DIRTT Environmental Solutions Ltd. - Annual Report 2022

The Management's Discussion and Analysis of Financial Condition and Results of Operations for DIRTT Environmental Solutions Ltd. is also included in the Form 10-K for the year ended December 31, 2022 filed on SEDAR on February 22, 2023 in its entirety.

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 for the fiscal years ended December 31, 2022 and 2021 together with our consolidated financial statements and related notes and other financial information appearing in this Annual Report. The discussion contains forward-looking statements reflecting our current expectations and estimates and assumptions concerning events and financial trends that may effect 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 “Special Note Cautionary Statement Regarding Forward Looking Statements” appearing elsewhere in the Annual Report.

Summary of Financial Results

DIRTT Environmental Solutions Ltd. and its subsidiary (“DIRTT”, the “Company”, “we” or “our”) is a leader in industrialized construction for interior spaces. DIRTT's system of physical products and digital tools empowers organizations, together with construction and design leaders, to build high-performing, adaptable, interior environments. Operating in the workplace, healthcare, education, and public sector markets, DIRTT’s system provides total design freedom, and greater certainty in cost, schedule, and outcomes.

DIRTT’s proprietary design integration software, ICE® (“ICE” or “ICE software”), translates the vision of architects and designers into a 3D model that also acts as manufacturing information. ICE is also licensed to unrelated companies and Construction Partners of the Company.

Key Fourth Quarter 2022 Highlights

The Company announced and successfully implemented a price increase of approximately 6.5% in November 2021. In addition, price increases of 5% and 10% were announced and implemented during June and July 2022, respectively. As of the fourth quarter of 2022, our revenue reflects the impact of virtually all of these price increases.
Revenues for the fourth quarter of 2022 were $42.4 million, a decrease of $0.5 million or 1% from $42.9 million for the same period in 2021, and a $4.3 million or 9% decrease from the third quarter of 2022. Our fourth quarter of 2021 benefited from the price increases announced in November of that year, which motivated various customers to accelerate order and deliveries to avoid the price increases. As such, and compared to prior year, the improvement in revenue from the pricing actions discussed above, was offset by a return to a more seasonal demand pattern and higher incidents of project push-out rates. Sequentially, this is more pronounced given the increased seasonal demand during the months within the third quarter of 2022.
Gross profit and gross profit margin for the fourth quarter of 2022 was $11.6 million or 27.3% of revenue, an increase of $3.2 million or 38% from $8.4 million or 19.6% of revenue for the same period of 2021, and an increase of $4.6 million or 65% from $7.0 million in the third quarter of 2022.
Adjusted Gross Profit (see “– Non-GAAP Financial Measures”) for the fourth quarter of 2022 was $13.6 million. This represents a $3.4 million or 33.4% increase over the third quarter of 2022 and a $2.7 million or 25.3% increase over the fourth quarter of 2021. Adjusted Gross Profit Margin (see “– Non-GAAP Financial Measures”) for the fourth quarter of 2022 was 32.0%, a 1030 bps improvement over the third quarter of 2022 and a 670 bps improvement over the fourth quarter of 2021. The improved Adjusted Gross Profit and Adjusted Gross Profit Margin were driven by commercial discipline as well as the realization of most of our price increases discussed above. Beyond the more efficient recovery of material input costs through the pricing actions taken in 2022, general inflation in services and labor costs have been offset by the favorable impact from the weakening Canadian dollar.
Net loss for the fourth quarter of 2022 was $5.9 million compared to $16.0 million for the same period of 2021. The lower net loss is primarily the result of the higher gross profit margin, explained above, of $3.2 million, a $0.2 million decrease in foreign exchange loss and a $9.7 million reduction in operating expenses offset by a $1.0 million decrease in government subsidies, a $0.2 million increase in interest expense, $0.6 million of tax expense and $1.2 million of reorganization costs. During the fourth quarter we benefited from the weakening Canadian dollar on Canadian dollar denominated costs.
Adjusted EBITDA (see “– Non-GAAP Financial Measures”) for the fourth quarter of 2022 was $0.6 million or 1.4% of revenue, an improvement of $10.3 million from a $9.7 million loss or (22.7)% of revenue for the fourth quarter of 2021 and an improvement of $6.0 million from a $5.4 million loss or (11.6)% of revenue for the third quarter of 2022.

On November 30, 2022, the Company issued 8.7 million shares in a private placement to its two largest shareholders and all of its directors and executive officers for aggregate gross consideration of approximately $2.8 million (the "Private Placement"). Concurrent with the Private Placement, the Company's two largest shareholders collectively committed to purchase common shares having an aggregate subscription price of not less than $2.0 million in any rights offering conducted by the Company on or before November 30, 2023.
The Company generated approximately $3.8 million of cash in the fourth quarter compared to cash used of $21.3 million, $19.1 million and $12.5 million in the first, second and third quarters of 2022, respectively. Our improved fourth quarter of 2022 cash flow was driven by proceeds from the Private Placement discussed above, improvement in Adjusted EBITDA and improved working capital management, offset by approximately $1.2 million ($13.5 million full year) of reorganization costs.

Key Annual 2022 Highlights

Revenues for the year ended December 31, 2022 were $172.2 million, an increase of $24.6 million or 17% from $147.6 million for the year ended December 31, 2021 driven primarily by the pricing actions discussed above and an increase in demand, primarily from the COVID impacted periods during 2021.
Gross profit for the year ended December 31, 2022 was $28.2 million or 16.4% of revenue, an increase of $4.7 million or 20% from $23.5 million or 15.9% of revenue for the year ended December 31, 2021. Included in gross profit is inventory write-downs of $1.0 million (0.6% of total revenue), primarily related to the discontinuance of the Reflect and other product lines and accelerated amortization and depreciation of $2.1 million on discontinued product lines and the closure of the Phoenix Facility.
Adjusted Gross Profit (see “– Non-GAAP Financial Measures”) for the year ended December 31, 2022 was $39.0 million, an increase of $4.9 million or 14.7% of revenue from $34.0 million or 23.1% of revenue for the year ended December 31, 2021. Adjusted Gross Profit Margin (see “– Non-GAAP Financial Measures”) for the year ended December 31, 2022 was 22.6%, a 500 bps decline from 23.1% for the year ended December 31, 2021. 2022 results include certain inventory writedowns of $1.0 million (0.6% of revenue), primarily related to the discontinuance of the Reflect and other product lines. The improved Adjusted Gross Profit and Adjusted Gross Profit Margin were driven by a combination of improved demand for our products and commercial discipline. Beyond the more efficient recovery of material input costs through the pricing actions taken in 2022, general inflation in services and labor costs have been offset by the favorable impact from the weakening Canadian dollar.
Management has taken steps to align our manufacturing footprint and salaried workforce with our current activity levels as well as cost reduction and profitability initiatives. In February 2022, we announced the closure of our Phoenix Facility and elimination of manufacturing and office positions. In July 2022, we announced a further reduction of salaried positions and in August 2022, we announced the temporary closure of our Rock Hill Facility as the Calgary manufacturing facility has sufficient capacity to absorb production and meet expected demand for the near term.
Net loss for the year ended December 31, 2022 was $55.0 million compared to $53.9 million for the year ended December 31, 2021. The higher net loss is primarily the result of the above noted increase in gross profit offset by a $1.8 million increase in operating expenses which included $13.5 million of reorganization costs (added back to Adjusted EBITDA), a $2.0 million increase in interest expense, a $3.7 million decrease of government subsidies and a $0.2 million increase in income tax expense. These decreases were partially offset by an increase of $1.8 million in foreign exchange gain. The Company benefited from a weakening Canadian dollar on Canadian dollar denominated costs compared to the prior year.
Adjusted EBITDA (see “– Non-GAAP Financial Measures”) for the year ended December 31, 2022 was a $26.2 million loss or (15.2)% of revenue, an improvement of $15.1 million from a $41.3 million loss or (28.0)% of revenue for the year ended December 31, 2021 for the above noted reasons.
The Company continues to evaluate certain non-dilutive, strategic initiatives expected to generate additional cash flows in the first half of 2023.

