Good day and welcome to the Energy Focus fourth quarter 2017 earnings call. Today's conference is being recorded. And at this time, I would like to turn the conference over to Mr. Michael Port, CFO. Please go ahead, sir.

Thank you operator. Good morning and thank you for joining us for the Energy Focus fourth quarter 2017 earnings conference call. Today, our Chairman, Chief Executive Officer and President, Ted Tewksbury and I will report on our results for the quarter. The news release and our annual report filed with the Securities and Exchange Commission on Form 10-K have been posted to our website under the Investors section. As a reminder, today's discussion will include forward-looking statements including predictions, expectations, estimates or other information that might be considered forward-looking. These forward-looking statements are subject to numerous risks and uncertainties and our actual results may differ materially from these statements. We encourage you to review our most recent filings with the SEC including our 10-K and 10-Qs for a complete discussion of these factors and other risks that may affect our future results or the market price of our stock. We are not obligating ourselves to publicly release any revisions to these forward-looking statements in light of new information or future events. Our prepared remarks this morning will include non-Generally Accepted Accounting Principles or GAAP measures to explain the impact of our restructuring costs on our GAAP operating results. A reconciliation of these non-GAAP measures can be found in this morning's press release. Now I would like to turn the call over to Ted.

Thanks Michael. Good morning everybody and thank you for joining the call today. Before we dive into the detailed financial results, I would like to take a moment to recap the big picture and why Energy Focus is uniquely positioned to be the leader in LED retrofit solutions for commercial and industrial applications. The primary reason customers do LED retrofits is economic. The energy savings are substantial ranging from 50% all the way up to 75% or more with the aid of sensors and connectivity. We believe this will drive virtually all commercial and industrial clients to eventually adopt LED lighting. It's just a matter of time. In addition to the economic advantages, but less well known, LED lighting is more conducive to human health, productivity and wellness than other light sources. In fact, the spectrum of LEDs more closely resemble natural sunlight than conventional fluorescent of incandescent lighting. So the change for LED retrofits is compelling. But not all LEDs are created equal. What sets Energy Focus apart is that we offer a premium product for applications where performance, quality and wellness really matter. Our tubular LEDs are rugged, reliable and military tough. It's good enough for the U.S. Navy, it's good enough for the most demanding commercial and industrial applications. Our products meet the tightest specifications in quality with correlated color temperature, color rendering index and efficacy by lumens per watt. We offer the longest lifetime backed up by a 10 year warranty. Big commercial customers who invested in LED retrofit projects want that investment to last. Our industry-leading lifetime lowers the total cost of ownership and minimizes maintenance cost. We deliver the industry's lowest optical flicker, UL certified at less than 1%. Flicker can cause headaches, eyestrain, seizures and interfere with concentration. That's one of the primary…

Thank you Ted. Total net sales for the fourth quarter were $4.7 million, down 34% compared to the fourth quarter of 2016. For the quarter, sales of commercial products represented 64% of net sales, while sales of military products represented 36% of net sales. This compares to the fourth quarter 2016 product mix of 46% and 54% for commercial and military sales, respectively. Our net sales of commercial products decreased 9% compared to the fourth quarter of 2016 reflecting the timing of our customers' projects and installation schedules. As we have discussed in previous earnings calls, during 2017 our distributor to the U.S. Navy was able to satisfy significantly all current demand out of their existing inventory balances resulting in a quarter-over-quarter decrease of 56% in net sales of our military products compared to the fourth quarter of 2016. Our fourth quarter 2017 gross margin was 34% compared to a negative gross margin in the fourth quarter of 2016. The fluctuations in quarter-over-quarter gross margin percentages are primarily driven by a year-end excess inventory reserve adjustment as required by U.S. GAAP. The fourth quarter 2016 gross margin was negatively impacted by a net $3.3 million write-off of inventory we deemed excess at December 31, 2016. During 2017, we initiated strategic efforts to liquidate inventory previously identified as excess resulting in a net favorable adjustment of approximately $800,000 to our gross margin for the fourth quarter of 2017. As you will note from our year-end 2017 balance sheet, we currently have reserves against our inventory of $4.2 million, a decrease of $1.4 million from the year-end 2016 inventory reserves. We continue to explore opportunities to further liquidate inventory previously identified as excess. Our fourth quarter 2017 operating expenses were $3.5 million compared to total operating expenses of $6.7 million for the…

[Operator Instructions] We will go ahead with our first question from Craig Irwin of ROTH Capital Partners. Please go ahead.

