1A. Risk Factors.”  These factors include, but are not limited to, the following:  

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These risks are not exhaustive. Because of these risks and other uncertainties, our actual results, performance or achievement, or industry results, may be materially different from the anticipated or estimated results discussed in the forward-looking statements in this Quarterly Report. New risk factors emerge from time to time, and it is not possible for our management to predict all risk factors nor can we assess the effects of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in, or implied by, any forward-looking statements. Our past results of operations are not necessarily indicative of our future results. You should not place undue reliance on any forward-looking statements, which represent our beliefs, assumptions and estimates only as of the dates on which they were made, as predictions of future events. We undertake no obligation to update these forward-looking statements, even though circumstances may change in the future, except as required under applicable securities laws. We qualify all of our forward-looking statements by these cautionary statements.

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PART I – FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

DIRTT Environmental Solutions Ltd.

Interim Condensed Consolidated Balance Sheets

(Unaudited – Stated in thousands of U.S. dollars)

The accompanying notes are an integral part of these interim condensed consolidated financial statements.

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DIRTT Environmental Solutions Ltd.

Interim Condensed Consolidated Statement of Operations

(Unaudited - Stated in thousands of U.S. dollars)

The accompanying notes are an integral part of these interim condensed consolidated financial statements.

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DIRTT Environmental Solutions Ltd.

Interim Condensed Consolidated Statement of Changes in Shareholders’ Equity

(Unaudited – Stated in thousands of U.S. dollars, except for share data)

The accompanying notes are an integral part of these interim condensed consolidated financial statements.

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 DIRTT Environmental Solutions Ltd.

Interim Condensed Consolidated Statement of Cash Flows

(Unaudited – Stated in thousands of U.S. dollars)

The following table provides a reconciliation of cash, cash equivalents and restricted cash reported within the interim condensed consolidated balance sheets.

The accompanying notes are an integral part of these interim condensed consolidated financial statements.

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DIRTT Environmental Solutions Ltd.

Notes to the Unaudited Interim Condensed Consolidated Financial Statements

(Amounts in thousands of U.S. dollars unless otherwise stated)

1. GENERAL INFORMATION

DIRTT Environmental Solutions Ltd. and its subsidiaries (“DIRTT”, the “Company”, “we” or “our”) is a leading technology-driven manufacturer of highly customized interiors. DIRTT combines its proprietary 3D design, configuration and manufacturing ICE® software (“ICE” or “ICE Software”) with integrated in-house manufacturing of its innovative prefabricated interior construction solutions and an extensive network of distribution partners (“Distribution Partners”). ICE provides accurate design, drawing, specification, pricing and manufacturing process information, allowing rapid production of high-quality custom solutions using fewer resources than traditional manufacturing methods. ICE is also licensed to unrelated companies and Distribution Partners of the Company. DIRTT is incorporated under the laws of the province of Alberta, Canada, its headquarters is located at 7303 – 30th Street S.E., Calgary, AB, Canada T2C 1N6 and its registered office is located at 4500, 855 – 2nd Street S.W., Calgary, AB, Canada T2P 4K7. DIRTT’s common shares trade on the Toronto Stock Exchange under the symbol “DRT” and on The Nasdaq Global Select Market (“Nasdaq”) under the symbol “DRTT”.

2. BASIS OF PRESENTATION

The accompanying unaudited interim condensed consolidated financial statements (the “Financial Statements”) have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X and, accordingly, the Financial Statements do not include all of the information and notes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of the Company, the Financial Statements contain all adjustments necessary, consisting of only normal recurring adjustments, for a fair statement of its financial position as of March 31, 2021, and its results of operations and cash flows for the three months ended March 31, 2021 and 2020. The condensed balance sheet at December 31, 2020, was derived from audited annual financial statements but does not contain all of the footnote disclosures from the annual financial statements. These Financial Statements should be read in conjunction with the audited consolidated financial statements as of December 31, 2020 and 2019 and for each of the three years in the period ended December 31, 2020 included in the Annual Report on Form 10-K of the Company as filed with the U.S. Securities and Exchange Commission. As described in Note 4, the Company adopted a new accounting standard relating to convertible debentures effective January 1, 2021. Further information on this standard and the impact on the Company of this standard is described in Note 4.

In these Financial Statements, unless otherwise indicated, all dollar amounts are expressed in United States (“U.S.”) dollars. DIRTT’s financial results are consolidated in Canadian dollars, the Company’s functional currency, and the Company has adopted the U.S. dollar as its reporting currency. All references to US$ or $ are to U.S. dollars and references to C$ are to Canadian dollars.

Principles of consolidation

The Financial Statements include the accounts of DIRTT and its subsidiaries. All intercompany balances, income and expenses, unrealized gains and losses and dividends resulting from intercompany transactions have been eliminated on consolidation.