Outlook

Annual revenue of $172.2 million fell just below the low end of the guidance range of $175 million to $185 million set during the second quarter of 2022, primarily driven by jobsite and project delays.

During 2022, our key focus was on stabilizing the Company’s balance sheet, slowing the pace of cash usage and implementing a number of initiatives designed to optimize both the cost and pricing structure. As early as the third quarter of 2022, we began seeing the improved financial effects of these changes. During the fourth quarter, this was even more magnified as Adjusted Gross Profit

returned to greater than 30% for the first time since 2020. Improvements in operational and supply chain led to reductions in labor and inventory carrying costs during the fourth quarter. Further, we reduced costs needed to operate our back office and general and administrative overhead to levels commensurate with our current and expected revenue levels.

We take great pride in our products’ ability to adjust and conform to a changing workplace. Our ability to adapt and respond to an unknown future is at the core of our value proposition. During 2022, we made adjustments, and in some cases, discontinued certain product lines that did not align with this value; our Reflect wall line principally among them.

As we shift to 2023, we expect to leverage each of the changes made during 2022, as well as being much more focused on disciplined spending and continuing to ensure our investments align with our available cash and growth expectations.

As of January 1, 2023, our 12-month forward pipeline, which represents known projects and leads at various stages of maturation which our sales teams are working to convert into orders, was $391 million, in line with October 1, 2022, and 26% higher than the $311 million balance as of January 1, 2022. The increase over prior year is driven by a combination of higher pricing and the volume impact of the higher secured projects where the required shipment dates have pushed out due to stretched construction schedules, experienced in the fourth quarter of 2022. The pipeline comprises 62% commercial, 20% healthcare, 7% education and 11% government verticals. The relative split between verticals remains consistent with pre-pandemic actual percentage results.

The January 2023 pipeline is not only higher than January 2022, but we also believe it is healthier. The percentage of projects we believe are at the stage of the project lifecycle where the project has been costed and budgeted for the next twelve months has increased. Thus, while the macro-economic conditions impacting DIRTT continue to be volatile, we believe we have a better project outlook today, than one year ago. While we are encouraged by the pipeline growth, our order pace and quarterly revenue and supply chain forecasting continues to be challenged by the high push out rates and longer than normal engineering and design time associated with large and complex projects.

Our Construction Partners have been and remain a key element in our go-to-market strategy. Enhancing both partner effectiveness and accountability will again be a priority in 2023. Our Construction Partners are a direct conduit to many of our end customers and we recommenced a Partner Advisory Council to elevate partner feedback within our organization and provide further insight to support our commercial and operational decision making.

We continue to evaluate under-performing Construction Partners and are working to provide additional support and training to them. We have also placed an emphasis on those Construction Partners that have demonstrated a commitment to growth, commercial discipline, and collaborative success. We believe this approach will serve to strengthen our pipeline and provide a strong platform in which to drive better organic growth.

We are closely monitoring our cost structure, including the underlying materials that comprise our products. Although we believe we are insulated from the near-term effects of a recession in the United States or Canada, we are susceptible to the inflationary impact of labor and commodity pricing, particularly aluminum and wood.

In response to the risk associated with these items, we have taken additional actions over the past two months that will reduce annualized overhead costs by approximately $3 million to $5 million. These cost reductions are related to efficiencies and streamlining our back office and operational support functions, not pursuant to a planned restructuring program. We are also evaluating certain purchase arrangements that will hedge against inflation and volatility associated with our primary materials.

We believe that the combination of the growth in our sales pipeline, the improved margins from pricing actions already taken and reduced cost structure set us up well to deliver year over year growth in revenue, gross margin and Adjusted EBITDA during 2023.

The Company’s current and immediate focus continues to be growing revenues, increasing profitability, and managing liquidity. Moving into 2023, the following items remain the focus of our management team:

Re-focused training and development of our Construction Partner and employee base surrounding our go-to-market strategy.
Continued offering of customer friendly incentives designed to improve volume and price certainty (e.g., price lock guarantee, quick pay discounts, rebate programs, etc.).
Establishing customer loyalty programs that will provide concierge level service to Construction Partners and end customers based on various volume, project, and forecast accuracy metrics.
Executing upon several supply chain optimization projects designed to improve Sales and Operational Planning and reduce slow moving and/or obsolete inventory items.
Tightly managing discretionary spend and overtime during periods of order volatility.

As many of our end customers continue implementing ‘return to work’ strategies, we have seen many cases where there is a strong need to modify their workspace to accommodate a more flexible environment in the short-term, which in turn could change again over the medium- to long-term as post-pandemic requirements continue to evolve. Additionally, many organizations in different sectors are trying to enhance their physical presence in local communities by adopting a single design model that works in multiple jurisdictions. We believe we are well-positioned to capitalize on both trends.

In 2023, we expect to deliver low to mid-single digit growth in revenue and see higher gross margins, net income (loss) and Adjusted EBITDA compared to 2022. We also expect to continue to stabilize the balance sheet and grow unrestricted cash through a combination of improved financial performance and contribution from our non-dilutive cash initiatives previously discussed.

We may opportunistically take actions to improve our debt and equity structure, though we anticipate that that Company's cash flows from operations and current financing source will be sufficient for the cash needs of the Company in 2023.

Non-GAAP Financial Measures

Note Regarding Use of Non-GAAP Financial Measures

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“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 Annual 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, reorganization expenses, foreign exchange gains and losses and impairment expenses 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 receipts and 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 receipts and 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.

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

Adjusted Gross Profit	Gross profit before deductions for costs of under-utilized capacity, depreciation and
	amortization
Adjusted Gross Profit Margin	Adjusted Gross Profit divided by revenue
EBITDA	Net income before interest, taxes, depreciation and amortization
Adjusted EBITDA	EBITDA adjusted to remove foreign exchange gains or losses; impairment expenses;
	reorganization expenses; stock-based compensation expense; government subsidies; and any
	other non-core gains or losses
Adjusted EBITDA Margin	Adjusted EBITDA divided by revenue

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.

