Honest Company, Inc. (HNST) FY 2021 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion, particularly information with respect to our future results of operations or financial condition, business strategy and plans, and objectives of management for future operations, includes forward-looking statements that involve risks and uncertainties as described under the heading “Special Note Regarding Forward-Looking Statements” in this Annual Report on Form 10-K. You should review the disclosure under the heading “Risk Factors” in this Annual Report on Form 10-K for a discussion of important factors that could cause our actual results to differ materially from those anticipated in these forward-looking statements. Unless the context otherwise requires, all references in this Annual Report on Form 10-K to “we,” “us,” “our,” “our company,” and “Honest” refer to The Honest Company, Inc. and its consolidated subsidiaries.
A discussion regarding our financial condition and results of operations for the year ended December 31, 2021 compared to the year ended December 31, 2020 is presented below. A discussion regarding our financial condition and results of operations for the year ended December 31, 2020 compared to the year ended December 31, 2019 can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the final prospectus for our initial public offering (“IPO”) dated as of May 4, 2021 and filed with the Securities and Exchange Commission (“SEC”) pursuant to Rule 424(b)(4) on May 6, 2021.
Overview
The Honest Company, Inc. (“Honest” and, together with its consolidated subsidiaries, the “Company,” “we,” “us” and “our”) is a digitally-native, mission-driven brand focused on leading the clean lifestyle movement, creating a community for conscious consumers and seeking to disrupt multiple consumer product categories. Our commitment to our core values, continual innovation and engaging our community has differentiated and elevated our brand and our products. Since our launch in 2012, we have been dedicated to developing clean, sustainable, effective and thoughtfully-designed products. By doing so with transparency, we have cultivated deep trust around what matters most to our consumers: their health, their families and their homes. We are an omnichannel brand, ensuring our products are available wherever our consumers shop. Our differentiated platform positions us for continued growth through our trusted brand, award-winning multi-category product offerings, deep digital-first connection with consumers and omnichannel accessibility.
Our integrated multi-category product architecture is intentionally designed to serve our consumers every day, at every age and through every life stage, no matter where they are on their journey. Our three categories are Diapers and Wipes, Skin and Personal Care, and Household and Wellness, which represented 63%, 32%, and 5%, respectively, of our revenue for the year ended December 31, 2021, compared to 63%, 26%, and 11%, respectively, of our revenue for the year ended December 31, 2020. We refer to Diapers and Wipes and Skin and Personal Care as our "core" product categories. At the center of our product ecosystem are our diapers, which are a strategic consumer acquisition tool that acts as an entry point for our portfolio, as new parents often go on to purchase products from our other categories for their everyday family needs. Our integrated multi-category product architecture is designed to drive loyalty, increase our consumer wallet share and generate attractive consumer lifetime value.
We believe that our consumers are modern, aspirational, conscious and style-forward and that they seek out high quality, effective and thoughtfully-designed products. We believe that they are passionate about living a conscious life and are enthusiastic ambassadors for brands they trust. As purpose-driven consumers, they transcend any one demographic, spanning gender, age, geography, ethnicity and household income. Honest consumers are often young, mobile-centric and digitally-inclined. We build relationships with these consumers through a disruptive digital marketing strategy that engages them with “snackable” digital content (short-form, easily digestible content), immerses them in our brand values, and inspires them to join the Honest community. Our direct connection with our community enables us to understand what consumers’ needs are and inspires our product innovation pipeline, generating a significant competitive advantage over more traditional consumer packaged goods, or CPG, peers.
Our omnichannel approach seeks to meet consumers however they want to shop, balancing deep consumer connection with broad convenience and accessibility. Since our launch, we have built a well-integrated omnichannel presence by expanding our retail accessibility across both Digital and Retail channels, including the launch of strategic partnerships with Costco, Target and Amazon in 2013, 2014 and 2017, respectively. For the year ended December 31, 2021, we generated 49% and 51% of our revenue from our Digital and Retail channels, respectively, compared to 55% and 45%, respectively, for the year ended December 31, 2020. We maintain direct relationships with our consumers via our flagship digital platform, Honest.com, which allows us to influence brand experience and better understand consumer preferences and behavior. We increase accessibility of our products to more consumers through both the third-party pureplay ecommerce sites that, with Honest.com, comprise the rest of our Digital channel, and our Retail channel, which includes leading retailers and their websites. As of December 31, 2021, our
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products can be found in approximately 43,000 retail locations across the United States, Canada and Europe. This distinctive business model has allowed us to efficiently scale our business while remaining agnostic as to the channel where consumers purchase our products. Our integrated omnichannel presence provides meaningful benefits to our consumers which we believe is not easily replicated by our competitors.
Initial Public Offering
On May 7, 2021, we completed our IPO of 25,807,000 shares of our common stock at a stock price of $16.00 per share, resulting in aggregate net proceeds to us of approximately $91.0 million, after deducting the underwriting discount and commissions of $6.7 million and offering expenses of $5.5 million. We sold 6,451,613 shares and certain existing stockholders sold an aggregate of 19,355,387 shares. We granted the underwriters an option for a period of 30 days to purchase up to an additional 3,871,050 shares of common stock from the selling stockholders at $16.00 per share less the underwriting discounts and commissions. In May 2021, the underwriters fully exercised the option to purchase these additional shares from the selling stockholders. We did not receive any proceeds from the sale of shares of our common stock by the selling stockholders.
Key Factors Affecting Our Performance
We believe that the growth of our business and our future success are dependent on many factors. While each of these factors presents significant opportunities for us, they also pose important challenges that we must successfully address to enable us to sustain the growth of our business and improve our operations while staying true to our mission, including those discussed below and in the section of this Annual Report on Form 10-K titled “Item 1A. Risk Factors.”
Ability to Grow Our Brand Awareness
Our brand is integral to the growth of our business and is essential to our ability to engage and stay connected with the growing clean lifestyle consumer. Honest is still unknown to many consumers, with unaided brand awareness of 29% among diaper buyers according to our consumer research as of January 2022. In order to increase the wallet share of existing conscious consumers and attract new ones, our brand has to maintain its trustworthiness and authenticity. Our ability to attract new consumers will depend, among other things, on our ability to successfully produce products that are free of defects and communicate the value of those products as clean, sustainable and effective, the efficacy of our marketing efforts and the offerings of our competitors. Beyond preserving the integrity of our brand, our performance will depend on our ability to augment our reach and increase the number of consumers aware of Honest and our product portfolio. We believe our brand strength will enable us to continue to expand across categories and channels, allowing us to deepen relationships with consumers and expand our access to global markets. Our performance depends significantly on factors that may affect the level and pattern of consumer spending in the product categories in which we operate.