Basis of measurement

These Financial Statements have been prepared on the historical cost convention except for certain financial instruments and certain components of stock-based compensation that are measured at fair value. Historical cost is generally based on the fair value of the consideration given in exchange for assets. The Company’s quarterly tax provision is based upon an estimated annual effective tax rate.

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Seasonality

Sales of the Company’s products are driven by consumer and industrial demand for interior construction solutions. The timing of customer’s construction projects can be influenced by a number of factors including the prevailing economic climate and weather.

3. COVID-19

On March 11, 2020, COVID-19 was declared a global pandemic by the World Health Organization and has had extraordinary and rapid negative impacts on global societies, workplaces, economies and health systems. The resulting adverse economic conditions have negatively impacted construction activity and consequently DIRTT’s business, with potential significant negative impacts extending to the first half of 2021 and beyond.

While many construction sites remain open and re-opening strategies have been implemented across North America, certain projects have experienced delays, impacted by both the implementation of social distancing and other safety-related measures and the re-emergence of COVID-19 in certain geographic areas. It is not possible to predict the timing and pace of economic recovery, or the resumption of delayed construction activity and related demand, nor is it possible to predict the impact of such developments on the Company’s ability to achieve its business objectives.

COVID-19 has increased the complexity of estimates and assumptions used to prepare the Company’s consolidated financial statements and the following key sources of estimation uncertainty:  

Credit risk

COVID-19 may cause DIRTT’s Distribution Partners and customers to experience liquidity issues and this may result in higher expected credit losses or slower collections. Management estimated the impact of expected credit losses and increased the provision by $0.6 million in the first quarter of 2020 (see Note 5). Management has continued to reassess the impact of COVID-19 on our Distribution Partners. The estimation of such credit losses is complex because of limited historical precedent for the current economic situation. In addition, the Company acquired trade credit insurance effective April 1, 2020.

Liquidity risk

The Company may have lower cash flows from operating activities available to service debts due to lower sales or collections. To address this risk and the uncertainty around the timing of a recovery, the Company issued convertible unsecured subordinated debentures in January 2021, for net proceeds of $29.5 million, and has credit facilities available as described in Note 6.

Government subsidies

As part of the Canadian federal government’s COVID-19 Economic Response Plan, the Canadian government established the Canadian Emergency Wage Subsidy (“CEWS”). The CEWS provides the Company with a taxable subsidy in respect of a specific portion of wages paid to Canadian employees during qualifying periods extending from March 15, 2020 to June 5, 2021 (with an extension to September 25, 2021 having been announced in the 2021 Canadian federal budget), based on the percentage decline of the Company in certain of its Canadian-sourced revenues during each qualifying period. Pursuant to proposed changes announced in the 2021 Canadian federal budget, the Company may be required to repay all or a portion of the CEWS amounts for any qualifying period commencing after June 5, 2021 where the aggregate compensation for specified executives during the 2021 calendar year exceeds the aggregate compensation for specified executives during the 2019 calendar year. The Company’s eligibility for the CEWS may change for each qualifying period and is reviewed by the Company for each qualifying period.

On November 19, 2020, the Canadian government also implemented the Canada Emergency Rent Subsidy (“CERS”). The CERS provides a taxable subsidy to cover eligible expenses for qualifying properties, subject to certain maximums, starting on September 27, 2020 to June 5, 2021 (with an extension to September 25, 2021 having been announced in the 2021 Canadian federal budget), with the amount of the subsidy based on the percentage decline of the Company in certain of its Canadian-sourced revenues in each qualifying period. The Company’s eligibility for the CERS may change for each qualifying period and is reviewed by the Company for each qualifying period.

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Impairment

At March 31, 2021, management determined an impairment provision was not required as our outlook is consistent with the assumptions used in our impairment test undertaken at December 31, 2021. In future periods, if our results or outlook are less than our forecast, this conclusion may need to be revisited.

4. ADOPTION OF NEW AND REVISED ACCOUNTING STANDARDS

On August 5, 2020, the Financial Accounting Standards Board issued Accounting Standards Update No. 2020-06, “Debt – Debt with Conversion and other Options (Subtopic 470-20) and Derivatives and Hedging – Contracts in Entity’s Own Equity (Subtopic 815-40)” (the “ASU”). The ASU eliminates the beneficial conversion and cash conversion accounting models for convertible instruments. It also amends the accounting for certain contracts in an entity’s own equity that are currently accounted for as derivatives because of specific settlement provisions. In addition, the new guidance modifies how particular convertible instruments and certain contracts that may be settled in cash or shares impact the diluted earnings per share computation. The amendments in the ASU are effective for fiscal years beginning after March 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after March 15, 2020, including interim periods within those fiscal years.

The Company early adopted this standard on January 1, 2021. The Company had no convertible debt instruments outstanding at December 31, 2020 and the convertible unsecured subordinated debentures issued in January 2021 have been evaluated under this new guidance and there were no other transitional impacts to consider.

