Applied Digital Corp

1. Business and Organization

Applied Digital Corporation (the “Company”), is a designer, builder, and operator of digital infrastructure providing cost-competitive solutions to customers. The Company hasthree reportable segments. Financial information for each segment is contained in Note 10 - Business Segments.

2. Basis of Presentation and Significant Accounting Policies

Principles of Consolidation

The accompanying interim unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC"), including the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in the Company's annual consolidated financial statements on Form 10-K have been condensed or omitted. The condensed consolidated balance sheet as of May 31, 2023 has been derived from the audited consolidated financial statements as of that date, but does not include all disclosures required for audited annual financial statements.

In the Company’s opinion, all necessary adjustments have been made for the fair presentation of the results of the interim periods presented. The results of operations for such interim periods are not necessarily indicative of the results to be expected for the full year. For further information, please refer to and read these interim unaudited condensed consolidated financial statements in conjunction with the Company's audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 2023 filed with the SEC on August 2, 2023.

Significant Accounting Policies and Use of Estimates

Use of Estimates

The preparation of the unaudited condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the balance sheet and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ significantly from those estimates. The most significant accounting estimates inherent in the preparation of the Company’s financial statements include estimates of the valuation allowance associated with the Company’s deferred tax assets.

Revenue Recognition

The Company recognizes revenue in accordance with Accounting Standards Codification 606, Revenue from Contracts with Customers.

Datacenter Hosting Revenue

The Company provides energized space to customers who locate their hardware within the Company’s co-hosting facility. All datacenter hosting performance obligations are achieved simultaneously by providing the hosting environment for the customers’ operations. Customers pay a fixed rate to the Company in exchange for a managed hosting environment supported by customer-provided equipment. Revenue is recognized based on the contractual fixed rate, net of any credits for non-performance, over the term of the agreements. Any ancillary revenue for maintenance or installation services is at a point in time when the maintenance or installation service is complete. As these services are directly attributable to the Company’s datacenter hosting service, this revenue is captured within the datacenter hosting revenue caption in our condensed consolidated statements of operations. Customer contracts include advance payment terms. All advanced service payments are recorded as deferred revenue and are recognized as revenue once the related service is provided.

Cloud Services Revenue

The Company also provides managed cloud infrastructure services to customers, such as artificial intelligence and machine learning developers, to help develop their advanced products. Customers pay a fixed rate to the Company in exchange for managed cloud services supported by Company-provided equipment. Revenues are recognized based on the fixed rate, net of any credits for non-performance, over the term of the agreements.

Segments

The Company has identified three reportable segments: cloud services (“Cloud services”), high-performance compute hosting (“HPC hosting”), and datacenter hosting (“Datacenter hosting”). The Company’s chief operating decision-maker evaluates performance, makes operating decisions and allocates resources on both a consolidated basis and on the basis of these three reportable segments. Intercompany transactions between segments are excluded for management reporting purposes.

The Datacenter hosting segment operates datacenters to provide energized space to crypto mining customers. Customer-owned hardware is installed in the Company’s facilities and the Company provides operational and maintenance services for a fixed fee.

The Cloud services segment operates through our Sai Computing brand and provides cloud services to customers, such as artificial intelligence and machine learning developers, to develop their advanced products. Customers pay a fixed rate to the Company in exchange for a managed hosting environment supported by Company-provided equipment.

The HPC hosting segment designs, builds, and operates datacenters which are designed to support high-compute applications using advanced and sophisticated infrastructures to provide services to customers.

See Note 3 - Basis of Presentation and Significant Accounting Policies to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended May 31, 2023, as filed with the SEC, for additional information regarding the Company’s significant accounting policies and use of estimates.

Recent Accounting Pronouncements

We reviewed all recently issued accounting pronouncements and concluded that they were either not applicable or not expected to have a significant impact on our consolidated financial statements.