Continued Innovation
Research, development and innovation are core elements underpinning our growth strategy. Through our in-house research and development laboratories, we are able to access the latest advancements in clean ingredients and continue to innovate in the clean conscious lifestyle space. Based in Los Angeles, California, our research and development team, including chemists and an in-house toxicologist, develops innovative clean products based on the latest green technology. At Honest, product innovation never stops. The improvement of existing products and the introduction of new products have been, and continue to be, integral to our growth. We have made significant investments in our product development capabilities and plan to do so in the future. We believe our rigorous approach to product innovation has helped redefine and grow the clean and natural product categories in which we operate. Our continued focus on research and development will be central to attracting and retaining consumers in the future. Our ability to successfully develop, market and sell new products will depend on a variety of factors, including our continued investment in innovation, integrated business planning processes and capabilities.
We use connectivity to our community of consumers to provide lifestyle insights that power innovation across categories. We use innovation to support our growth objectives across our portfolio, as highlighted in the three core pillars of our Innovation Framework; that we bring product innovation that 1) feeds and nurtures our core values, 2) expands within our existing product categories, and 3) grows into new potential product categories adjacent to existing categories that fit with our value proposition to the consumer.
We continue to innovate in each of our product categories in areas such as breakthrough new product formulations, innovative packaging, costovation (defined below) and marketing strategy, with a focus in the future of driving “big bets” across potential product adjacencies where we have; 1) permission to play with consumers, 2) relevant domain expertise, and 3) the opportunity to expand across a broader consumer demographic within an existing Honest home. We are also focused on building a portfolio of products in complementary categories through our Innovation Strategy and the momentum created by our Digital Strategy. We are building an Honest community with the goal of creating a more holistic clean, conscious home for consumers
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and customers alike. We strive for continuous improvement in our existing products’ safety, sustainability, efficacy and design profile, which we refer to as costovation.
Continued Product Category Growth
Our product mix is a driver of our financial performance given our focus on accretive product launches and innovation to increase product margins. Even though our growth strategy aims to boost sales across all categories, we intend to prioritize growth in Skin and Personal Care given its attractive margin characteristics and leverage our brand equity and consumer insights to extend into new adjacent product categories. Since we launched our Innovation Strategy, we have enhanced our product portfolio by strategically discontinuing certain products and making calculated extensions within our three product categories. These product changes have contributed to our revenue and margin growth.
Continued Execution of Omnichannel Strategy
The continued execution of our omnichannel strategy impacts our financial performance. We intend to continue leveraging our marketing strategy to drive increased consumer traffic to our flagship digital platform, Honest.com, as it is a valuable tool for creating direct connections with our consumers, influencing brand experience and understanding consumer preference and behavior. Our partnerships with leading third-party retail platforms and national retailers have broadened our consumer reach, raised our brand awareness and enhanced our margins through operating leverage. We will continue to pursue partnerships with a wide variety of retailers, including online retailers, big-box retailers, grocery stores, drugstores and specialty retailers. Our ability to execute this strategy will depend on a number of factors, such as retailers’ satisfaction with the sales and profitability of our products, channel shifts of their customers, and their own supply chain, order timing, and inventory needs, which may fluctuate from period to period. In the second quarter of 2021, we experienced volatility in orders from a key digital partner that reduced its inventory on-hand in consumables to free up space for other products ahead of a major promotional event. In the third quarter of 2021, orders from this key digital partner came back in line with end-consumer consumption, although we have not seen inventory levels at this customer return to prior levels. We have a new arrangement with this digital partner and beginning with the third quarter of 2021 this partner began to fulfill orders to their customers from a dedicated space within our warehouse, which allows them to free up space in their own warehouse and accelerate shipment time to the end consumer.
Operational and Marketing Efficiency
To grow our business, we intend to continue to improve our operational and marketing efficiency, which includes attracting new consumers, increasing community engagement and improving fulfillment and distribution operations. We invest significant resources in marketing and content generation, use a variety of brand and performance marketing channels and work continuously to improve brand exposure at our retail partners to acquire new consumers. It is important we maintain reasonable costs for these marketing efforts relative to the revenue we expect to derive from our consumers. We leverage our proprietary Honest Omni-Analytics to generate valuable consumer insights that guide our omnichannel strategy and inform our marketing spend optimization. Our future success depends in part on our ability to effectively attract consumers on a cost-efficient basis and achieve efficiencies in our operations.
Our paid advertising includes search engine marketing, display, paid social media and product placement and traditional advertising, such as direct mail, television, radio and magazine advertising. Our paid advertising significantly increased in 2021 compared to 2020, which impacted our ability to cost-effectively drive traffic to Honest.com and contributed to the decline in Digital revenue in 2021 compared to 2020. We drive a significant amount of traffic to our website via search engines and, therefore, rely heavily on search engines. We expect continued price increases in our paid advertising that may impact marketing efficiencies, costs and revenue in our Digital channel in the future.
Overall Macro Trends
We have strategically positioned ourselves to benefit from several macro trends related to changes in consumer behavior. We believe consumers’ increasing interest in a conscious lifestyle has contributed to significant demand for our products. Further, the rise in digital shopping has complemented our flagship digital platform, Honest.com, our presence with third-party ecommerce players and our Retail partners’ websites. In 2021, we saw a significant shift from Digital to Retail as more consumers became vaccinated and chose to return to in-store shopping. Changes in macro-level consumer spending trends, including as a result of the COVID-19 pandemic, have resulted and could in the future result in fluctuations in our operating results.
Impact of COVID-19
The COVID-19 pandemic caused general business disruption worldwide beginning in January 2020. The full extent to which the COVID-19 pandemic will directly or indirectly impact our cash flow, business, financial condition, results of operations and prospects will depend on future developments that are uncertain.