Results of Operations

Year Ended December 31, 2022 Compared to the Year Ended December 31, 2021

	For	the Year Ended December 31,
	2022	2021	% Change
		($ in thousands)
Revenue	172,161	147,593	17
Gross Profit(1)	28,160	23,460	20
Gross Profit Margin	16.4 %	15.9 %
Operating Expenses
Sales and Marketing	26,950	31,041	(13 )
General and Administrative	25,462	30,595	(17 )
Operations Support	9,498	9,372	1
Technology and Development	7,555	8,234	(8 )
Stock-Based Compensation	4,277	4,713	(9 )
Reorganization	13,461	-	100
Goodwill Impairment	-	1,443	(100 )
Total Operating Expenses	87,203	85,398	2
Operating Loss	(59,043 )	(61,938 )	5
Operating Margin	(34.3 )%	(42.0 )%
(1) Gross Profit for the year ended December 31, 2022 includes $1.0 million primarily related to the write off of inventory of discontinued product lines, and $2.1 million of accelerated depreciation and amortization on software associated with discontinued product lines and the closure of the Phoenix Facility

Revenue

The following table sets forth the contribution to revenue of our DIRTT Solutions and related offerings.

	For the Year Ended December	For the Year Ended December	31,
	2022	2021	% Change
		($ in thousands)
Product	147,448	129,031	14
Transportation	18,030	13,231	36
LicensefeesfromConstruction Partners	778	738	5
Total product revenue	166,256	143,000	16
Installationand otherservices	5,905	4,593	29
	172,161	147,593	17

In response to significant increases in the costs of raw materials, shipping materials, labor, and freight, effective November 16, 2021, DIRTT increased product and transportation prices on new projects by approximately 6.5%. On February 17, 2022, we implemented a further price increase of 5% that came into effect June 1, 2022. On June 21, 2022 an additional price increase of 10% was announced effective July 21, 2022. As of the fourth quarter of 2022, product sales reflect virtually all of these price increases. The first quarter of 2022 marked the transition of the COVID-19 pandemic to an endemic with the broad easing of health restrictions, including work-from-home mandates, across North America. While the resurgence in COVID-19 infections due to the Omicron variant at the beginning of the year temporarily sent many employees back to their home offices and delayed return dates, the Company and our Construction Partners experienced an uptick in planning activity and opportunity growth in our commercial vertical which began to translate into an increase in orders beginning in March 2022.

During the year ended December 31, 2022, revenue was $172.2 million, an increase of $24.6 million or 17% from the year ended December 31, 2021. The improvement in revenue was driven by the pricing actions and increased product demand discussed

above, offset by secured projects where the required shipment dates have pushed out due to stretched construction schedules increased. Further, 2021 revenue benefited from the price increases announced in November 2021, which motivated various customers to accelerate order and deliveries into 2021 to avoid the price increases. During the fourth quarter of 2022, we returned to a normalized seasonal demand pattern.

Installation and other services revenue was $5.9 million for the year ended December 31, 2022 compared to $4.6 million in the year ended December 31, 2021. This revenue primarily reflects services performed by our ICE and design teams for third parties. Except in limited circumstances, our Construction Partners, rather than the Company, perform installation services, and accordingly, we are not anticipating significant growth in this revenue stream.

Our success is partly dependent on our ability to profitably develop our Construction Partner network to expand our market penetration and ensure best practices are shared across local markets. At December 31, 2022, we had 67 (December 31, 2021: 69) Construction Partners servicing multiple locations. In February 2022, we announced the establishment of a Partner Advisory Council to provide a greater link with Construction Partners and end clients who they service. The Partner Advisory Council will offer advice on sales and marketing, product issues and new market needs, market conditions, competitive landscape, and other related areas of mutual interest.

We periodically analyze our revenue growth by vertical markets in the defined markets of commercial, healthcare, government and education. The following table presents our product and transportation revenue by vertical market.

	For the Year Ended December	For the Year Ended December	31,
	2022	2021	% Change
		($ in thousands)
Commercial	115,102	84,488	36
Healthcare	19,739	30,130	(34 )
Government	16,564	16,012	3
Education	14,073	11,632	21
LicensefeesfromConstruction Partners	778	738	5
Total product revenue	166,256	143,000	16
Servicerevenue	5,905	4,593	29
	172,161	147,593	17

	For the Year Ended December 31,	For the Year Ended December 31,
	2022 2021
	(in %)
Commercial	70	60
Healthcare	12	21
Government	10	11
Education	8	8
Total Product Revenue(1)	100	100

(1) Excludes license fees from Construction Partners.

Commercial revenues increased by 36% in the year ended December 31, 2022 from the prior year, reflecting improving market conditions as health restrictions and work-from-home requirements ease and include one large customer in the technology sector with revenue of $8.8 million. Healthcare decreased by 34% in the year ended December 31, 2022 from the prior year. Such sales tend to be larger individual projects and are subject to timing due to a typically longer sales cycle, resulting in variability in sales levels. In 2021, we had one large healthcare customer with revenue of $9.6 million which did not recur in 2022.

Education sales in 2022 increased by 21% over the prior year. At the beginning of the pandemic, education spending effectively paused with many institutions suspending in-person classes. There were no individually significant education projects and the increases represent higher volumes of projects due to the easing of health restrictions and many students returning to in-person learning. Government revenues in 2022 increased by 3% over 2021.

Revenue continues to be derived almost exclusively from projects in North America and predominantly from the United States. The following table presents our revenue dispersion by geography:

	For the Year Ended December	For the Year Ended December	31,
	2022	2021	% Change
		($ in thousands)
Canada	25,477	17,299	47
U.S.	146,684	130,294	13
	172,161	147,593	17

Historically, approximately 15-25% and 75-85% of revenues are derived from sales to Canada and the United States, respectively. In 2020 and 2021, revenues from Canada fell to 11% and 12%, respectively, of total sales while sales to the United States increased to 89% and 88%, respectively, of total sales. COVID-19 infection rates and resulting regulatory responses by governments and public health officials have varied significantly by region, impacting the relative contribution of sales from each country. The geographical split for 2022 returned to historical averages and reflects the easing of health restrictions in Canada which occurred later than in the United States.

Sales and Marketing Expenses

Sales and marketing expenses decreased by $4.1 million to $27.0 million for the year ended December 31, 2022 from $31.0 million for the year ended December 31, 2021. The decrease was largely related to a decrease of $3.8 million in salaries and benefits costs and $0.7 million decrease in depreciation expense. The decreases were offset by $0.6 million increase in travel, meals and entertainment expenses as business activity has increased with the easing of restrictions during 2022.