Although there are several other new accounting standards issued or proposed by the Financial Accounting Standards Board, which the Company has adopted or will adopt, as applicable, the Company does not believe any of these accounting pronouncements has had or will have a material impact on its Financial Statements.

5. TRADE AND OTHER RECEIVABLES

Accounts receivable are recorded at the invoiced amount, do not require collateral and do not bear interest. The Company estimates an allowance for credit losses using the lifetime expected credit loss at each measurement date taking into account historical credit loss experience as well as forward-looking information in order to establish rates for each class of financial receivable with similar risk characteristics. Adjustments to this estimate are recognized in the statement of operations.

In order to manage and assess our risk, management maintains credit policies that include regular review of credit limits of individual receivables and systematic monitoring of aging of trade receivables and the financial wellbeing of our customers. At March 31, 2021, approximately 85% of our trade accounts receivable are insured, relating to accounts receivables from counterparties deemed creditworthy by the insurer and excluding accounts receivable from government entities, that have arisen since April 1, 2020 when the trade credit insurance became effective.

Our trade balances are spread over a broad Distribution Partner base, which is geographically dispersed. For the three months ended March 31, 2021, one Distribution Partner (2020 – none) accounted for $3.6 million of revenue, which is greater than 10% of total revenue. In addition, and where possible, we collect a 50% deposit on sales, excluding government and certain other clients.

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The Company’s aged receivables were as follows:

Due to the uncertainties associated with the COVID-19 pandemic as well as the disruption to businesses in North America, the overall credit quality of certain receivables declined at March 31, 2020 compared to January 1, 2020. As a result of this consideration and the Company’s ongoing review of the credit quality of receivables, expected credit losses were increased by $0.6 million during the quarter ended March 31, 2020. No adjustments to our expected credit losses were required at March 31, 2021. During the first quarters of 2021 and 2020, no receivables were written off. Receivables are generally considered to be past due when over 60 days old unless there is a separate payment arrangement in place for the collection of the receivable.

6. LONG-TERM DEBT

Revolving Credit Facility

On February 12, 2021, the Company entered into a loan agreement governing a C$25.0 million senior secured revolving credit facility with the Royal Bank of Canada (“RBC”), as lender (the “RBC Facility”). Under the RBC Facility, the Company is able to borrow up to a maximum of 90% of investment grade or insured accounts receivable plus 85% of eligible accounts receivable plus the lesser of 75% of the book value of eligible inventory and 85% of the net orderly liquidation value of eligible inventory less any reserves for potential prior ranking claims (the “Borrowing Base”). At March 31, 2021, available borrowings are C$9.4 million ($7.5 million), of which no amounts have been drawn. Interest is calculated at the Canadian or U.S. prime rate plus 30 basis points or at the Canadian Dollar Offered Rate or LIBOR plus 155 basis points. Under the RBC Facility, if the Aggregate Excess Availability, defined as the Borrowing Base less any loan advances or letters of credit or guarantee and if undrawn including unrestricted cash, is less than C$5.0 million, the Company is subject to a fixed charge coverage ratio (“FCCR”) covenant of 1.10:1 on a trailing twelve month basis. Additionally, if the FCCR has been below 1.10:1 for the 3 immediately preceding months,

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the Company is required to maintain a reserve account equal to the aggregate of one year of payments on outstanding loans on the Leasing Facilities (defined below). The Company did not meet the 3 month FCCR requirement during the first quarter of 2021 which resulted in requiring the restriction of $1.1 million of cash. Should an event of default occur or the Aggregate Excess Availability be less than C$6.25 million for 5 consecutive business days, the Company would enter a cash dominion period whereby the Company’s bank accounts would be blocked by RBC and daily balances will set-off any borrowings and any remaining amounts made available to the Company.  

Leasing Facilities

The Company has a C$5.0 million equipment leasing facility in Canada (the “Canada Leasing Facility”) and a $14.0 million equipment leasing facility in the United States (the “U.S. Leasing Facility” and, together with the Canada Leasing Facility, the “Leasing Facilities”) with RBC, and one of its affiliates, which are available for equipment expenditures and certain equipment expenditures already incurred. The Leasing Facilities, respectively, have seven and five-year terms and bear interest at 4.25% and 4.50%. The U.S. Leasing Facility is amortized over a six-year term and extendible at the Company’s option for an additional year.

During the first quarter of 2021, the Company received $nil (twelve months ended December 31, 2020: $3.5 million) of cash consideration under the U.S. Leasing Facility. Subsequent to March 31, 2021, we completed a $7.2 million draw of our U.S. Leasing Facility related to reimbursements for equipment purchases for our South Carolina plant, $1.4 million of the proceeds was deposited into restricted cash. During the first quarter of 2021, the Company received $nil (twelve months ended December 31, 2020 – C$3.6 million or $2.6 million) of cash consideration under the Canada Leasing Facility. The associated financial liabilities are shown on the consolidated balance sheet in current other liabilities and long-term debt and other liabilities. 