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Business Operations
As a result of the COVID-19 pandemic, our headquarters was temporarily closed but has since reopened in a limited capacity. We have also implemented travel restrictions. These actions represent a significant change in how we operate our business, but we believe that we successfully navigated this transition. In an effort to provide a safe work environment for our employees, we have implemented various social distancing measures, including replacing many in-person meetings with virtual interactions. We will continue to take actions as may be required or recommended by government or health authorities or as we determine are in the best interests of our employees and other business partners in light of the pandemic.
The operations of our retail partners, manufacturers and suppliers have also been impacted by the COVID-19 pandemic. While the duration and extent of the COVID-19 pandemic depends on future developments that cannot be accurately predicted at this time, it has already had an adverse effect on the global economy and the ultimate societal and economic impact of the COVID-19 pandemic remains unknown. In particular, the conditions caused by this pandemic may negatively impact collections of accounts receivable and reduce expected spending from new consumers, all of which could adversely affect our business, financial condition, results of operations and prospects in the future.
Supply Chain Disruptions
We have experienced some impacts on our inventory availability and delivery capacity since the outbreak, which to date has not materially impacted our ability to service our consumers and retail and third-party ecommerce customers. In the fourth quarter of 2021, we experienced lower than expected inventory receipts due largely to global supply chain delays, including a delay in receiving shipments from overseas. We have taken measures to bolster key aspects of our supply chain, such as ensuring sufficient inventory to support our continued growth in the face of the pandemic. As a result of the COVID-19 pandemic and other macroeconomic trends, we and our distribution partners have experienced some disruptions to the operations of our fulfillment centers, including a nationwide truck driver shortage. For example, during the fourth quarter of 2021, some employees at two of our warehouse facilities were ill with COVID-19 and/or following quarantine protocols, which coupled with the nationwide truck driver shortage, negatively impacted our and our distribution partner's ability to fulfill orders in a timely manner and had a negative impact on our results of operations.
We continue to work with our existing manufacturing, logistics and other supply chain partners to ensure our ability to service our consumers and retail and third-party ecommerce customers. We have experienced and anticipate to see an increase in commodity prices, labor costs, input costs and transportation costs that has continued into 2022. For example, some of our contracts with third-party manufacturers have clauses that trigger good faith renegotiation of purchase costs in the case of significant raw material cost escalation. In the fourth quarter of 2021, we were informed by two third-party manufacturers in our Diapers and Wipes and Skin and Personal Care categories that those hurdles had been met. As a result, we negotiated and agreed to higher purchase prices which will negatively impact our cost of goods in 2022. We implemented price increases in 2021 and plan to pursue productivity initiatives to offset these price increases, but we experienced forward buys by a number of customers in the fourth quarter of 2021 in response to our announced price increases and also expect continued input cost inflation in 2022 that will hamper our ability to drive margin expansion.
Consumer Preferences
We believe that during 2020, COVID-19 drove a demand shift towards our Digital channel as consumers shifted to online shopping amid the pandemic. Additionally, in 2020 our Household and Wellness product category benefited from increasing demand for sanitization and disinfecting products. In response, we accelerated our development timeline for certain product launches, launching our disinfecting spray and alcohol wipes in 2020. In 2021, we saw a decline in consumer demand for sanitization and disinfecting products, coupled with retailers managing heavy inventories of these products in stores. Toward the end of 2021, we began to see increased consumer willingness to return to in-store shopping as the economy reopens and more of the population is vaccinated, driving revenue growth within our Retail channel, specifically within our Diapers and Wipes and Skin and Personal Care product categories in 2021.
Inventory
The appropriate level of our inventory reserve is based on current and forecasted demand. For example, based on macro Household & Wellness trends, consumer demand for sanitizing and disinfecting products has decelerated at a more rapid than expected rate as more consumers have become vaccinated and retailers continue to manage heavy inventories of sanitization and disinfecting products in stores. We recorded an inventory write-off of $5.6 million throughout the year relating to certain sanitization and disinfecting products as the amount of inventory was significantly in excess of existing demand. Management is implementing various strategies to address this reduction in demand and the related impact on gross margin, including higher markdowns and promotions to clear through inventory, liquidation efforts, investing in new product ideas and developing new creative advertising. There is no guarantee that customer demand will increase in our favor or that we will be able to successfully
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implement these strategies. Depending on future consumer behavior in relation to changes in the COVID-19 pandemic and related aging of inventory, among other factors, we may incur additional inventory write-downs and customer returns.
Components of Results of Operations
Revenue
We generate revenue through the sale of our products through Digital and Retail channels in the following product categories: Diapers and Wipes, Skin and Personal Care, and Household and Wellness. The Digital channel includes direct sales to the consumer through our website and sales to third-party ecommerce customers, who resell our products through their own online platforms. The Retail channel includes sales to traditional brick and mortar retailers, who may also resell our products through their own online platforms. Our revenue is recognized net of allowances for returns, discounts, credits and any taxes collected from consumers.
In 2019, we entered into a license agreement with Butterblu, LLC, or Butterblu, pursuant to which we license certain of our trademarks to Butterblu for the manufacture and distribution of certain baby apparel products in exchange for royalties. Butterblu operates and maintains our baby apparel offerings independently through the honestbabyclothing.com website. Our baby apparel offerings and our agreement with Butterblu are not currently material to our business and not expected to be material in the future. For the year ended December 31, 2021, we collected $0.9 million in royalty revenue. For the year ended December 31, 2020, we did not collect any royalty revenue under this agreement due in part because we granted Butterblu temporary payment relief.
Cost of Revenue
Cost of revenue includes the purchase price of merchandise sold to customers, inbound and outbound shipping and handling costs, freight and duties, shipping and packaging supplies, credit card processing fees and warehouse fulfillment costs incurred in operating and staffing warehouses, including rent. Cost of revenue also includes depreciation and amortization for warehouse fulfillment facilities and equipment, allocated overhead and direct and indirect labor for warehouse personnel.
Gross Profit and Gross Margin
Gross profit represents revenue less cost of revenue. Gross margin is gross profit expressed as a percentage of revenue. Our gross margin may in the future fluctuate from period to period based on a number of factors, including the mix of products we sell, the channel through which we sell our products, the innovation initiatives we undertake in each product category, the promotional environment in the marketplace, manufacturing costs, commodity prices and transportation rates, among other factors.
Operating Expenses
Our operating expenses consist of selling, general and administrative, marketing and research and development expenses.