General and Administrative Expenses

General and administrative (“G&A”) expenses decreased $5.1 million to $25.5 million for the year ended December 31, 2022 from $30.6 million for the year ended December 31, 2021. The decrease was related to a $3.3 million decrease in salaries and benefits costs associated with the planned headcount reductions as part of our cost savings initiatives, a $2.0 million decrease in professional services costs and a $0.7 million decrease in depreciation expense, offset by a $0.9 million increase in costs incurred associated with the contested election of directors to $1.8 million in 2022 from $0.9 million in 2021. The decreases were partially offset by increased office costs as employees returned to work during 2022.

Operations Support Expenses

Operations support is comprised primarily of project managers, order entry and other professionals that facilitate the integration of our Construction Partner project execution and our manufacturing operations. Operations support expenses of $9.5 million in 2022 increased marginally from $9.4 million in 2021. The increase was due to lower capitalized hours in 2022 compared to 2021 as there were limited internal design projects compared to the prior year. The increases were offset by lower travel, meals and entertainment costs compared to 2021.

Technology and Development Expenses

Technology and development expenses relate to non-capitalizable costs associated with our product and software development teams and are primarily comprised of salaries and benefits of technical staff.

Technology and development expenses decreased by $0.7 million to $7.6 million for the year ended December 31, 2022, compared to $8.2 million for the year ended December 31, 2021, primarily related to decreased salaries and benefits costs and professional fees in the current year offset by a decrease in capitalized software development costs.

Stock-Based Compensation

Stock-based compensation expense for the year ended December 31, 2022 was $4.3 million compared to $4.7 million in 2021. The movement in this expense was largely the impact of grants of RSUs to the Company's employees, including those in lieu of cash compensation to the Company’s former interim Chief Executive Officer in January 2022 and DSUs granted to the Board of Directors, lowered by the impact of fair value adjustments on cash settled awards as a result of our share price decreasing during the year ended December 31, 2022. The Board of Directors receives 100% of their remuneration in DSUs.

Goodwill Impairment

We test goodwill for impairment annually during the fourth quarter of the calendar year. Due to the impact of the COVID-19 pandemic on our financial results in 2021, we determined it was necessary to use the quantitative approach to perform our goodwill impairment test. Based on our testing, the fair value of goodwill did not exceed the carrying value of its net assets and, accordingly,

the entire $1.4 million balance of goodwill was impaired as at December 31, 2021. There was no impairment charge for the year ended December 31, 2022.

Reorganization

For the year ended December 31, 2022, we incurred $13.5 million of reorganization costs. Reorganization costs for the year include insurance costs incurred on change of control of the Board of Directors following the contested director elections, costs associated with the closure of the Phoenix Facility, costs associated with the temporary suspension of operations at the Rock Hill Facility and termination benefits associated with these changes, cost reduction initiatives explained below and management changes that occurred during the year.

We have undertaken several initiatives to align our manufacturing footprint with our current activity levels. This included the closure of the Phoenix Facility completed in the second quarter of 2022, with related manufacturing to be undertaken by both our Savannah and Calgary Facilities. Of the initial estimate of cost savings of approximately $2.4 million from this closure, we expect to realize annualized savings of approximately $1.0 million, as $1.4 million of work force reductions were offset by additions in Calgary and Savannah due to increased demand. On August 23, 2022, we announced the temporary closure of our Rock Hill Facility, as the Calgary Facility has sufficient capacity to absorb production and meet expected demand for the near term.

Additionally, in February 2022, we announced a reduction of our salaried workforce including manufacturing and office positions which, along with other cost reduction initiatives, were expected to yield annualized savings of approximately $13.0 million. The reductions were followed by a further reduction of salaried positions, as announced in July 2022, and the temporary closure of our Rock Hill Facility, announced in August 2022, which are expected to result in approximately $5.0 million in annualized savings. Of these cost reduction initiatives, $15.0 million was implemented during 2022. $3.0 million comprising of certain manufacturing positions and other cost reductions, has been deferred as we work to increase manufacturing headcount in light of increased demand.

Government Subsidies

Government subsidies for the year ended December 31, 2022 was $7.8 million compared to $11.5 million for the same period of 2021. During the third quarter of 2022, the Company determined it was eligible for the Employee Retention Credit ("ERC") in the United States. The ERC is a refundable payroll tax credit based on qualified wages paid by an eligible employer between March 12, 2020, and October 1, 2021 for companies experiencing a significant decline in gross receipts during a calendar quarter or having operations fully or partially suspended during the quarter due to COVID-19. The Company is eligible for ERC for the first three quarters of 2021 and has filed a claim for $7.3 million in payroll tax credits ($7.1 million net of expenses). As of December 31, 2022 these credits have not been received and are included in other receivables in the balance sheet.

2021 government subsidies related to the Canadian Emergency Wage Subsidy ("CEWS") and the Canadian Emergency Rent Subsidy ("CERS"). At December 31, 2021, all amounts recorded at December 31, 2021 were collected. The last claim period under the CEWS and CERS programs ended on October 23, 2021. The Company is not eligible for and did not receive any new Canadian government subsidies in year ended December 31, 2022.

Interest expense

Interest expense increased by $2.0 million from $3.1 million for the year ended December 31, 2021 to $5.1 million for the year ended December 31, 2022. The increased interest expense is a result of the issuance of C$35.0 million ($27.4 million) of Debentures in December 2021 and draws on the Leasing Facilities.

Income Tax

The provision for income taxes comprises U.S. and Canadian federal, state and provincial taxes based on pre-tax income. Income tax expense for the year ended December 31, 2022 was $0.02 million, compared to a $0.2 million recovery for the same period of 2021. For the year ended December 31, 2022, the Company recorded valuation allowances of $13.6 million (2021 - $12.0 million) against deferred tax assets due to operating losse ~~s w~~ hich impacted our ability to generate sufficient taxable income in Canada and the United States to fully deduct historical losses. As at December 31, 2022, we had C$106.7 million of loss carry-forwards in Canada and $55.7 million in the United States. These loss carry-forwards will begin to expire in 2032.

Net Loss

Net loss increased to $55.0 million or $0.63 net loss per share in the year ended December 31, 2022 from a net loss of $53.7 million or $0.63 net loss per share for the year ended December 31, 2021. The increased loss is primarily the result of a $1.8 million increase in operating expenses (which includes $13.5 million of reorganization expenses), a $2.0 million increase in interest expense, a $3.7 million decrease in government subsidies, and a $0.2 million increase in income tax expense. These decreases were offset by a $4.7 million increased gross profit and $1.8 million increase in foreign exchange gains.