Convertible Debentures

On January 25, 2021, the Company completed a C$35.0 million bought-deal financing of convertible unsecured subordinated debentures (the “Debentures”) with a syndicate of underwriters. On January 29, 2021, the Company issued a further C$5.25 million of Debentures under the terms of an overallotment option granted to the underwriters. The Debentures will mature and be repayable on January 31, 2026 (the “Maturity Date”), unless earlier redeemed, repurchased or converted. The Debentures accrue interest at the rate of 6.00% per annum payable semi-annually in arrears on the last day of January and July of each year commencing on July 31, 2021.

The Debentures are convertible into common shares of DIRTT, at the option of the holder, at any time prior to the close of business on the business day prior to the earlier of the Maturity Date and the date specified by the Company for redemption of the Debentures at a conversion price of C$4.65 per common share, being a ratio of approximately 215.0538 common shares per C$1,000 principal amount of Debentures. The conversion rate is subject to adjustment if certain corporate events occur prior to the Maturity Date.       

The net proceeds from the sale of the Debentures were C$37.6 million ($29.5 million), after deducting C$2.7 million of transaction costs which includes the underwriters’ commission and directly attributable professional fees. The Company accounted for the Debentures as a liability as the Debentures meet the definition of traditional convertible debt and there are no embedded derivatives requiring bifurcation. The Debentures are shown on the consolidated balance sheet in long-term debt. Interest expense was determined using the effective interest rate method with an effective interest rate of 7.5%. The contractual interest expense for the Debentures during the three months ended March 31, 2021 was $0.3 million which is included in other current liabilities on the balance sheet.

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The Debentures are not redeemable by the Company before January 31, 2024, except in certain limited circumstances following a change of control. On and after January 31, 2024 and prior to January 31, 2025, provided that the current market price of our common shares at the time at which notice of redemption is given is at least 125% of the conversion price, the Debentures may be redeemed by the Company, in whole or in part from time to time, at our option on not more than 60 days’ and not less than 30 days’ prior written notice, for an amount equal to the principal amount thereof plus accrued and unpaid interest thereon. On and after January 31, 2025 and prior to the Maturity Date, the Debentures may be redeemed by the Company, in whole or in part from time to time, at our option on not more than 60 days’ and not less than 30 days’ prior written notice, for an amount equal to the principal amount thereof plus accrued and unpaid interest thereon.

7. STOCK-BASED COMPENSATION

In May 2020, our shareholders approved the DIRTT Environmental Solutions Ltd. Long-Term Incentive Plan (the “2020 LTIP”) at the annual and special meeting of shareholders. The 2020 LTIP gives the Company the ability to award options, share appreciation rights, restricted share units, restricted shares, dividend equivalent rights granted in connection with restricted share units, vested share awards, and other share-based awards and cash awards to eligible employees, officers, consultants and directors of the Company and its affiliates. In accordance with the 2020 LTIP, the sum of (i) 5,850,000 common shares plus (ii) the number of common shares subject to stock options previously granted under the Company’s Amended and Restated Incentive Stock Option Plan (the “Stock Option Plan”) that, following May 22, 2020, expire or are cancelled or terminated without having been exercised in full have been reserved for issuance under the 2020 LTIP.       

The Company also maintains the DIRTT Environmental Solutions Ltd. Deferred Share Unit Plan for Non-Employee Directors pursuant to which deferred share units (“DSUs”) are granted to the Company’s non-employee directors. DSUs are settled solely in cash.

Prior to the approval of the 2020 LTIP, the Company granted awards of options under the Stock Option Plan and awards of performance share units (“PSUs”) under the DIRTT Environmental Solutions Ltd. Performance Share Unit Plan (the “PSU Plan”). Following the approval of the 2020 LTIP, no further awards will be made under either the Stock Option Plan or the PSU Plan, but both remain in place to govern the terms of any awards that were granted pursuant to such plans and remain outstanding.

Stock-based compensation expense

The following summarizes PSUs, DSUs and RSUs (as defined below) granted, exercised, forfeited and expired during the periods:

Restricted share units (time-based vesting)

Restricted share units that vest based on time have an aggregate time-based vesting period of three years and generally one-third of the RSUs vest every year over a three-year period from the date of grant (“RSUs”). At the end of a three-year term, the RSUs will be settled by way of the provision of cash or shares to employees (or a combination thereof), at the discretion of the Company. The weighted average fair value of the RSUs granted was C$3.11 (2020 – C$2.05) which was determined using the closing price of the Company’s common shares on their respective grant dates.