Good morning and thanks for taking my questions. So Ted, an impressive operating result. You guys have clearly got everything operationally that you can control in a very good place over the last year. The one thing that I know is harder to control is revenue. Now the agencies are showing some pretty good traction pushing revenue now for you. But can you talk about potential investments in new products and things you see as opportunities? Your recently announced, I guess, emergency lighting product is a nice positive. But can you frame out for us the actions that you think are a priority for 2018 to drive product revenue?

Sure. Yes. Thanks Craig. We don't have a whole lot of control over revenue in 2017 because the sales pipeline was built by the previous sales organization. We do have control over future revenue by virtue of the operational actions in the new product pipeline that we are putting in place today and in 2017. It's just that there is a delay. And I tried to be very transparent about the six to 12 month time it takes to develop new products, some times longer. And then on the sales side, the time from initial engagement with the customer until the time you get a purchase order, which can be six to 12 months. So we are working on revenue, but we are working on future revenue and we hope to see that in 2018. Now as far as what we can do today to make that revenue materialize, it's two things which I hope I emphasized sufficiently in the prepared remarks. One is selling more of the products that we already have. And to do that, we needed to have a nationwide sales force so that we could reach all of the commercial and industrial customers. And I am very comfortable right now that we have not only the right number of people, but very high-caliber experienced salespeople and most of our regional sales managers have upwards of three decades of sales and specifically lighting sales experience. So in conjunction with the 33 agents that we currently have, we have the right people to drive sales with existing products as well as new products. Now on the new products front, that's been divided into recently introduced new products which will contribute to 2018 revenue and then there's future products in development which will layer on either late in 2018…

That's encouraging. And I know there's a lot of work that's gone into that plan. So one of the things that I learned at Strategies in Light last week is that you share a supplier with General Electric. GE is primary OEM producer of tubular LED bulbs. Obviously, they are one of the gorillas in the market. The fact that Energy Focus is in there sort of suggests that maybe you have an interesting cost structure versus others in the market and don't share the extreme turmoil that GE is seeing these days, a lot of uncertainty on the part of GE's customers as far as continuity of further supply. Can you say whether or not the uncertainty about some of the other suppliers in the tubular LED market is translating to increased attention, increased interest in areas you focus given the strong brand recognition out there?

You know, I can't say with any certainty whether or not that's the case, Craig. It very well could be, but I am not aware of that at this time.

Okay. And then last question, if I may. So in the fourth quarter of 2016 you wrote down $3.3 million in inventory, obviously calling that obsolete. But this quarter, you were able to sell almost a quarter of that out into the market. Does this mean that maybe there's reason for optimism about some product lines that you had thought might have been no longer saleable into the market? Was there maybe something that we should read as potential positive in that for the longer term?

Craig, this is Michael. I think the message that we should take from that is that and we have talked about it before that really, in 2016 we had built up a substantial amount of inventory that exceeded what for U.S. GAAP purposes was a measurement of what we considered currently saleable. Our products, in terms of obsolescence, they are still usable. There will always be improvements in terms of energy efficiency and other improvements that we can make, but our basic tubes will be still saleable, but we just had too much of it. And as a result, as I mentioned, we still have about $1.4 million of inventory that we have identified as being reserved. We are looking at making some strategic sales and some strategic opportunities to move that inventory. But I don't think it will have a major quarter-over-quarter impact moving forward as we have worked real hard to get that down and in control.

Great. Thanks again. I will hop back into the queue.

Thanks Craig.

We will go ahead with our next question from Carter Driscoll of B. Riley FBR. Please go ahead.

Good morning guys. And I also echo congratulations on the cost side. So could you comment on maybe some of the geographic regions where you are starting to see either better sales leads, maybe not fully translatable into revenue yet? But if I recall correctly, last quarter you had very heavy geographic concentration in the Midwest and specifically in Ohio and Texas, if I recall for C&I and I think you had called out both the Coast and even the Southeast U.S. Maybe if you could just elaborate on both, some of the new states that you are seeing some penetration and then maybe end market, obviously, kind of K-12 and healthcare have been the primary end markets for C&I, but maybe any adjacent or lateral opportunities? Thank you.