Selling, General and Administrative
Selling, general and administrative expenses consist primarily of personnel costs, principally for our selling and administrative functions. These include personnel-related expenses, including salaries, bonuses, benefits and stock-based compensation expense. Selling, general and administrative expenses also include technology expenses, professional fees, facility costs, including insurance, utilities and rent relating to our headquarters, depreciation and amortization and overhead costs. We expect our general and administrative expenses to increase in absolute dollars as we continue to grow our business and organizational capabilities. Since our IPO, we have also incurred additional costs for employees and third-party professional fees related to operating as a public company and costs to comply with the rules and regulations applicable to companies listed on a national securities exchange, costs related to compliance and reporting obligations, and increased expenses for insurance, investor relations and professional services.
Marketing
Marketing expenses include costs related to our branding initiatives, retail customer marketing activities, point of purchase displays, targeted online advertising through sponsored search, display advertising, email and influencer marketing campaigns, market research, content production and other public relations and promotional initiatives. We expect marketing expenses to continue to increase in absolute dollars as we continue to expand brand awareness, introduce new product innovation across multiple product categories and implement new marketing strategies.
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Research and Development
Research and development expenses consist primarily of personnel-related expenses for our research and development team. Research and development expenses also include costs incurred for the development of new products, improvement in the quality of existing products and the development and implementation of new technologies to enhance the quality and value of products. This includes the expense related to claims and clinical trials as well as formulation and packaging testing. Research and development expenses also include allocated depreciation and amortization and overhead costs. We expect research and development expenses to increase in absolute dollars as we invest in the enhancement of our product offerings through innovation and the introduction of new adjacent product categories.
IPO-Related Expenses
In December 2020, we paid bonuses totaling $9.5 million to certain employees, including members of management, relating to preparation of our IPO, and after the closing of the IPO, we paid an additional $9.5 million in bonuses to certain employees, including members of management, which we collectively refer to as the IPO Bonuses, excluding in each case payroll taxes and expenses. The IPO Bonuses were recognized in selling, general and administrative and research and development expense. In addition, upon the effective date of the registration statement for our IPO in May 2021, we recognized stock-based compensation expense in selling, general and administrative and research and development expenses of $3.1 million related to certain performance and market-based stock options and $0.2 million related to certain restricted stock units that vested upon this liquidity event.
Interest and Other Income (Expense), Net
Interest income consists primarily of interest income earned on our short-term investments and our cash and cash equivalents balances. Interest expense consists primarily of the portion of rent payments recognized as imputed interest expense under build-to-suit accounting associated with our leasing arrangements.
Other income (expense), net consists primarily of our foreign currency exchange gains and losses relating to transactions denominated in currencies other than the U.S. dollar. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in both the volume of foreign currency transactions and foreign currency exchange rates.
Income Tax Provision
We are subject to federal and state income taxes in the United States. Our annual estimated tax rate differed from the U.S. federal statutory rate of 21% primarily as a result of a valuation allowance against deferred tax assets, stock-based compensation, state taxes, nondeductible executive compensation and other permanent differences. We maintain a full valuation allowance for our federal and state deferred tax assets, including net operating loss carryforwards, as we have concluded that it is not more likely than not that the deferred tax assets will be realized.
Results of Operations
The following table sets forth our consolidated statements of operations data for each of the periods indicated:
| For the year ended December 31, | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | |||||||||
| (In thousands) | ||||||||||
| Revenue | $ | 318,639 | $ | 300,522 | ||||||
| Cost of revenue | 209,467 | 192,626 | ||||||||
| Gross profit | 109,172 | 107,896 | ||||||||
| Operating expenses | ||||||||||
| Selling, general and administrative(1) | 84,059 | 71,253 | ||||||||
| Marketing | 54,260 | 44,478 | ||||||||
| Research and development(1) | 7,679 | 5,705 | ||||||||
| Total operating expenses | 145,998 | 121,436 | ||||||||
| Operating loss | (36,826) | (13,540) | ||||||||
| Interest and other income (expense), net | (1,776) | (837) | ||||||||
| Loss before provision for income taxes | (38,602) | (14,377) | ||||||||
| Income tax provision | 77 | 89 | ||||||||
| Net loss | $ | (38,679) | $ | (14,466) |
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(1) Includes stock-based compensation expense as follows:
| For the year ended December 31, | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | |||||||||
| (In thousands) | ||||||||||
| Selling, general and administrative | $ | 15,820 | $ | 7,558 | ||||||
| Research and development | 1,027 | 347 | ||||||||
| Total | $ | 16,847 | $ | 7,905 |
The following table sets forth our consolidated statements of operations data expressed as a percentage of revenue*:
| For the year ended December 31, | ||||||||
|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | |||||||
| (as a percentage of revenue) | ||||||||
| Revenue | 100.0 | % | 100.0 | % | ||||
| Cost of revenue | 65.7 | 64.1 | ||||||
| Gross profit | 34.3 | 35.9 | ||||||
| Operating expenses | ||||||||
| Selling, general and administrative | 26.4 | 23.7 | ||||||
| Marketing | 17.0 | 14.8 | ||||||
| Research and development | 2.4 | 1.9 | ||||||
| Total operating expenses | 45.8 | 40.4 | ||||||
| Operating loss | (11.6) | (4.5) | ||||||
| Interest and other income (expense), net | (0.6) | (0.3) | ||||||
| Loss before provision for income taxes | (12.1) | (4.8) | ||||||
| Income tax provision | — | — | ||||||
| Net loss | (12.1) | % | (4.8) | % |
* Amounts may not sum due to rounding.