Three Months Ended December 31, 2022 Compared to the Year Ended December 31, 2021

	For the three months ended December 31,	For the three months ended December 31,	For the three months ended December 31,
	2022	2021	% Change
		($ in thousands)
Revenue	42,427	42,928	(1 )
Gross Profit(1)	11,589	8,416	38
Gross Profit Margin	27.3 %	19.6 %
Operating Expenses
Sales and Marketing	5,856	9,271	(37 )
General and Administrative	4,050	8,028	(50 )
Operations Support	2,151	2,488	(14 )
Technology and Development	1,841	2,229	(17 )
Stock-Based Compensation	731	921	(21 )
Reorganization	1,180	-	NA
Goodwill Impairment	-	1,443	(100 )
Total Operating Expenses	15,809	24,380	(35 )
Operating Loss	(4,220 )	(15,964 )	74
Operating Margin	(9.9 )%	(37.2 )%

Annual 2022 Non-GAAP Measures

Adjusted Gross Profit and Adjusted Gross Profit Margin for the Years Ended December 31, 2022, 2021 and 2020

The following table presents a reconciliation for the years ended December 31, 2022, 2021, and 2020 of Adjusted Gross Profit to our gross profit and Adjusted Gross Profit Margin to gross profit, which are the most directly comparable GAAP measures for the periods presented:

	For the Year Ended December 31,	For the Year Ended December 31,	For the Year Ended December 31,
	2022	2021	2020
		($ in thousands)
Gross profit	28,160	23,460	53,283
Gross profit margin	16.4 %	15.9 %	31.1 %
Add: Depreciation and amortization expense	10,789	8,808	8,110
Add: Costs ofunder-utilized capacity	-	1,756	2,010
Adjusted Gross Profit	38,949	34,024	63,403
Adjusted Gross Profit Margin	22.6 %	23.1 %	37.0 %

For the year ended December 31, 2022, gross profit and gross profit margin increased to $28.2 million or 16.4% from $23.5 million or 15.9% in the prior year. Adjusted Gross Profit increased to $38.9 million and Adjusted Gross Profit Margin decreased to 22.6% for the year ended December 31, 2022, from $34.0 million or 23.1% for the year ended December 31, 2021. The 0.5% decrease in Adjusted Gross Profit Margin was a result of increased materials, transportation, packaging and other variable costs incurred prior to the effect date of the announced price increases, offset by the price actions discussed above. As a result of higher sales activities, gross profit benefited by 9.2% and 11.9% on utilization of labor and fixed costs, respectively. Labor costs increased $1.5 million for the year-to-date period as we incurred incremental costs during the second quarter associated with moving production to the Calgary and Savannah Facilities following the closure of the Phoenix Facility, rate increases, and adding capacity following an improvement in demand. Fixed costs increased $0.8 million due to cost inflation and the impact of adding the Rock Hill Facility in 2021 to the fixed cost base. In 2022 we incurred a $0.8 million charge, or 0.5% related to Reflect and other discontinued product lines. 2021 Adjusted Gross Profit benefited from the removal of $1.8 million, or 1.2% Adjusted Gross Profit impact, on under-utilized capacity not captured in product costs. 2022 gross profit was impacted by $2.1 million of incremental depreciation and amortization on the acceleration of useful lives associated with discontinued product lines and the Phoenix Facility. Gross profit for the year ended 2022 benefited by approximately $1.5 million from the impact of the weakening Canadian dollar on U.S. dollar reported results, which is included in the above variances.

During the first quarter of 2020, 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 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 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 (1.2% of 2021 first quarter gross profit margin) in cost of sales. For the remaining quarters of 2021 and 2022, we did not have abnormal excess capacity as our workforce was better aligned with current production volumes.

In August 2022 we announced the temporary suspension of operations at the Rock Hill Facility. Idle facility costs incurred since suspension of operations of $0.5 million are included in cost of sales.

EBITDA and Adjusted EBITDA for the Years Ended December 31, 2022, 2021 and 2020

The following table presents a reconciliation for the results of 2022, 2021 and 2020 of EBITDA and Adjusted EBITDA to our net loss, which is the most directly comparable GAAP measure for the years presented:

	For the Year Ended December 31,	For the Year Ended December 31,	For the Year Ended December 31,
	2022	2021	2020
		($ in thousands)
Net loss for the period	(54,963 )	(53,668 )	(11,298 )
Add back (deduct):
Interest Expense	5,160	3,131	305
Interest Income	(51 )	(77 )	(238 )
Tax expense (recovery)	21	(204 )	2,104
DepreciationandAmortization	15,119	14,513	11,706
EBITDA	(34,714 )	(36,305 )	2,579
Foreign Exchange Gains	(1,445 )	335	576
Stock-Based Compensation	4,277	4,713	2,351
Government Subsidies	(7,765 )	(11,455 )	(12,721 )
Reorganization Expense	13,461	-	-
Goodwill Impairment	-	1,443	-
Adjusted EBITDA	(26,186 )	(41,269 )	(7,215 )
Net Loss Margin(1)	(31.9 )%	(36.4 )%	(6.6 )%
Adjusted EBITDA Margin	(15.2 )%	(28.0 )%	(4.2 )%
(1) Net loss divided by revenue.

For the year ended December 31, 2022, Adjusted EBITDA and Adjusted EBITDA Margin increased by $15.1 million to a $26.2 million loss or (15.2)% from $41.3 million loss or (28.0)% in the same period of 2021. This reflects a $4.9 million increase in Adjusted Gross Profit and $1.8 million in lower costs of underutilized capacity, discussed above, a $7.0 million decrease in salary and wage expenses reflecting the impact of headcount reductions resulting from restructuring activities during 2022, $1.2 million of decreased professional fees, as well as the impact of a weakening Canadian dollar relative to the US dollar on Canadian-based operating expenses, excluding depreciation and stock-based compensation.

Reconciliation of Q4 2022 Non-GAAP Measures

Adjusted Gross Profit and Adjusted Gross Profit Margin for the Three Months Ended December 31, 2022, 2021 and 2020

The following table presents a reconciliation for the three months ended December 31, 2022, 2021, and 2020 of Adjusted Gross Profit to our gross profit, which is the most directly comparable GAAP measure for the periods presented:

	For the three months ended December 31,	For the three months ended December 31,	For the three months ended December 31,
	2022	2021	2020
		($ in thousands)
Gross profit	11,589	8,416	11,540
Gross profit margin	27.3 %	19.6 %	27.4 %
Add: Depreciation and amortization expense	1,997	2,425	1,982
Add: Costs ofunder-utilized capacity	-	-	-
Adjusted Gross Profit	13,586	10,841	13,522
Adjusted Gross Profit Margin	32.0 %	25.3 %	32.0 %

EBITDA and Adjusted EBITDA for the Three Months Ended December 31, 2022, 2021 and 2020

The following table presents a reconciliation for the three months ended results of 2022, 2021 and 2020 of EBITDA and Adjusted EBITDA to our net loss, which is the most directly comparable GAAP measure for the periods presented:

	For the three months ended December 31,	For the three months ended December 31,	For the three months ended December 31,
	2022	2021	2020
		($ in thousands)
Net loss for the period	(5,906 )	(16,012 )	(4,178 )
Add back (deduct):
Interest Expense	1,225	1,014	109
Interest Income	(1 )	(15 )	(16 )
Tax expense (recovery)	37	(551 )	(86 )
DepreciationandAmortization	2,917	3,875	3,033
EBITDA	(1,728 )	(11,689 )	(1,138 )
Foreign Exchange Gains	425	621	1,450
Stock-Based Compensation	731	921	751
Government Subsidies	-	(1,021 )	(3,918 )
Reorganization Expense	1,180	-	-
Goodwill Impairment	-	1,443	-
Adjusted EBITDA	608	(9,725 )	(2,855 )
Net Loss Margin(1)	(13.9 )%	(37.3 )%	(9.9 )%
Adjusted EBITDA Margin	1.4 %	(22.7 )%	(6.8 )%

(1) Net loss divided by revenue.