Reclassifications

We have reclassified certain prior period revenue amounts from datacenter hosting revenue to related party datacenter hosting revenue on our condensed consolidated statements of operations. We have also reclassified amounts from accounts payable and accrued expenses and prepaid expenses and other current assets to accounts payable, accrued expenses, prepaid expenses, and other current assets as well as from customer deposits and deferred revenue to the associated related party caption lines and from prepaid expenses and other current assets to other assets in our condensed consolidated balance sheets to conform to our current period presentation. Lastly, we have reclassified interest income from selling, general and administrative to interest expense, net in our condensed consolidated statement of operations to conform to our current period presentation. These reclassifications had no impact on reported net income, cash flows, or total assets and liabilities.

Cash, Cash Equivalents, and Restricted Cash

Cash, cash equivalents, and restricted cash within the consolidated balance sheets that are included in the consolidated statements of cash flows as of November 30, 2023 and May 31, 2023 were as follows (in thousands):

3. Property and Equipment

Property and equipment consisted of the following as of November 30, 2023, and May 31, 2023 (in thousands):

Depreciation expense totaled $2.6 million and $4.9 million for the three and six months ended November 30, 2023 and $0.8 million and $1.7 million for the three and six months ended November 30, 2022.

4. Revenue from Contracts with Customers

Below is a summary of the Company’s revenue concentration by major customers for the three and six months ended November 30, 2023 and 2022, respectively.

Deferred Revenue

As of November 30, 2023, the Company had $52.0 million in deferred revenue (inclusive of related party deferred revenue), which represents the Company’s remaining performance obligations, and expects to recognize the entire balance within the next 12 months. Changes in the Company's deferred revenue balances for the six months ended November 30, 2023 and 2022, respectively, are shown in the following tables (in thousands):

Customer Deposits

Changes in the Company's customer deposits balances for the six months ended November 30, 2023 and 2022, respectively, are shown in the following table (in thousands):

5. Related Party Transactions

Related Party Revenue

The following table illustrates related party revenue for the three and six months ended November 30, 2023 and November 30, 2022 (in thousands):

*Customer D is a subsidiary of an entity which is deemed to beneficially own over 5% of the Company's outstanding common stock

**Customer E is 60% owned by an individual who is deemed to beneficially own over 5% of the Company's outstanding common stock

The following table illustrates related party deferred revenue and deposits balances as of November 30, 2023 and May 31, 2023 (in thousands):

Related Party Sublease Income

The Company receives sublease income from B. Riley Asset Management, which is also a wholly-owned subsidiary of B. Riley Financial, Inc. Mr. Cummins, the CEO of the Company, is also the President of B. Riley Asset Management. The following table illustrates related party revenue for the three and six months ended November 30, 2023 and November 30, 2022 (in thousands):

B. Riley Loan

During the six months ended November 30, 2023, the Company borrowed an additional $8.0 million and repaid the outstanding balance of $44.5 million. Interest expense associated with the loan was $0.5 million for the six months ended November 30, 2023. Total remaining unused capacity on the B. Riley Loan as of November 30, 2023, was $5.5 million.

6. Debt

Long-term debt consisted of the following components (in thousands):

Remaining Principal Payments

Below is a summary of the remaining principal payments due over the life of the term loans as of November 30, 2023 (in thousands):

Letters of Credit

As of November 30, 2023, the Company had letters of credit totaling $25.4 million. The Company has restricted cash related to its letters of credit and is required to keep these balances in separate accounts for the duration of the letter of credit agreements, which all have terms ending within the 12 months following November 30, 2023.