Comparison of the Year Ended December 31, 2021 and 2020
Revenue
| For the year ended December 31, | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ change | % change | |||||||||||||||||||
| (In thousands, except percentages) | ||||||||||||||||||||||
| By Product Category | ||||||||||||||||||||||
| Diapers and Wipes | $ | 200,923 | $ | 188,452 | $ | 12,471 | 6.6 | % | ||||||||||||||
| Skin and Personal Care | 101,697 | 79,542 | 22,155 | 27.9 | ||||||||||||||||||
| Household and Wellness | 16,019 | 32,528 | (16,509) | (50.8) | ||||||||||||||||||
| Total Revenue | $ | 318,639 | $ | 300,522 | $ | 18,117 | 6.0 | % |
| For the year ended December 31, | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ change | % change | |||||||||||||||||||
| (In thousands, except percentages) | ||||||||||||||||||||||
| By Channel | ||||||||||||||||||||||
| Digital | $ | 157,546 | $ | 166,733 | $ | (9,187) | (5.5) | % | ||||||||||||||
| Retail | 161,093 | 133,789 | 27,304 | 20.4 | ||||||||||||||||||
| Total Revenue | $ | 318,639 | $ | 300,522 | $ | 18,117 | 6.0 | % |
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Revenue was $318.6 million for the year ended December 31, 2021, as compared to $300.5 million for the year ended December 31, 2020. The increase of $18.1 million, or 6.0%, was primarily due to a $22.2 million increase in revenue from Skin and Personal Care products and a $12.5 million increase in revenue from Diapers and Wipes, offset by a $16.5 million decrease in revenue from Household and Wellness products. The revenue increase from Skin and Personal Care was primarily driven by increased sales volume on our products across the Retail channel as a result of continued investment in marketing innovation, our Content, Community, Commerce marketing strategy, expanded distribution and merchandising programs with our retail partners and improved retail unit volume, including $4.2 million through the non-monetary sale of our legacy beauty inventory in exchange for future marketing and transportation credits. The revenue increase in Diapers and Wipes was primarily driven by the increase in sales volume of our diaper business, especially in the Retail Channel, driven by our new Clean Conscious Diaper product offering launched in the first quarter of 2021, offset by a decline in wipes revenue largely due to out-of-stocks driven by supply chain challenges. The revenue decrease in Household and Wellness during the year ended December 31, 2021 was primarily due to a decrease in overall consumer demand for sanitization and disinfecting products as more consumers became vaccinated against COVID-19, as well as the discontinuation of non-recurring retail rotational program that occurred during the fourth quarter of 2020.
Revenue growth increased in our Retail channel for the year ended December 31, 2021, compared to the year ended December 31, 2020, primarily due to the continued channel shift to Retail as sales across products saw higher volumes with our retail partners as more consumers became vaccinated against COVID-19 and returned to in-store shopping. In addition to this shift, we also saw continued retail distribution expansion, additional merchandising programs and overall increases in retail unit volume with our retail partners. The reduction in revenue in our Digital channel was primarily due to the Retail channel shift, lower traffic to our Digital platforms including Honest.com, in the year ended December 31, 2021, and a reduction in inventory on-hand by a key digital partner who reduced inventory in consumables in the second quarter of 2021 to free up space for other products ahead of a major promotional event.
Cost of Revenue and Gross Profit
| For the year ended December 31, | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ change | % change | |||||||||||||||||||
| (In thousands, except percentages) | ||||||||||||||||||||||
| Cost of revenue | $ | 209,467 | $ | 192,626 | $ | 16,841 | 8.7 | % | ||||||||||||||
| Gross profit | $ | 109,172 | $ | 107,896 | $ | 1,276 | 1.2 | % |
Cost of revenue was $209.5 million for the year ended December 31, 2021, as compared to $192.6 million for the year ended December 31, 2020. The increase of $16.8 million, or 8.7%, was primarily due to increased product costs and fulfillment expenses associated with the increased sales of our products, in part related to overall inflationary pressures which has resulted in an increase in the price of raw materials, a $5.6 million increase in inventory write-down related to certain household products for which demand significantly declined subsequent to the demand we saw in 2020 due to the COVID-19 pandemic. Cost of revenue as a percentage of revenue increased by 164 basis points primarily due to the inventory write-down on sanitization, disinfecting and other COVID-19 driven products which reflected 174 basis points of the increase, offset by costovation initiatives. Higher input costs in transportation, freight and warehouse labor were mostly offset by productivity initiatives, including our Clean Conscious Diaper and Beauty Restage, a shift in mix towards sales of Skin and Personal Care products which are higher margin products and leveraging fixed fulfillment costs over a larger revenue base as compared to the year ended December 31, 2020.
Gross profit was $109.2 million for the year ended December 31, 2021, as compared to $107.9 million for the year ended December 31, 2020. The increase of $1.3 million, or 1.2%, was primarily due to the higher level of sales, particularly in Skin and Personal Care and Diapers and Wipes products.
Operating Expenses
Selling, General and Administrative Expenses
| For the year ended December 31, | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ change | % change | |||||||||||||||||||
| (In thousands, except percentages) | ||||||||||||||||||||||
| Selling, general and administrative | $ | 84,059 | $ | 71,253 | $ | 12,806 | 18.0 | % |
Selling, general and administrative expenses were $84.1 million for the year ended December 31, 2021 as compared to $71.3 million for the year ended December 31, 2020. The increase of $12.8 million, or 18.0%, was primarily due to increased costs associated with both preparing to be and operating as a public company. These incremental expenses included a $10.5 million increase in salary and stock compensation, as well as an increase of $2.5 million in public company insurance expense,
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$1.8 million in audit fees and $1.4 million in legal expenses, offset by a $3.3 million decrease in bonus payments compared to the year ended December 31, 2020.
Marketing Expenses
| For the year ended December 31, | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ change | % change | |||||||||||||||||||
| (In thousands, except percentages) | ||||||||||||||||||||||
| Marketing | $ | 54,260 | $ | 44,478 | $ | 9,782 | 22.0 | % |
Marketing expenses were $54.3 million for the year ended December 31, 2021, as compared to $44.5 million for the year ended December 31, 2020. The increase of $9.8 million, or 22.0%, was primarily due to an increase of $4.5 million in retail marketing expenses, $3.2 million in digital advertising expenses and $1.0 million in video and photo production costs. The increase in retail marketing expense was driven in part by the launch of our Clean Conscious Diaper in January 2021, as well as by marketing for a key digital partner’s promotional event. The increase in digital advertising expenses drove our Content, Community, Commerce marketing strategy within Skin and Personal Care and Diapers and Wipes. The increase in video and production costs were primarily related to our product innovations and promotional events launched in the first nine months of 2021, including our new Clean Conscious Diaper product offering and our new sustainable package initiative and new line of skin care products, which we refer to as our "Beauty Restage".