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Restricted share units (performance-based vesting)

The Company granted to certain executives and senior employees restricted share units with service and performance-based conditions for vesting (the “PRSUs”). If the Company’s share price increases to certain values for 20 consecutive trading days, as outlined below, a percentage of the PRSUs will vest at the end of the three-year service period. The grant date fair value of the PRSUs were valued using the Monte Carlo valuation method and determined to have a weighted average grant date fair value of C$3.27 (2020 – C$1.70).  

Deferred share units

The fair value of the liability and the corresponding expense is charged to profit or loss at the grant date. Subsequently, at each reporting date between the grant date and settlement date, the fair value of the liability is remeasured with any changes in fair value recognized in profit or loss for the year. DSUs outstanding at March 31, 2021 had a fair value of $1.2 million which is included in other liabilities on the balance sheet (December 31, 2020 – $0.9 million).

Performance share units

Under the terms of the PSU Plan, PSUs granted vest at the end of a three-year term. At the end of a three-year term, employees will be awarded cash at the discretion of the board of directors of the Company, calculated based on certain Adjusted EBITDA, total shareholder return, or revenue growth related to performance conditions.

The fair value of the liability and the expense attributable to the vesting period is charged to profit or loss at the grant date. Subsequently, at each reporting date between the grant date and settlement date, the fair value of the liability is remeasured with any changes in fair value recognized in profit or loss. As at March 31, 2021, outstanding PSUs had a fair value of $0.1 million which is included in other liabilities on the balance sheet (December 31, 2020 – $0.1 million).                  

Options         

The following summarizes options granted, exercised, forfeited and expired during the periods:   

In 2018, 1,725,000 stock options were granted to an executive with performance conditions for vesting. For 825,000 stock options, vesting is upon an increase in the Company’s share price to C$13.26, and for 900,000 stock options, vesting is upon an increase in the Company’s share price to C$19.89. These options were valued using the Monte Carlo valuation method and determined to have a weighted average grant fair value of C$2.14 on original grant. These awards were accounted for at the fair value attributable to the vesting period until October 9, 2019 when these were reclassified to equity accounting and were re-valued at a weighted average fair value of C$0.83.

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Range of exercise prices outstanding at March 31, 2021:

Dilutive Instruments

For the three months ended March 31, 2021, 4.8 million options (2020 – 5.6 million), 4.4 million RSUs and PRSUs (2020 – nil) and 11.0 million shares which would be issued if the principal amount were settled in our common shares at the quarter end share price (2020 – nil) were excluded from the diluted weighted average number of common shares calculation as their effect would have been anti-dilutive to the net loss per share.

8. REVENUE

In the following table, revenue is disaggregated by performance obligation and timing of revenue recognition. All revenue comes from contracts with customers. See Note 9 for the disaggregation of revenue by geographic region.

 DIRTT sells its products and services pursuant to fixed-price contracts, which generally have a term of one year or less. The transaction price used in determining the amount of revenue to recognize is based upon agreed contractual terms with the customer and is not subject to variability.

Revenue recognized at a point in time represents the majority of the Company’s sales and revenue is recognized when a customer obtains legal title to the product, which is when ownership of products is transferred to, or services are delivered to the contract counterparty. Revenue recognized over time is limited to installation and other services provided to customers and is recorded as performance obligations which are satisfied over the term of the contract.

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Contract Liabilities

Contract liabilities primarily relate to deposits received from customers and deferred revenue from license subscriptions. The balance of contract liabilities was higher as at March 31, 2021 compared to December 31, 2020 mainly due to the timing of orders and payments. Contract liabilities as at December 31, 2020 and 2019, respectively, totaling $1.5 million and $2.7 million were recognized as revenue during the three months ended March 31, 2021 and 2020, respectively.

Sales by Industry

The Company periodically reviews the growth of product and transportation revenue by vertical market to evaluate the success of industry-specific sales initiatives. The nature of products sold to the various industries is consistent and therefore review is focused on sales performance.

9. SEGMENT REPORTING

The Company has one reportable and operating segment and operates in two principal geographic locations - Canada and the United States. Revenue continues to be derived almost exclusively from projects in North America and predominantly from the United States, with periodic international projects from North American Distribution Partners. The Company’s revenue from operations from external customers, based on location of operations, and information about its non-current assets, is detailed below.

Revenue from external customers

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Non-current assets, excluding deferred tax assets

10. INCOME TAXES

As at March 31, 2021, the Company recorded a valuation allowance of C$3.6 million ($2.8 million) against deferred tax assets (“DTAs”) incurred during the quarter in its Canadian entity as the Company’s Canadian entity has experienced cumulative losses in recent years (December 31, 2020 – C$6.6 million or $5.2 million). Although earnings were positive in 2019, ongoing near-term uncertainties on the business caused by the COVID-19 pandemic and the related decline in business activity impacted the Canadian entity’s ability to generate earnings. Accordingly, it is not more likely than not that the Canadian entity’s DTAs will be utilized in the near term.