Year Ended December 31, 2021 Compared to the Year Ended December 31, 2020

Discussion and analysis of our financial condition and results of operations for the fiscal year ended December 31, 2021 compared to the fiscal year ended December 31, 2020 is included under the heading Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2021, as filed with the SEC and applicable securities commissions or similar regulatory authorities in Canada on February 23, 2022.

Liquidity and Capital Resources

Cash and cash equivalents at December 31, 2022 totaled $10.8 million, an decrease of $49.5 million from December 31, 2021. The decrease in cash over the year primarily reflects the impact of $44.3 million of cash used in operations, of which $1.8 million related to one-time costs associated with the contested director elections and $13.5 million of reorganization costs. In addition, capital expenditures totaled $4.3 million and scheduled leasing repayments totaled $2.5 million.

The impact of COVID-19 on the Company’s sales and operations has been severe, including a contraction of demand since the beginning of the pandemic and more recently, significant inflation on raw material costs. This has resulted in a significant usage of cash which we have financed through existing cash on hand and external financings, as described further below. In response, we have implemented multiple initiatives during 2022 to reduce our overall fixed cost base and pricing actions to better recover the inflationary impacts to material, labor and transportation input costs, each of which has been discussed elsewhere in this Annual Report. During the second half of 2022, we began to realize the benefits of these actions. During the fourth quarter of 2022, cash and cash equivalents increased $4.0 million to $10.8 million from $6.8 million at September 30, 2022. The improved cash flow was driven by a combination of improved EBITDA from the pricing initiatives, cash flow provided from the working capital initiatives, and approximately $2.0 million of net proceeds received on the Private Placement during the quarter.

We expect the benefit of the actions discussed above to continue to be realized in 2023 and beyond. While these actions, combined with and our project pipeline are promising, we continue to see unpredictability in our pace of orders.

Accordingly, we are taking several actions to improve our balance sheet in the short term. First, we have determined our eligibility for the ERC for the first three quarters of 2021 and have filed a claim for $7.3 million in payroll tax credits ($7.1 million net of expenses). Second, we have certain properties that are currently owned that we are evaluating for sale and leasing back. We do not intend to vacate these premises as they still serve a valuable aspect of our value proposition, but we expect to receive a one-time cash payment, in exchange for future rent payments. Third, we are evaluating initiatives related to the use of ICE software by third parties to supplement the relatively small revenues we have previously recognized from our licensing of ICE software to certain strategic partners for use in their businesses and our related licensing and developer software support for these counterparties.

To finance the Company's short-term cash requirements, the Company entered into irrevocable subscription agreements with its two largest shareholders, 22NW and 726 and all the directors and officers of the Company on November 14, 2022 to issue 8.7 million shares for gross consideration of $2.8 million. The Private Placement closed on November 30, 2022. In addition, in connection with the Private Placement, 22NW and 726, or their principals, have irrevocably committed to backstopping any rights offering occurring by the Company within twelve months of closing the Private Placement in the aggregate amount of $2.0 million.

We have assessed the Company’s liquidity as at December 31, 2022 using multiple downside and upside scenarios, our sales outlook for the next twelve months in combination with existing cash balances, available credit facilities, the strategic transactions being evaluated and the Private Placement discussed previously, and potential equity or debt financing. Based upon this analysis, we believe the Company has sufficient liquidity to remain a going concern for at least the next 12 months. However, a number of factors, including our ability to satisfy the expected growth in pipeline demand and those discussed below, could adversely impact our liquidity over such period.

To the extent that existing cash and cash equivalents, available facilities and any increased liquidity from the aforementioned strategic actions are not sufficient to fund future activities, we may seek to raise additional funds through equity or debt financings. If additional funds are raised through the incurrence of indebtedness, such indebtedness may have rights that are senior to holders of our Debentures and our equity securities or contain instruments that may be dilutive to our existing shareholders. Any additional equity or debt financing may be dilutive to our existing shareholders. While we believe we can access capital markets when needed or under acceptable terms, there can be no assurance we will be able to do so.

During 2021, we completed financings to increase our liquidity in light of the highly uncertain economic conditions caused by the pandemic. In January 2021, we issued C$40.3 million of the January Debentures for net proceeds after costs of C$37.6 million ($29.5 million). The January Debentures accrue interest at a rate of 6.00% per annum and are convertible into common shares of DIRTT at an exercise price of C$4.65 per common share, or if not converted will mature and be repayable on the January Debenture Maturity Date. Interest and principal are payable in cash or shares at the option of the Company.

In February 2021, we entered into the RBC Facility, a C$25.0 million senior secured revolving credit facility with RBC. Under the RBC Facility, the “Borrowing Base” is 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. Available borrowings under the RBC Facility at December 31, 2022 were C$7.2 million ($5.3 million). On February 9, 2023, the Company extended the RBC Facility (the “Extended RBC Facility”). The Extended RBC Facility has an borrowing base of C$15 million and a one year term.

On November 15, 2021, we issued C$35.0 million of the December Debentures for net proceeds after costs of C$32.7 million ($25.6 million). The December Debentures accrue interest at a rate of 6.25% per annum and are convertible into common shares of DIRTT at an exercise price of C$4.20 per common share, or if not converted will mature and be repayable on the December Debenture Maturity Date. Interest and principal are payable in cash or shares at the option of the Company.

The Company has a C$5.0 million Canada Leasing Facility of which C$4.4 million ($3.3 million) has been drawn, and a $14.0 million U.S. Leasing Facility of which $13.3 million has been drawn with RBC and one of its affiliates. The Leasing Facilities are available for equipment expenditures and certain equipment expenditures already incurred.

The following table summarizes our consolidated cash flows for the years indicated:

	For the Year Ended December	For the Year Ended December	31,
	2022	2021	2020
		($ in thousands)
Net cash flows (used in) provided by operating activities	(44,260 )	(31,210 )	12,485
Net cash flows used in investing activities	(4,024 )	(14,138 )	(19,392 )
Net cash (used in) provided by financing activities	(874 )	62,452	5,724
Effect of foreign exchange on cash,cash equivalents and restricted cash	(11 )	458	(145 )
Net (decrease) increase in cash, cash equivalents and restricted cash	(49,169 )	17,562	(1,328 )
Cash,cash equivalents and restricted cash,beginningofperiod	63,408	45,846	47,174
Cash, cash equivalents and restricted cash, end of period	14,239	63,408	45,846

	For the Year Ended December 31,	For the Year Ended December 31,	For the Year Ended December 31,
	2022	2021	2020
Cash and cash equivalents	10,821	60,313	45,846
Restricted cash	3,418	3,095	-
Total cash, cash equivalents and restricted cash	14,239	63,408	45,846

Operating Activities

Net cash flows used in operating activities were $44.3 million for the year ended December 31, 2022 compared to $31.2 million used by operating activities for the year ended December 31, 2021. Included in the $44.3 million used in operating activities in the year ended December 31, 2022 are $13.5 million of reorganization costs, $1.8 million of professional fees associated with the contested director elections, and $3.8 million of increased inventory arising from higher raw material prices and taking on incremental inventory from suppliers to mitigate against potential supply chain disruption, offset by the receipt of a $3.2 million income tax refund related to 2020. During the third and fourth quarter of 2022 we began to draw down our aluminum supply inventory. In the fourth quarter of 2022 we achieved positive operating cash flows through the realization of price increases, the implementation of a quick pay discount program which led to higher collections, and a focus on reduced spending. Apart from the above noted items, working capital changes primarily reflect government subsidies receivable offset by higher customer deposits.