Research and Development Expenses
| For the year ended December 31, | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ change | % change | |||||||||||||||||||
| (In thousands, except percentages) | ||||||||||||||||||||||
| Research and development | $ | 7,679 | $ | 5,705 | $ | 1,974 | 34.6 | % |
Research and development expenses were $7.7 million for the year ended December 31, 2021, as compared to $5.7 million for the year ended December 31, 2020. The increase of $2.0 million, or 34.6%, was primarily due to an increase of $1.0 million in salary and stock-based compensation, a $0.5 million increase in clinical and claims testing expenses and a $0.3 million increase in pilot trials to support product innovation.
Interest and Other Income (Expense), Net
| For the year ended December 31, | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ change | % change | |||||||||||||||||||
| (In thousands, except percentages) | ||||||||||||||||||||||
| Interest and other income (expense), net | $ | (1,776) | $ | (837) | $ | (939) | 112.2 | % |
Interest and other income (expense), net was net expense of $1.8 million for the year ended December 31, 2021, as compared to net expense of $0.8 million for the year ended December 31, 2020. Interest expense consists primarily of the portion of rent payments recognized as imputed interest expense under build-to-suit accounting associated with our leasing arrangements. The increase of $0.9 million, or 112.2%, was primarily due to a decrease in interest income on our short-term investments due to a lower average investment balance and lower average interest rates.
Liquidity and Capital Resources
We have incurred net losses and net cash outflows from operating activities since our inception. Prior to our IPO, our available liquidity and operations were financed primarily through the sale of redeemable convertible preferred stock, equity securities and to a lesser extent, debt financing. Upon the closing of our IPO, we received net proceeds of approximately $91.1 million, after deducting underwriting discounts and commissions of $6.7 million and offering expenses of $5.4 million. As of December 31, 2021, we had $50.8 million of cash and cash equivalents and $42.4 million of short-term investments. Although we are dependent on our ability to raise capital or generate sufficient cash flow from operations to achieve our business objectives, we believe our existing cash, cash equivalents, and short-term investments will be sufficient to meet our short-term and long-term working capital and capital expenditure needs. Future capital requirements will depend on many factors, including our rate of revenue growth, gross margin and the level of expenditures in all areas of the Company. To the extent that existing capital resources and sales growth are not sufficient to fund future activities, we will need to raise capital through additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all. Failure to raise additional capital, if and when needed, could have a material adverse effect on our financial position, results of operations, and cash flows.
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2021 Credit Facility
In April 2021, we entered into a first lien credit agreement (the “2021 Credit Facility”), with JPMorgan Chase Bank, N.A., as administrative agent and lender, and the other lenders party thereto, which provides for a $35.0 million revolving credit facility that matures on April 30, 2026. The 2021 Credit Facility includes a subfacility that provides for the issuance of letters of credit in an amount of up to $10.0 million at any time outstanding, which reduces the amount available under the 2021 Credit Facility.
The 2021 Credit Facility is subject to customary fees for loan facilities of this type, including a commitment fee based on the average daily undrawn portion of the revolving credit facility. The interest rate applicable to the 2021 Credit Facility is, at our option, either (a) the LIBOR (or a replacement rate established in accordance with the terms of the 2021 Credit Facility) (subject to a 0.00% LIBOR floor), plus a margin of 1.50% or (b) the CB floating rate minus a margin of 0.50%. The CB floating rate is the higher of (a) the Wall Street Journal prime rate and (b)(i) 2.50% plus (ii) the adjusted LIBOR rate for a one-month interest period.
The 2021 Credit Facility will terminate and borrowings thereunder, if any, will be due on April 30, 2026. As of December 31, 2021, there was no outstanding balance under the 2021 Credit Facility. We are required to follow certain covenants. As of March 22, 2022, we were in compliance with all covenants under the 2021 Credit Facility.
Refer to Note 8 included in the consolidated financial statements for more information on the 2021 Credit Facility.
Cash Flows
The following table summarizes our cash flows for the periods presented:
| For the year ended December 31, | ||||||
|---|---|---|---|---|---|---|
| (In thousands) | 2021 | 2020 | ||||
| Net cash (used in) operating activities | $ | (38,154) | $ | (12,066) | ||
| Net cash (used in) provided by investing activities | $ | (8,623) | $ | 36,696 | ||
| Net cash provided by (used in) financing activities | $ | 60,368 | $ | (973) |
Operating Activities
Our largest source of operating cash is from the sales of our products through Digital and Retail channels to our consumers and customers. Our primary uses of cash from operating activities are for cost of revenue expenses, selling, general and administrative expenses, marketing expenses and research and development expenses. We have generated negative cash flows from operating activities and have supplemented working capital requirements through net proceeds from the sale and maturity of short-term investments.
Net cash used in operating activities of $38.2 million for the year ended December 31, 2021 was primarily due to net loss of $38.7 million, non-cash adjustments of $21.3 million and a net decrease in cash related to changes in operating assets and liabilities of $20.8 million. Non-cash adjustments primarily consisted of stock-based compensation of $16.8 million and depreciation and amortization of $4.1 million. Changes in cash flows related to operating assets and liabilities primarily consisted of a $9.0 million increase in accounts receivable due to higher revenue from retail customers, $6.7 million use of cash due to the timing of payments associated with our accounts payable and operating leasing obligations, a $6.1 million increase in prepaid expenses and other assets due to timing of payments, as well as the non-monetary sale of our legacy beauty inventory for future marketing and transportation credits and a $1.0 million decrease in inventory due to timing of inventory purchases.
Net cash used in operating activities of $12.1 million for the year ended December 31, 2020 was primarily due to net loss of $14.5 million, non-cash adjustments of $12.9 million and a net decrease in cash related to changes in operating assets and liabilities of $10.5 million. Non-cash adjustments primarily consisted of stock-based compensation of $7.9 million and depreciation and amortization of $4.9 million. Changes in cash flows related to operating assets and liabilities primarily consisted of a $24.1 million use of cash to increase investment in inventory to support our growth across our business, including on wipes, sanitization products and our new innovation products in 2020, and a $1.5 million use of cash due to timing of payments on prepaid expenses and other assets. These uses of cash were partially offset by a $13.7 million increase in accounts payable and accrued expenses driven by the aforementioned investment in inventory to support growth across the business and a $1.5 million reduction in accounts receivable due to timing of cash collection from retail customers.
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Investing Activities
Our primary source of investing cash is the sale and maturity of short-term investments and our primary use of investing cash is the purchase of short-term investments and property and equipment.