11. OTHER LIABILITIES

(1)The following table presents a reconciliation of the warranty and other provisions balance:

12. COMMITMENTS

As at March 31, 2021, the Company had outstanding purchase obligations of approximately $2.9 million related to inventory and property, plant and equipment purchases (December 31, 2020 – $3.2 million). As at March 31, 2021, the Company had undiscounted operating lease liabilities of $42.8 million (December 31, 2020 – $44.3 million).

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The following discussion and analysis of our financial condition and results of operations should be read together with our unaudited interim condensed consolidated financial statements and related notes and other financial information appearing in this Quarterly Report. This discussion contains forward-looking statements reflecting our current expectations and estimates and assumptions concerning events and financial trends that may affect our future operating results or financial position. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors, including those described under the headings “Risk Factors” and “Cautionary Statement Regarding Forward-Looking Statements” appearing elsewhere in this Quarterly Report.

Summary of Financial Results

Outlook  

On November 12, 2019, DIRTT unveiled a four-year strategic plan for the Company, based on three key pillars: commercial execution, manufacturing excellence, and innovation. Our long-term objective is to scale our operations to profitably capture the significant market opportunity created by driving conversion from conventional construction to DIRTT’s process of modular, prefabricated interiors. While the strategic plan was developed and introduced pre-pandemic, we believe it is as or even more relevant in the post-pandemic world. Furthermore, our execution of the plan to date positions us well as we move forward.

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Throughout 2020, we were able to mitigate the COVID-19 induced slowdown in overall construction activity through the completion of projects that were in progress when the pandemic started. With most of these projects delivered by the end of the fourth quarter of 2020, the first quarter of 2021 reflected the full impact of the slow down in non-residential construction activity on DIRTT’s business. We are seeing signs which suggest that revenues of $29.5 million in the first quarter of 2021 will be a low point in the pandemic. This view is supported by growing customer engagement through increased demand for tours, both virtual and in-person at our DIRTT Experience Centers (“DXC’s”), as well as increased project quoting activity. We continue to advance our strategic accounts strategy, with over 40 relationships in various stages of development in the first quarter compared to 35 at year-end.  

Accordingly, we anticipate revenues in the second quarter of 2021 will approach or return to the quarterly ranges experienced in the first half of 2020. The second quarter will benefit from the recognition of $2.0 million of revenue for COVID-19 vaccination trailers that were delivered to one customer in April. While we continue to see signs of a recovery commencing in the second half of 2021, the timing and magnitude of this recovery continues to be uncertain and is subject to a number of factors, both positive and negative as described further below.

From a macroeconomic viewpoint, we believe that non-residential construction market conditions are beginning to improve as reflected in several industry statistics, particularly in the United States where an accelerated vaccine distribution/rollout program has led some states to ease public health restrictions, and employers to begin the deliberate process of reoccupying their space. Conversely, Canada is experiencing a resurgence of active COVID-19 cases, the reintroduction of public health measures and a slower vaccine roll out, which we expect to continue to depress activity levels in the short term. The CEWS, which has been extended to June 2021, continues to provide some economic relief by partially funding our Canadian workforce costs. In addition, the 2021 federal budget includes the proposed extension of the CEWS to September 2021, subject to legislative implementation by Parliament.

In conventional construction, we are observing increases in the price of steel and wallboard as well as shortages of raw materials, including wallboard, negatively impacting project budgets and, in some cases, schedules. We believe that this has the potential to drive demand for DIRTT due to increasing price competitiveness of our solutions as well as our ability to help preserve schedules through our short lead times. Conversely, as DIRTT is installed in the final stages of a project, any delays in the pre-installation schedule could negatively impact the timing of DIRTT project delivery, including those in the second half of 2021, making forecasting revenue by specific quarter difficult.

Aluminum and medium density fiberboard, our two main raw materials, have also experienced some increase in price, but not to the same extent as steel and wallboard and we have largely been able to mitigate these increases through efficiency improvements in our manufacturing process. In addition and to date, we have not experienced any major raw material shortages, but we are actively monitoring supply conditions and seeking to maintain appropriate levels of inventory to mitigate such risk.

Our financial position, which we bolstered with a C$40.25 million issuance of convertible unsecured subordinated debentures in January 2021 for net proceeds of C$37.6 million or approximately $29.5 million, has allowed us to continue advancing the development of our commercial function. In the first quarter, we continued selective hiring, adding to our sales and strategic account representatives as well as our segment and solutions support specialists. The rollout of our Customer Relationship Management system to all of our sales representatives continues and is on track for completion by June 30, 2021. The construction of our Dallas DXC is well underway and is expected to open in the third quarter of 2021. Lastly, we continued to identify and establish relationships with potential new Distribution Partners in underserved regions as well as progressing the onboarding of new partners.