7. Stockholders' Equity

Equity Plans

On October 9, 2021, the Company’s Board of Directors approvedtwo equity incentive plans, which the Company’s stockholders approved on January 20, 2022. Thetwo plans consist of the 2022 Incentive Plan, previously referred to in the Company’s SEC filings as the 2021 Incentive Plan (the “Incentive Plan”), which provides for grants of various equity awards to the Company’s employees and consultants, and the 2022 Non-Employee Director Stock Plan previously referred to in the Company’s SEC filings as the 2021 Non-Employee Director Stock Plan (the “Director Plan” and, together with the Incentive Plan, the “Plans”), which provides for grants of restricted stock to non-employee directors and for deferral of cash and stock compensation if such deferral provisions are activated at a future date. As of November 30, 2023, the Company had issued awards for approximately 14.2 million shares of common stock of the Company (the “Common Stock”) under the plans. During the three and six months ended November 30, 2023 the Company recognized $4.8 million and $10.4 million in stock-based compensation.

Restricted Stock Awards

The following is a summary of the activity and balances for unvested restricted stock awards granted for the six months ended November 30, 2023:

As of November 30, 2023, total remaining expense to be recognized related to these awards was $0.9 million and the weighted average remaining recognition period for the unvested awards was 0.9 years.

Restricted Stock Units

The following is a summary of the activity and balances for unvested restricted stock units granted for the six months ended November 30, 2023:

As of November 30, 2023, total remaining expense to be recognized related to these awards was $29.2 million and the weighted average remaining recognition period for the unvested awards was 2.1 years.

Public Offering

During the six months ended November 30, 2023, the Company began issuing and selling common stock under an "at the market" sale agreement pursuant to which the Company may sell up to $125 million in aggregate proceeds of Common Stock. As of November 30, 2023, the Company has sold approximately 14.8 million shares. Net proceeds, less commission and legal fees of approximately $3.3 million, were approximately $97.9 million.

Extinguishment of Noncontrolling Interest

On August 31, 2023, pursuant to the joint venture agreement, the minority partner in 1.21 Gigawatts LLC exercised the option to exchange their interest in the joint venture for approximately 1.5 million shares for a value of $9.8 million of the Company’s common stock. The Company is now the sole member of 1.21 Gigawatts LLC and will report all activity as attributable to the Company in future periods.

8. Leases

The Company enters into leases for equipment, office space, and land. The Company’s lease agreements do not contain any material residual value guarantees or material restrictive covenants. The Company presents operating and finance right of use assets and liabilities separately on the balance sheet as their own captions, with the liabilities split between current and long-term, respectively.

Components of lease expense were as follows (in thousands):

(1)Amortization of right-of-use assets is included within depreciation expense, and is recorded within cost of revenues and selling, general and administrative expense in the condensed consolidated statements of operations.

The following table represents the Company’s future minimum lease payments as of November 30, 2023:

Supplemental cash flow and other information related to leases is as follows:

The Company has entered into operating leases which are executed but not yet commenced with total minimum payments of approximately $130.4 million. The payments are for various leases with terms ranging from 2 years to 7 years.

9. Commitments and Contingencies

Energy Commitment

The Company also has a minimum commitment of approximately $89.2 million related to the energy services agreement for its Jamestown, North Dakota co-hosting facility with a remaining term of approximately 3.2 years as of November 30, 2023.

Claims and Litigation

From time to time, the Company may be involved in litigation relating to claims arising out of operations in the normal course of business.

On August 12, 2023, a putative securities class action complaint, captioned McConnell v. Applied Digital Corporation, Wesley Cummins and David Rench, No. 3:23-cv-1805, was filed in the U.S. District Court for the Northern District of Texas, Dallas Division against Applied Digital Corporation (the “Company”) and two of its officers, Chief Executive Officer Wesley Cummins and Chief Financial Officer David Rench, asserting violations of Sections 10(b) and 20(a) of the Securities Exchange Act. The complaint alleges that the defendants made materially false and misleading statements regarding the Company’s business, operations, and compliance policies. Specifically, the complaint alleges that the Company overstated the profitability of its datacenter hosting business and its ability to successfully transition into a low-cost cloud services provider and that the Company’s board of directors was not “independent” within the meaning of NASDAQ listing rules.