Net cash used in investing activities of $8.6 million for the year ended December 31, 2021 was due to purchases of short-term investments of $65.3 million, offset by proceeds from the sales and maturities of short-term investments of $27.4 million and $29.5 million, respectively.
Net cash provided by investing activities of $36.7 million for the year ended December 31, 2020 was due to proceeds from the sales and maturities of short-term investments of $5.8 million and $53.5 million, respectively, net of purchases of short-term investments of $22.5 million and purchases of property and equipment of $0.2 million.
Financing Activities
Our financing activities primarily consisted of proceeds from sales of securities, payment of dividends, payment of offering costs, proceeds from stock option award exercises and principal payments of financing lease obligations.
Net cash provided by financing activities of $60.4 million for the year ended December 31, 2021 primarily consisted of proceeds from our IPO of $96.5 million, net of underwriting discounts and commissions and proceeds from the exercise of stock options of $5.7 million, offset by dividend payments of $35.0 million and payments of offering costs in connection with our IPO of $5.5 million.
Net cash used in financing activities of $1.0 million for the year ended year ended December 31, 2020 primarily consisted of principal payments of financing lease obligations of $1.0 million.
Dividends
In April 2021, our board of directors declared a cash dividend of $35.0 million to the holders of record of our common stock and our redeemable convertible preferred stock as of May 3, 2021, which we paid on June 29, 2021 (the “2021 Dividend”). Other than the 2021 Dividend, we have not declared or paid cash dividends on our capital stock, and we do not anticipate declaring or paying any cash dividends other than the 2021 Dividend in the foreseeable future. Any future determination regarding the declaration and payment of dividends, if any, will be at the discretion of our board of directors and will depend on then-existing conditions, including our financial condition, operating results, contractual restrictions (including any restrictions in our then-existing debt arrangements), capital requirements, business prospects and other factors our board of directors may deem relevant. The 2021 Credit Facility contains restrictions on our ability to pay dividends.
Non-GAAP Financial Measure
We prepare and present our consolidated financial statements in accordance with GAAP. However, management believes that adjusted EBITDA, a non-GAAP financial measure, provides investors with additional useful information in evaluating our performance.
We calculate adjusted EBITDA as net income (loss), adjusted to exclude: (1) interest and other (income) expense, net; (2) income tax provision; (3) depreciation and amortization; (4) stock-based compensation expense, including payroll tax; (5) professional fees and expenses and executive termination expenses related to our Innovation Strategy; (6) the IPO Bonuses, including associated payroll taxes and expenses, and third-party costs associated with our IPO in 2021; and (7) in certain periods, litigation and settlement fees associated with certain non-ordinary course litigation.
Adjusted EBITDA is a financial measure that is not required by, or presented in accordance with GAAP. We believe that adjusted EBITDA, when taken together with our financial results presented in accordance with GAAP, provides meaningful supplemental information regarding our operating performance and facilitates internal comparisons of our historical operating performance on a more consistent basis by excluding certain items that may not be indicative of our business, results of operations or outlook. In particular, we believe that the use of adjusted EBITDA is helpful to our investors as it is a measure used by management in assessing the health of our business, determining incentive compensation and evaluating our operating performance, as well as for internal planning and forecasting purposes.
Adjusted EBITDA is presented for supplemental informational purposes only, has limitations as an analytical tool and should not be considered in isolation or as a substitute for financial information presented in accordance with GAAP. Some of the limitations of adjusted EBITDA include that (1) it does not reflect capital commitments to be paid in the future; (2) although
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depreciation and amortization are non-cash charges, the underlying assets may need to be replaced and adjusted EBITDA does not reflect these capital expenditures; (3) it does not consider the impact of stock-based compensation expense; (4) it does not reflect other non-operating expenses, including interest expense; (5) it does not include the IPO Bonuses, including associated payroll taxes and expenses, or third-party costs associated with the preparation of the IPO; (6) it does not reflect tax payments that may represent a reduction in cash available to us; and (7) does not include certain non-ordinary cash expenses that we do not believe are representative of our business on a steady-state basis. In addition, our use of adjusted EBITDA may not be comparable to similarly titled measures of other companies because they may not calculate adjusted EBITDA in the same manner, limiting its usefulness as a comparative measure. Because of these limitations, when evaluating our performance, you should consider adjusted EBITDA alongside other financial measures, including our net income (loss) and other results stated in accordance with GAAP.
The following table presents a reconciliation of net income (loss), the most directly comparable financial measure stated in accordance with GAAP, to adjusted EBITDA, for each of the periods presented:
| For the year ended December 31, | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| (In thousands) | 2021 | 2020 | ||||||||
| Reconciliation of Net Loss to Adjusted EBITDA | ||||||||||
| Net loss | $ | (38,679) | $ | (14,466) | ||||||
| Interest and other (income) expense, net | 1,776 | 837 | ||||||||
| Income tax provision | 77 | 89 | ||||||||
| Depreciation and amortization | 4,146 | 4,854 | ||||||||
| Stock-based compensation | 16,847 | 7,905 | ||||||||
| Innovation Strategy expenses(1) | — | 1,511 | ||||||||
| Related IPO and other transaction-related expenses(2) | 12,160 | 10,459 | ||||||||
| Payroll tax expense related to stock-based compensation | 211 | 13 | ||||||||
| Adjusted EBITDA | $ | (3,462) | $ | 11,202 |
(1) Includes professional fees and expenses and executive severance and termination expenses related to our Innovation Strategy.
(2) Includes IPO-related expenses, including IPO Bonuses, and other transaction-related third-party expenses, which are generally incremental costs incurred associated with the preparation of the IPO.
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Material cash requirements
We lease warehouse and office facilities under operating lease agreements and a built-to-suit lease under a financing arrangement. We have unconditional purchase commitments for software service subscriptions, advertising services and certain other services. See Note 11 “Commitments and Contingencies,” to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information on our short-term and long-term leases and purchase obligations.
Recent Accounting Pronouncements
Refer to Note 2 to our consolidated financial statements included in this Annual Report on Form 10-K for a discussion of recently issued accounting pronouncements not yet adopted and recently adopted accounting pronouncements.