Yes. As far as geographies, you are correct. We have always historically had a lot of strength in Ohio in the Midwest and then, more recently, in Texas. We have got a large energy service company that's one of our biggest customers in Texas and they contributed significant amount of revenue this quarter. We have also built out the Southeast Florida. There's a lot of healthcare facilities there as well and seeing very good early leads and building up a pipeline there. California has been very strong. And then the Northeast is probably the biggest opportunity that we have where we have seen a little bit of a time delay on the Northeast, but that's one of the primary focus areas because of the high energy costs, the large concentrations of schools and hospitals. And so that's, we think, a big potential opportunity for us. As far as the end markets, if you look at commercial for Q4, it splits up roughly into a third. About a third of it came from healthcare and other third came from education and then the remaining third went through agencies and distribution into a wide variety of commercial and industrial subsegments. And that's the piece that we haven't had access to before. So that's new and it's broad-based. Unfortunately, now that we are working through the agencies, we don't have as much visibility and granularity on specific end customers as we did when we were direct. But as long as it's growing, we are happy.

Right. Just as a follow up to that, did you get that type of granularity in arrears? I mean, do you split it down within the agency sales and try to back maybe some burgeoning opportunities laterally outside of education and healthcare?

Yes, very much so.

Yes. This is Michael, Carter. Our structure is that the regional sales managers work very closely with the sales agents. We just don't sign the sales agents and send them out into their territories. Our regional original salespeople are committed to not only educating the agencies in the value proposition of the Energy Focus products, but also working with them to get out in front of customers, introduce customers. It goes both ways to have a good partnership on the agency model. And so we are actually seeing a lot of interest and a lot of traction in that regard as well.

Okay. And just for my comment --

You will see increasing customer diversification going forward and I expect that third from the other category to start to grow and we will be able to give you more granularity in future calls.

Okay. And do you have a different target for what you think the agency sales could be as a percent of total revenue by, let's say, year-end?

Yes. So in Q4, as I said, we were already up to 18%. The target is 60% for all of 2018.

And compensation, I am sure it's fairly industrywide structured for the agents. Is there an end-of-year true-up or is that done on a quarterly basis for hitting potential hurdles?

The agents are paid commissions based on their sales. There are no target true-ups for achieving an excess of certain amounts at this point.

Okay. And how do you feel about your balance sheet position currently relative to still limited visibility on the revenue side? Do you feel you have sufficient capital availability right now? And what potential levers could you use, at least maybe from a customer perspective? Could you ever enter in a relationship where you could finance using their balance sheet some core purchases? Or is that something you haven't contemplated?

Well, right now, we are pretty, I must say, I am ever comfortable with the amount of cash that's available on the balance sheet, I would like to have more. But given the level to which we have reduced our cash burn, which is down close to $1 million now a quarter and $10.8 million in the balance sheet, I have a reasonably high level of confidence that we are going to be able to reach escape velocity and get to breakeven before cash becomes a problem. But having said that, we had a Board meeting yesterday and every Board meeting we talk about cash and financing options and so forth. And so if and when the time comes when we do need to raise capital, we have got a number of options to do that.

Okay. I guess last question. You talked about pricing environment. Obviously you don't play in the commodity space or big-box retailers that face that outsized pressure. Do you have an idea as your sales composition changes, what you would face in terms of industrywide price pressure on an annual basis or a bracket you could share?

Well, actually on the ASP erosion side, most of our challenges have been in the military segment where we had two new competitors who came in with products which we don't think meet the high-quality standards of ours, but apparently were good enough. And we saw, as we have discussed in past calls, some fairly significant reductions in the pricing of those Navy products, which has led to a fairly drastic decline in our gross margins for that business. On the commercial side, I am actually less concerned because of some of the differentiations that I spoke of in the prepared remarks. We are the only company that is able to offer a combination of performance, quality, ruggedness that I outlined. We have less than 1% flicker, which is really a must-have for many of the schools and hospitals. And then the 10-year product life is something that very few companies have. So on the commercial side, I think we can continue to maintain healthy margins and price stability going forward.