In our manufacturing operations, we have deliberately retained our manufacturing capabilities despite temporarily low activity levels. Gross margin in the first quarter reflects this approach which includes the impacts of $1.8 million of costs of over capacity as well as the negative impact of fixed costs on low production volumes. While we mitigated the impact of low activity levels on labor costs to the extent possible through the use of furlough days, we were unable to absorb the entire impact. As activity improves, we expect gross margins to improve due to the decrease in excess labor capacity and leveraging of fixed costs.  

We recently began commissioning our new tile manufacturing facility in South Carolina (the “South Carolina Facility”), and it began producing saleable tiles in April 2021. The South Carolina Facility is scheduled for full commissioning in early June 2021. This new facility, which is highly automated, operates with approximately one-sixth the labor requirement of the similar production capacity in Calgary, reduces single plant risk and increases our total tile production capacity. The South Carolina Facility’s physical proximity to customers located on the East Coast results in an improvement of up to four days in shipping time with commensurate reductions in freight costs for the end customer.

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Net working capital at March 31, 2021 was $70.5 million compared to $53.5 million at December 31, 2020.  This includes $58.7 million of cash on hand compared to $45.8 million at December 31, 2020. The increase in cash on hand reflects $29.5 million of net proceeds from the issuance of Debentures in January 2021 offset by cash used in operations of $12.1 million and capital expenditures of $3.6 million. In February 2021, we completed the conversion of our cashflow-based credit facility to an asset backed credit facility to provide incremental working capital financing should it be necessary in the future. Subsequent to quarter end, we completed a $7.2 million draw of our U.S. Leasing Facility primarily related to our South Carolina Facility and anticipate drawing an additional three to four million during the second or third quarter. We expect capital expenditures for the balance of 2021 to be approximately $10.4 million.  

While we believe the first quarter sales represented a low point in the pandemic, the strength of our balance sheet and the incremental steps we have taken to bolster liquidity give us the confidence to continue the execution of our strategic plan with the continued expectation of a recovery in the second half of 2021, along with increased flexibility should the recovery take longer than expected.  

Non-GAAP Financial Measures

Note Regarding Use of Non-GAAP Financial Measures

Our condensed consolidated interim financial statements are prepared in accordance with GAAP. These GAAP financial statements include non-cash charges and other charges and benefits that we believe are unusual or infrequent in nature or that we believe may make comparisons to our prior or future performance difficult.

As a result, we also provide financial information in this Quarterly Report that is not prepared in accordance with GAAP and should not be considered as an alternative to the information prepared in accordance with GAAP. Management uses these non-GAAP financial measures in its review and evaluation of the financial performance of the Company. We believe that these non-GAAP financial measures also provide additional insight to investors and securities analysts as supplemental information to our GAAP results and as a basis to compare our financial performance period over period and to compare our financial performance with that of other companies. We believe that these non-GAAP financial measures facilitate comparisons of our core operating results from period to period and to other companies by removing the effects of our capital structure (net interest income on cash deposits, interest expense on outstanding debt and debt facilities, or foreign exchange movements), asset base (depreciation and amortization), the impact of under-utilized capacity on gross profit, tax consequences and stock-based compensation. We remove the impact of all foreign exchange from Adjusted EBITDA. Foreign exchange gains and losses can vary significantly period-to-period due to the impact of changes in the U.S. and Canadian dollar exchange rates on foreign currency denominated monetary items on the balance sheet and are not reflective of the underlying operations of the Company. We remove the impact of under-utilized capacity from gross profit, and fixed production overheads are allocated to inventory on the basis of normal capacity of the production facilities. In periods where production levels are abnormally low, unallocated overheads are recognized as an expense in the period in which they are incurred. In addition, management bases certain forward-looking estimates and budgets on non-GAAP financial measures, primarily Adjusted EBITDA.

Government subsidies, depreciation and amortization, stock-based compensation expense, and foreign exchange gains and losses are excluded from our non-GAAP financial measures because management considers them to be outside of the Company’s core operating results, even though some of those expenses may recur, and because management believes that each of these items can distort the trends associated with the Company’s ongoing performance. We believe that excluding these expenses provides investors and management with greater visibility to the underlying performance of the business operations, enhances consistency and comparativeness with results in prior periods that do not, or future periods that may not, include such items, and facilitates comparison with the results of other companies in our industry.

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The following non-GAAP financial measures are presented in this Quarterly Report, and a description of the calculation for each measure is included.

You should carefully evaluate these non-GAAP financial measures, the adjustments included in them, and the reasons we consider them appropriate for analysis supplemental to our GAAP information. Each of these non-GAAP financial measures has important limitations as an analytical tool due to exclusion of some but not all items that affect the most directly comparable GAAP financial measures. You should not consider any of these non-GAAP financial measures in isolation or as substitutes for an analysis of our results as reported under GAAP. You should also be aware that we may recognize income or incur expenses in the future that are the same as, or similar to, some of the adjustments in these non-GAAP financial measures. Because these non-GAAP financial measures may be defined differently by other companies in our industry, our definitions of these non-GAAP financial measures may not be comparable to similarly titled measures of other companies, thereby diminishing their utility.