Critical Accounting Policies and Estimates
We believe that the following accounting policies involve a high degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of our operations. See Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a description of our other significant accounting policies. The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and judgments that affect the amounts reported in those financial statements and accompanying notes. Although we believe that the estimates we use are reasonable, due to the inherent uncertainty involved in making those estimates, actual results reported in future periods could differ from those estimates.
Revenue Recognition
We generate revenue through the sale of our products through Digital and Retail channels in the following product categories: Diapers and Wipes, Skin and Personal Care and Household and Wellness. The Digital channel includes direct to the consumer sales through our website and sales to third-party ecommerce customers, who resell our products through their own online platforms. The Retail channel includes sales to traditional brick and mortar retailers, who may also resell our products through their own online platforms. Our revenue is recognized net of allowances for returns, discounts, credits and any taxes collected from customers.
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We account for revenue contracts with customers by applying the following steps in accordance with Accounting Standard Codification, or ASC, 606, Revenue from Contracts with Customers:
•Identification of the contract, or contracts, with a customer
•Identification of the performance obligations in the contract
•Determination of the transaction price
•Allocation of the transaction price to the performance obligations in the contract
•Recognition of revenue when, or as, we satisfy a performance obligation
We elected an accounting policy to record all shipping and handling costs as fulfillment costs. We accrue the cost of shipping and handling and recognize revenue and costs at the point in time that control of the goods transfers to the customer.
Direct-to-Consumer
For direct sales to the consumer through our website, our performance obligation consists of the sale of finished goods to the consumer. Consumers may purchase products at any time or enter into subscription arrangements. Consumers place orders online in accordance with our standard terms and conditions and authorize payment when the order is placed. Credit cards are charged at the time of shipment. For subscription arrangements, consumers sign up to receive products on a periodic basis. Subscriptions are cancellable at any time without penalty, and no amounts are collected from the consumer until products are shipped. Revenue is recognized when transfer of control to the consumer takes place, which is when the product is delivered to the carrier. Sales taxes collected from consumers are accounted for on a net basis and are excluded from revenue.
Consumers may purchase gift cards, which are recorded as deferred revenue at the time of purchase. We recognize revenue when these gift cards are redeemed for products and the revenue recognition criteria as described above have been met.
Retail and Third-Party Ecommerce
For retail and third-party ecommerce sales, our performance obligation consists of the sale of finished goods to retailers and third-party ecommerce customers. Revenue is recognized when control of the promised goods is transferred to those customers at time of shipment or delivery, depending on the contract terms. After the completion of the performance obligation, we have the right to consideration as outlined in the contract. Payment terms vary among the retail and third-party ecommerce customers although terms generally include a requirement of payment within 30 to 45 days of product shipment.
Sales Returns and Allowances
For direct-to-consumer, retail and third-party ecommerce sales, we record estimated sales returns in the same period that the related revenue is recorded. We use the expected value method to estimate returns, taking into consideration assumptions of demand based on historical data and historical returns rates. When estimating returns, we also consider future business initiatives and relevant anticipated future events. Estimated sales returns and ultimate losses may vary from actual results, which could be material to the consolidated financial statements. The estimated sales returns allowance is recorded as a reduction in revenue.
For direct-to-consumer, retail and third-party ecommerce sales, we offer credits in the form of discounts, which are recorded as reductions in revenue and are allocated to products on a relative basis based on their respective standalone selling price.
For retail and third-party ecommerce sales, we routinely commit to one-time or ongoing sales incentive programs that may require us to estimate and accrue the expected costs of such programs, including trade promotion activities and contractual allowances. We record these programs as a reduction to revenue unless we receive a distinct benefit in exchange for credits claimed by the customer and can reasonably estimate the fair value of the benefit received, in which case we record the programs as marketing expense. We recognize a liability or a reduction to accounts receivable, and reduce revenue based on the estimated amount of credits that will be claimed by customers. An allowance is recorded as a reduction to accounts receivable if the customer can deduct the program amount from the outstanding invoice.
Estimates for these sales incentive programs are developed using the most likely amount and are included in the transaction price to the extent that a significant reversal of revenue would not result once the uncertainty is resolved. In developing our estimate, we use historical analysis and contractual rates in determining the accruals for these activities. Also, we consider the susceptibility of the incentive to outside influences, the length of time until the uncertainty is resolved, and our experience with similar contracts. Judgment is required to determine the timing and amount of recognition of sales incentive program accruals which we estimate based on past practice with similar arrangements.
Inventories
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Inventories consists of finished goods and are stated at the lower of cost or estimated net realizable value. Cost is computed based on weighted-average historical costs. We allocate certain overhead costs to the carrying value of our finished goods. The carrying value of inventories is reduced for any excess and obsolete inventory. Excess and obsolete inventory reductions are determined based on assumptions about future demand and sales prices, estimates of the impact of competition, and the age of inventory. If actual conditions are less favorable than those previously estimated by management, additional inventory write-downs could be required.
Stock-Based Compensation
We recognize stock-based compensation expense for employees and non-employees based on the grant-date fair value of stock awards over the applicable service period. For awards that vest based on continued service, stock-based compensation cost is recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the awards. For awards with performance vesting conditions, stock-based compensation cost is recognized on a graded vesting basis over the requisite service period when it is probable the performance condition will be achieved.
The determination of stock-based compensation cost is inherently uncertain and subjective and involves the application of valuation models and assumptions requiring the use of judgment. If factors change and different assumptions are used, stock-based compensation expense and net losses could be significantly different.
Income Taxes
Income taxes are accounted for using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and tax basis of assets and liabilities and are measured using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates or tax law on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.
A valuation allowance is provided on deferred tax assets when it is determined that it is more likely than not that some portion or all of the net deferred tax assets will not be realized.
We recognize the tax benefit from uncertain tax positions only if it is more likely than not that the tax positions will be sustained on examination by the tax authorities, based on the technical merits of the position. The tax benefit is measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. We recognize interest and penalties related to income tax matters in income tax expense.
Emerging Growth Company Status
In April 2012, the JOBS Act was enacted. Section 107(b) of the JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to take advantage of the extended transition period to comply with new or revised accounting standards and to adopt certain of the reduced disclosure requirements available to emerging growth companies. As a result of the accounting standards election, we will not be subject to the same implementation timing for new or revised accounting standards as other public companies that are not emerging growth companies which may make comparison of our financials to those of other public companies more difficult.