Okay. Maybe my last question is, you are talking about new product development and categorized tubes, fixtures and connected devices. Fair to assume that what's induce the LIGHTFAIR will be in that second bucket, even if you can't get special facility?

Well, what we will show at LIGHTFAIR will not be in the connected lighting bucket. It will be some of the intermediate products between RedCap and connected lighting, which we expect to have similarly market entrance towards the end of the year. And if I could, while I have got you on the line, just to go back to your previous question about price erosion, one of the other initiatives that we have launched in this company which is new, is that every new product that's introduced, including RedCap and every new product from now on going forward, as soon as that product is introduced, it goes into a cost-reduction initiative so that we don't get stuck as we have in the past with its uncompetitive high-cost structures as we did on the military Intellitube and some of the military products. So that's become a part of our process and then we are also doing cost reductions on those older products of the military Intellitube so that we can continue to win that business and grow the military.

So as a follow up to that, what from kind of first iteration of a product down to whether it's a successive product launch within that family, what do you think an average cost down could be?

Well, I mean, it depends on the initial starting point. In the case of the military Intellitube, we are assuming at 30% to 40% cost reduction.

I appreciate taking my questions. I will take the rest offline. Thank you gentlemen.

Thank you.

And we will go ahead with our next question from Colin Rusch of Oppenheimer. Please go ahead.

Thanks so much, guys. Could you talk a little bit about how we should think about normalized gross margins as we enter into 2018?

Well, I think if you look at where 2017 ended up, even though we had some gives and takes, I think moving forward to where we were at 2017 is a pretty good projection of where we can be, putting aside some of the cost opportunities and ASP conditions that Ted just talked about.

Okay. Perfect. And then in terms of incremental operating margins, how should we think about incremental sale expenses as you grow revenue? Obviously, timing is a little bit uncertain, but are your sales teams incentivized on a percentage basis? And how can we think about the operating leverage as you grow sales?

Yes. So in my prepared remarks, I think in terms of our base operating expenses, I think we are pretty well positioned to leverage those expenses to be able to support increased sales. So to your point, the main keys that become variable after that are the commissions. And depending on the structure, the commission percentage will range between 3% and 7% depending on the structure of the contract from the product and the sale.

Okay. Great. I will take the rest offline. Thanks so much, guys.

Thank you.

And your next question comes from Amit Dayal of H.C. Wainwright. Please go ahead.

Thank you. Good morning guys.

Good morning.

One question on backlog. In your press release, you talked about entering 2018 with a much stronger backlog compared to what you have seen over the last 12 months. Could you give us any more color on what's driving the strength here? And what sort of levels are you seeing in terms of numbers around this?

Yes. I would rather not disclose numbers at this stage. As I did say in the prepared remarks, we are entering the first quarter of 2018 with higher backlog than we had since the fourth quarter of 2016. And I would remind you that throughout 2016, we had a contract with our military distributor whereby they were required to purchase $3.1 million worth of military Intellitubes every quarter, because that's what led to our inventory buildup. But after that contract, our backlog would have been much lower throughout 2016 and after the claim that this is the highest beginning of quarter backlog that we have had in a much longer period of time. So that's extremely encouraging. Now where is it coming from? It's coming from a variety of sources, including our traditional tubular LEDs as well as RedCap. But what's really the driving force behind it is the agency. We have got, as I mentioned, a 100 times more feet on the street calling on customers than we had one year ago. And as a result, that pipeline is filling up, the sales funnel is filling up. And that's exactly what we want. Look, I know there's a lot of frustration around our inability to provide guidance and forecasting. The reason for that is the small numbers that we have got traditionally in the funnel. Now that we are starting to increase the number of opportunities, we will have the opportunity to average out some of that volatility and give you better forecasting.

Understood. And just around the guidance, Ted, for 2018 can we expect sort of year-over-year improvements on a quarterly basis from a revenue point of view?

I think that's well said. That is my goal. I cannot give you, it's very difficult for me to give you absolute numbers, but what I am directing my team here to do is show continuous incremental improvement on the topline and on EPS every quarter. That's my goal. Now that's not guidance, but that's the closest I can give you to guidance.