Investing Activities

We invested $2.4 million in property, plant and equipment during the year ended December 31, 2022 compared to $11.8 million during 2021. The expenditures for 2022 comprised $1.0 million of working capital changes, $0.8 million of manufacturing upgrades, $0.3 million related to our website design and $0.3 million related to DXC refreshes and IT equipment. The decrease in investing activities is largely due to reduced spending as the Rock Hill Facility and Dallas DXC were completed in 2021.

We invested $1.7 million on capitalized software during the year ended December 31, 2022 compared to $2.3 million for the comparative period in 2021.

Actual capital expenditures of $4.3 million were below our 2022 capital budget of $7.0 million. Our 2022 capital expenditure program comprised approximately $2.5 million related to refreshes of DXCs, continued enhancement of our customer relationship management system and website redesign, approximately $2.5 million on software development and approximately $2.0 million on manufacturing and other capital upgrades of which actual expenditures have been less than budget.

Financing Activities

For the year ended December 31, 2022, $0.9 million of cash was used in financing activities, comprising mainly of $2.5 million of scheduled payments under the Leasing Facilities and $1.0 million relating to taxes paid on the vesting of RSUs for the year ended December 31, 2022 offset by the receipt of $2.0 million net proceeds from the Private Placement and a draw of C$0.9 million ($0.7 million) under the Canada Leasing Facility. For the year ended December 31, 2021, $62.5 million of cash was provided by financing activities, mainly due to the proceeds received from the issuance of C$37.6 million and C$32.7 million of Debentures in January and December of 2021, respectively, and the receipt of $9.8 million of cash consideration under the U.S. Leasing Facility.

We currently expect to fund anticipated future investments with available cash, which includes the net proceeds from the Private Placement, and drawings on the RBC Facility. We also expect to pursue additional strategic actions to improve available cash, which included filing an application for ERC for the first three quarters of 2021 for $7.1 million, net of expenses, evaluating properties we own for sale and lease back and evaluating multiple initiatives related to the use of our ICE software. Refer to “–Liquidity and Capital Resources" for further details. Apart from cash flow from operations, issuing equity and debt has been our primary source of capital to date. Additional debt or equity financing may be pursued in the future as we deem appropriate. We may also use debt or pursue equity financing depending on the price of our common shares at the time, interest rates, and nature of the investment opportunity and economic climate. No assurance can be given that any of these actions will be successful, will be sufficient for our needs.

Consolidated cash flows for the quarter as indicated:

	For the three months ended December 31,	For the three months ended December 31,	For the three months ended December 31,
	2022	2021	2020
		($ in thousands)
Net cash flows (used in) provided by operating activities	3,249	(7,338 )	5,090
Net cash flows used in investing activities	(429 )	(1,582 )	(9,713 )
Net cash (used in) provided by financing activities	928	26,369	(258 )
Effect of foreign exchange on cash,cash equivalents and restricted cash	62	(123 )	27
Net (decrease) increase in cash, cash equivalents and restricted cash	3,810	17,326	(4,854 )
Cash,cash equivalents and restricted cash,beginningofperiod	10,429	46,082	50,700
Cash, cash equivalents and restricted cash, end of period	14,239	63,408	45,846

Credit Facility

On February 12, 2021, the Company entered into the RBC Facility. Under the RBC Facility, the Borrowing Base is 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. At December 31, 2022, available borrowings are C$7.2 million ($5.3 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 three immediately preceding months, 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. The Company did not meet the three month FCCR requirement during the fourth quarter of 2022, which resulted in requiring the restriction of $3.4 million of cash. Should an event of default occur or the Aggregate Excess Availability be less than C$6.25 million for five 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. On February 9, 2023, the Company extended the RBC Facility (the “Extended RBC Facility”). The Extended RBC Facility has an borrowing base of C$15 million and a one year term. Interest is calculated as at the Canadian or U.S. prime rate plus 75 basis points or at the Canadian Dollar Offered Rate or LIBOR plus 200 basis points. Under the Extended RBC Facility, until such time that the trailing twelve month FCCR is above 1.25 for three consecutive months, a cash balance equivalent to 1-years worth of Leasing Facilities payments must be maintained.

During 2020, the Company entered into the Leasing Facilities, consisting of the C$5.0 million Canada Leasing Facility and the $14.0 million U.S. Leasing Facility with RBC, 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 5.59%. The U.S. Leasing Facility is amortized over a six-year term and is extendible at the Company’s option for an additional year.

The Company has drawn $13.3 million of cash consideration under the U.S. Leasing Facility and commenced the lease term in 2020 for the equipment at the Rock Hill Facility. The Company has drawn C$4.4 million ($3.3 million) of cash consideration under the Canada Leasing Facility and commenced the lease term for the Canadian equipment expenditures during 2020. C$0.9 million ($0.7 million) of the Canada Leasing Facility was drawn during the year ended December 31, 2022.

We are restricted from paying dividends unless Payment Conditions (as defined in the RBC Facility) are met, including having a net borrowing availability of at least C$10 million over the proceeding 30-day period, and having a trailing twelve month fixed charge coverage ratio above 1.10:1 and certain other conditions. The RBC Facility is currently secured by substantially all of our real property located in Canada and the United States

Contractual Obligations

The following table summarizes DIRTT’s contractual obligations at December 31, 2022:

		Payments due by period	Payments due by period	Payments due by period
	Less than 1year	1to 3 years	3 to 5 years	Greater than 5 years	Total

			($ in thousands)
Accounts payable and accrued liabilities	19,881	-	-	-	19,881
Other liabilities	2,056	-	-	-	2,056
Customer deposits and deferred revenue	4,866	-	-	-	4,866
Current and long-term portion of long-term debt	6,567	13,594	61,507	131	81,799
and accrued interest1
Lease liabilities (undiscounted)	5,889	8,381	5,615	13,538	33,423
Purchase obligations	2,150	-	-	-	2,150
Total	41,409	21,975	67,122	13,669	144,175

(1) Includes principal and interest. See Note 14 to our Consolidated Financial Statements for additional information.