On November 15, 2023, a putative securities complaint, captioned Robert Weich v. Wes Cummins, Chuck Hastings, Kelli McDonald, Douglas Miller, Virginia Moore, and Richard Nottenburg, No. A-23-881629-C, was filed in the U.S. District Court for Clark County, Nevada against certain members of Applied Digital Corporation’s Board of Directors and two of its officers, Chief Executive Officer Wesley Cummins and Chief Financial Officer David Rench, asserting breaches of fiduciary duties and unjust enrichment from April 2022 through the present. The complaint alleges that the defendants made materially false and misleading statements regarding the Company’s business, operations, and compliance policies. Specifically, the complaint alleges that the Company overstated the profitability of its datacenter hosting business and its ability to successfully transition into a low-cost cloud services provider and that the Company’s board of directors was not “independent” within the meaning of NASDAQ listing rules.

The Company is unable to estimate a range of loss, if any, that could result were there to be an adverse final decision in this action. If an unfavorable action were to occur, it is possible that the impact could be material to the Company’s results of operations in the period(s) in which any such outcome becomes probable and estimable.

As of November 30, 2023, there were no other pending or threatened lawsuits that could reasonably be expected to have a material effect on the results of the Company’s consolidated operations. There are also no legal proceedings in which any of the Company’s management or affiliates is an adverse party or has a material interest adverse to the Company’s interest.

Settlement of Potential Claim

During the second quarter of fiscal year 2024, the Company entered into a settlement agreement with respect to employment-related claims by a former executive. The terms of the settlement included payment to the claimant of $2.3 million, which is included in Loss on legal settlement on our condensed consolidated statements of operations.

10. Business Segments

Revenue by segment (excluding HPC hosting as that segment hasno revenue) was as follows (in thousands):

Segment profit (loss) and a reconciliation to net loss before income tax expenses is as follows (in thousands):

We also provide the following additional segment disclosures (in thousands):

Information on segment assets and a reconciliation to consolidated assets are as follows (in thousands):

11. Earnings Per Share

Basic net income (loss) per share (“EPS”) of common stock is computed by dividing the Company’s net earnings (loss) by the weighted average number of shares of common stock outstanding during the period. Diluted EPS reflects the potential dilution that could occur if the securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.

Potentially dilutive securities are excluded from the computation of diluted net loss per share as their inclusion would be anti-dilutive. The table below shows the calculation for earnings per share:

12. Subsequent Events

At-The-Market Common Stock Offering

The Company completed sales of common stock under the “at the market” common stock sale agreement dated June 26, 2023. The Company sold approximately 4.2 million shares subsequent to November 30, 2023. Net proceeds from these sales, less commission fees of approximately $0.7 million, are approximately $23.1 million.

Indemnification Agreements

On January 13, 2024, the Company entered into an individual Indemnification Agreement with each member of its Board of Directors. The Indemnification Agreements generally provide that the Company will indemnify the indemnitees, to the fullest extent permitted by applicable law, against liabilities that may arise by reason of their status with, or service to, the Company. The Indemnification Agreements also generally provide that the Company advance expenses incurred by the indemnitees as a result of any proceeding related to such matters.

Conditional Agreement

On January 15, 2024, the Company entered into a conditional agreement to provide HPC datacenter capacity at its Ellendale, North Dakota campus, subject to finalization of definitive lease documents. The conditional agreement is for a total of 100 MWs for a term of 10 years, with a total value of approximately $2.2 billion over such 10 year term. The conditional agreement is conditioned upon each party securing satisfactory financing for the completion of construction, with the ability of each party to terminate within 45 days, without penalty, if the condition is not satisfied.

Other Agreements

Subsequent to November 30, 2023, the Company entered into three additional agreements for services in our cloud services and datacenter hosting segments totaling a combined $104.4 million over a weighted average term of 32 months.