Right. And how does sort of the military segment play out in terms of your expectations for 2018? Are you focusing the same amount of resources in that channel? Are you lowering your efforts over there? How are you dealing with trying to grow that business?

We have already dramatically reduced our resources, focused on the military. We already have the products that the military needs and wants. And as we have said before, we firmly believe that we have by far the most rugged, highest quality, military certified product on the market. And we continue to compete for that business aggressively. As I said, we are doing continued cost reductions on those products. That said, we have been very conservative as far as our forecast there. It's because of the uncertainty and with the relaxation in military's requirements and their willingness to settle for lower-quality products has cast a cloud on our ability to forecast that market.

And Amit, this is Michael. Remember, a lot of times those bids come out in relatively large quantities at one point that you either win or lose. So it's very difficult for the new competitors in the market to really be able to forecast because of the magnitude and the significance of either winning or losing one contract or one bid within the year.

Right. Understood. Just one last one for me. On the connected lighting front, will you be able to leverage your existing agency channel to move these products through the market? Or will you have to sort of create an organic team to do this?

Well, absolutely, we would be using the existing agency channel.

Understood. All right. Thank you guys. That's all I had.

Thank you.

And we will go ahead with our next question from Mr. Mark Miller from The Benchmark Company. Please go ahead.

In terms of your anticipated sales growth in 2018, you mentioned RedCap and two other new products. What percent of the sales growth roughly is going to be coming from new products?

Mark, the anticipation right now, one, it's not only the new product introduction, but it's also the pull-through that it will have on the impact of our other product lines. So while we are excited about all of the other introductions that we have, really, it's rounding out the portfolio of the Energy Focus products to make us that much more attractive, the value proposition that much stronger. So I don't think we are looking at it as a significant increase in revenue for any one particular product, but it's to raise the level of sales across the board with that introduction.

And just to elaborate on that answer. We sell RedCap and what we call a kit. So code requires that you have one emergency battery backup up in the ceilings or in our case in the tube for every five to 10, some times more conventional tubes. So we saw RedCap together with five or 10 tubes. So the pull-through effect that Michael alluded to is quite literal. Every time we sell a RedCap, we pull around 10 conventional tubes. So it is a bit difficult to break it out by individual products.

As you mentioned that the sales were roughly one-third in healthcare, at least in commercial, one-third education and then other areas. Is that roughly the composition of your backlog?

I don't know.

We do have some military products in the backlog that might skew that a little bit, but I think that's fairly representative as well.

No. That was for commercial.

I am sorry.

[indiscernible].

Yes. So I think it still follows and I apologize. In terms of looking at the total there, it's a military in there.

I think that's about right. I mean what's happening here is that we are seeing growth in that new category that's outside of healthcare and education. So that may be a little bit larger, but again it's roughly one-third.

Any examples of these new areas in terms of specifics? What new areas are these you are talking about besides education and healthcare?

Warehouses, offices, small retail facilities. I wish I could claim one of the big-box retailers. I am not able to do that quite yet, although we are hopeful that will come through.

Okay. Thank you.

And that's your factories, things like that.

And we will now take our next question from James Liberman from Wells Fargo Advisors. Please go ahead.

Thank you. I wondered if it's premature to talk about some of the other opportunities within the government sphere which would be upgrading of lighting in buildings around the country, the defense or nondefense? Or is this still very complicated by uncertainty over budgetary issues, et cetera?

Well, that's a great question and some of those other government opportunities are also being opened up to us by the agencies who have the right relationships with the ESCOs and with those government agencies. Just to give you an example, in Q4 on the military side, we talked about roughly $1.7 million in revenue, 88% of that was ship retrofits. There was another 8% that came from military bases and that's an area where we have struggled in the past getting access, but the agencies are giving us the kind of access to get into those opportunities. So we do expect the government sales opportunities to continue to grow.

Thank you very much.

Thank you.

And we have no further questions. At this time, I would like to hand it back over to Mr. Ted Tewksbury for closing remarks.

Thank you for joining us today and for your continued interest in Energy Focus. As a reminder, Michael and I will be at the ROTH Conference in Orange County, California and we hope to see some of you there. In the meantime, thanks again and enjoy the rest of your day.

This concludes today's call. We thank you for your participation. You may now disconnect your lines and have a wonderful day.