Critical Accounting Policies and Estimates

Our significant accounting policies are described in Note 2 to our Consolidated Financial Statements appearing elsewhere in this Annual Report. Our critical accounting estimates include the areas where we have made what we consider to be particularly difficult, subjective or complex judgments in making estimates, and where these estimates can significantly affect our financial results under different assumptions and conditions. We prepare our financial statements in conformity with GAAP. As a result, we are required to make estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the periods presented. Actual results could be different from these estimates. Critical estimates and assumptions made by management include:

Estimates of liabilities associated with the potential and amount of warranty, legal claims and other contingencies

We have warranty obligations with respect to manufacturing defects on most of our manufactured products. Warranty periods generally range from one to ten years. We have recorded a reserve for estimated warranty and related costs based on historical experience and periodically adjust these provisions to reflect actual experience. We assess the adequacy of our warranty accrual on a quarterly basis, and adjust the previous amounts recorded, if necessary, to reflect the change in estimate of the future costs of claims yet to be serviced. Typically, product deficiencies requiring our warranty are identified and remediated within a year of production. The following provides information with respect to our warranty accrual. At December 31, 2022 and 2021, we had $1.3 million and $1.5 million, respectively, accrued for warranty and other provisions, and third-party costs associated with remedying deficiencies were $1.1 million during the fiscal year ended December 31, 2022, as compared to $0.8 million during the fiscal year ended December 31, 2021.

We establish reserves for estimated legal contingencies when we believe a loss on litigation is probable and the amount of the loss can be reasonably estimated. Revisions to contingent liability reserves are reflected in operations in the period in which there are changes in facts and circumstances that affect our previous assumptions with respect to the likelihood or amount of loss. Reserves for contingent liabilities are based upon our assumptions and estimates regarding the probable outcome of the matter. We estimate the probable cost by evaluating historical precedent as well as the specific facts relating to each contingency (including the opinion of outside advisors). Should the outcome differ from our assumptions and estimates, or other events result in a material adjustment to the accrued estimated reserves, revisions to the estimated reserves for contingent liabilities would be required and would be recognized in the period the new information becomes known. At December 31, 2022 and 2021, we had $0.05 million and $0.1 million provided for legal provisions, respectively.

Estimates of useful lives of depreciable assets and the fair value of long-term assets used for impairment calculations

We evaluate the recoverability of our property, plant, and equipment (“PP&E”), capitalized software costs and right of use assets when events or changes in circumstances indicate a potential impairment exists. If impairment is indicated, the impairment loss is measured as the amount the assets carrying value exceeds the fair value of the assets.

Our determination of the fair value associated with long-term assets involves significant estimates and assumptions, including those with respect to the determination of asset groups, future cash inflows and outflows, discount rates, and asset lives. In the current year, estimates of cash inflows are dependent on the timing and extent of recovery of the slowdown experienced as a result of the COVID-19 pandemic. These significant estimates require considerable judgment, which could affect our future results if the current estimates of future performance and fair values change.

We estimate the useful lives of PP&E, capitalized software costs and right of use assets based on the period over which the assets are expected to be available for use. The estimated useful lives are reviewed annually and are updated if expectations differ from previous estimates due to physical wear and tear, technical or commercial obsolescence and legal or other limits on the use of the relevant assets. In addition, the estimation of the useful lives of the relevant assets may be based on internal technical evaluation and experience with similar assets. It is possible, however, that future results of operations could be materially affected by changes in the estimates brought about by changes in factors mentioned above. The amounts and timing of recorded expenses for any period would be affected by changes in these factors and circumstances. A reduction in the estimated useful lives of the PP&E and capitalized software assets would increase the recorded expenses and decrease the non-current assets.

We test goodwill for impairment annually during the fourth quarter of the calendar year. Due to the ongoing impact of the COVID-19 pandemic on our financial results in 2021, we determined it was necessary to use the quantitative approach to perform our goodwill impairment test. Based on our testing, the fair value of goodwill did not exceed the carrying value of its net assets and, accordingly, the entire $1.4 million balance of goodwill was impaired as at December 31, 2021. There was no impairment charge for the year ended December 31, 2022.

Estimates of future taxable earnings used to assess the realizable value of deferred tax assets

We use the asset and liability method of accounting for income taxes. Under this method, deferred income tax assets and liabilities arise from temporary differences between the tax bases of assets and liabilities and their carrying amounts reported in the financial statements. Deferred income tax assets also reflect the benefit of unutilized tax losses that can be carried forward to reduce income taxes in future years. Such method requires the exercise of significant judgment in determining whether or not our deferred tax assets are probable of recovery from taxable income of future years and, therefore, can be recognized in the financial statements. Also, estimates are required to determine the expected timing upon which tax assets will be realized and upon which tax liabilities will be settled. We assess the ability to recover our deferred tax assets every quarter and concluded that a valuation allowance was required against our deferred tax assets at December 31, 2022 of $29.8 million (2021 - $17.3 million).

Tax interpretations, regulations, and legislation in the various jurisdictions in which the Company and its subsidiaries operate

The determination of our provision for income taxes requires significant judgment, the use of estimates and the interpretation and application of complex tax laws. Our provision for income taxes reflects a combination of income earned and taxed in the various U.S. federal and state, and Canadian federal and provincial, jurisdictions. Jurisdictional tax law changes, increases or decreases in permanent differences between book and tax items, accruals or adjustments of accruals for tax contingencies or valuation allowances, and the change in the mix of earnings from these taxing jurisdictions all affect the overall effective tax rate.

We have no liability for uncertain tax positions. However, should we accrue for such liabilities, when and if they arise in the future, we will recognize interest and penalties associated with uncertain tax positions as part of our income tax provision.

Estimates of the fair value of stock awards, including whether the performance criteria will be met and measurement of the ultimate payout amount

We use a fair-value based approach for measuring stock-based compensation and record compensation expense over an award’s vesting period based on the award’s fair value at the date of grant. Our awards vest based on service conditions, and compensation expense is recognized on a straight-line basis. Stock-based compensation expense is recognized only for those awards that ultimately vest.

Estimates of ability and timeliness of customer payments of accounts receivable

Our expected credit loss reflects reserves for customer receivables to reduce receivables to amounts expected to be collected. Management uses significant judgment in estimating expected credit losses. In estimating the Company’s current estimate of expected credit losses, management considers 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. While we believe these processes effectively address our exposure for doubtful accounts and credit losses have historically been within expectations, changes in the economy, industry, or specific customer conditions may require adjustments to the expected credit loss. We have a contract with a trade credit insurance provider, whereby a portion of our trade receivables are insured. The trade credit insurance provider determines the coverage amount, if any, on a customer-by-customer basis. Based on our trade receivables balance as at December 31, 2022 and 2021, approximately 77% and 90%, respectively, of that balance was covered by trade credit insurance provider.

At December 31, 2022, we had an allowance for expected credit loss of $0.1 million (2021 - $0.1 million).

Recent Accounting Pronouncements

Please refer to Note 3 to our Consolidated Financial Statements presented elsewhere in this Annual Report.