 EBITDA and Adjusted EBITDA for the Three Months Ended March 31, 2021 and 2020

The following table presents a reconciliation for the first quarter results of 2021 and 2020 of EBITDA and Adjusted EBITDA to our net income (loss), which is the most directly comparable GAAP measure for the periods presented:

For the three months ended March 31, 2021, Adjusted EBITDA and Adjusted EBITDA Margin decreased to $11.4 million loss or (38.6)%, respectively, from a $5.5 million loss or (13.4)% in the same period of 2020, respectively. This reflects an $8.4 million decrease in Adjusted Gross Profit and $0.3 lower costs of underutilized capacity, discussed below. Reductions in Adjusted EBITDA were partially offset by lower professional fees, reduced

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commissions on lower revenues and cost reductions as a result of reduced activity related to COVID-19. Additionally, in the first quarter of 2020, we increased our provision for expected credit losses by $0.6 million.

Adjusted Gross Profit and Adjusted Gross Profit Margin for the Three Months Ended March 31, 2021 and 2020

The following table presents a reconciliation for the three months ended March 31, 2021 and 2020 of Adjusted Gross Profit to our gross profit, which is the most directly comparable GAAP measure for the periods presented:

Gross profit and gross profit margin decreased to $3.4 million or 11.4% for the three months ended March 31, 2021, from $11.3 million or 27.6% for the three months ended March 31, 2020. Adjusted Gross Profit and Adjusted Gross Profit Margin decreased to $7.2 million or 24.3% for the three months ended March 31, 2021, from $15.6 million or 38.0% for the three months ended March 31, 2020. The decreases are largely due to reduced fixed cost leverage caused by reductions in revenues partially offset by $0.5 million of related severance costs incurred during the first quarter of 2020.

During the fourth quarter of 2019, we determined that we were carrying abnormal excess capacity in our manufacturing facilities as a result of the slowdown in sales and determined certain production overheads should be directly expensed in cost of sales, representing production overheads that were not attributable to production. In the first quarter of 2020, we separately classified $2.0 million as costs related to our under-utilized capacity (1.2% of gross profit margin) in cost of sales. We took steps to manage our excess capacity, including the reduction in staffing by 14%, with a further 12% reduction in April 2020, and the undertaking of planned factory curtailments. The staffing reductions realigned our capacity with expected activity levels; however, our fixed costs will affect our Adjusted Gross Profit Margin, which we expect to remain below historical percentages until sales improve. Between January and April 2020, we reduced our manufacturing workforce by 25% to bring labor capacity in line with expected ongoing requirements. In the first quarter of 2021, we experienced the full impact of the slowdown in non-residential construction activity on our business. In anticipation of a recovery in demand for our products and services in the second half of 2021 and to preserve our skilled workforce, we deliberately maintained manufacturing headcount, while implementing selective furlough days, in the first quarter of 2021 despite the shortfall in revenues relative to capacity. As a result, in the first quarter of 2021 we separately classified $1.8 million as costs related to our under-utilized capacity (6% of gross profit margin) in cost of sales.

Following the completion of third-party testing in 2019, we determined that timber included in certain projects installed between 2016 and 2019 potentially did not meet the fire-retardant specifications under which the projects were sold. As a result, we recorded a $2.5 million provision in the fourth quarter of 2019 and began contacting customers to determine whether remedial actions are required. In the second quarter of 2020, we identified and validated an in-situ solution that we believe will meet the fire-retardant specification under which the projects were sold and reduced the associated provision to $1.3 million, which represents expected costs to prepare impacted sites and apply the in-situ solution. In the third quarter of 2020, we completed building code reviews of the affected projects and determined that the timber as installed met the requisite building code requirements as it related to fire retardance. During the fourth quarter of 2020, we further reduced our timber provision by $0.5 million as we believe this reduces any obligation to remediate previously installed projects. Additionally, we entered into agreements with certain customers to compensate them for product charges not fulfilled. During the quarter ended March 31, 2021, we incurred no costs (2020 – $0.1 million) associated with remediating previously installed timber projects.

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Results of Operations

Three Months Ended March 31, 2021, Compared to Three Months Ended March 31, 2020

Revenue

Revenue reflects sales to our Distribution Partners for resale to their clients and, in limited circumstances, our direct sales to clients. Our revenue is generally affected by the timing of when orders are executed, particularly large orders, which can add variability to our financial results and shift revenue between quarters.

The following table sets forth the contribution to revenue of our DIRTT product and service offerings: