Good day, everyone, and welcome to the Energy Focus’ Second Quarter Fiscal Year 2018 Financial Results Conference Call. As a reminder, today’s call is being recorded for replay purposes through August 15, 2018. I would now like to turn the conference over to Mr. Jim Fanucchi of Darrow Associates. Mr. Fanucchi, please go ahead.

Thank you, Melissa. Good morning and thank you for joining us for the Energy Focus Second Quarter 2018 Earnings Conference Call. With me today is Dr. Ted Tewksbury, our Chairman, Chief Executive Officer and President; and Jerry Turin, our Chief Financial Officer. The news release and our second quarter 10-Q 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-Q 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 include non-generally accepted accounting principles, or GAAP, 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’d like to turn the call over to Dr. Tewksbury.

Thanks, Jim. Good morning, everyone, and thank you for joining the call today. Prior to reviewing the quarter, I’d like to welcome Jerry Turin, who joined us as Chief Financial Officer in May. Jerry’s proven track record of turning around and scaling public and private technology companies makes him ideally suited to help Energy Focus accelerate our return to growth and profitability. We are very excited to have Jerry on the team. The second quarter of 2018 was one of the solid executions on all fronts: financial, sales, operations and new products. Our sequential progress in each of these areas demonstrates that the restructuring and the organizational changes we implemented over the past year have reached an inflection point for future growth. To quickly summarize our second quarter results, sales grew 11% quarter-over-quarter to $5.2 million, commercial revenue increased 36% sequentially, while military and maritime sales declined by 10% from the prior quarter. Gross margin of 25.1%, increased by 7.6 percentage points sequentially and operating expenses declined again. As a result of these improvements, we were able to reduce our net loss to $0.15 per share, a $0.05 improvement over the last quarter. Jerry will elaborate on our financial results in a moment, but first, let me provide some color on our customers, market and pricing trends, sales channels and new products. Commercial sales of $3 million in the second quarter represented 57% of total revenue. Commercial sales continued to be dominated by our health care and education verticals, both of which grew by double-digit percentages sequentially. Customers in these markets continued to see the benefit of Energy Focus as value proposition of flicker-free light, military-tough quality and industry-leading 10-year warranty. At the LIGHTFAIR trade show in May, The Department of Energy presented a report affirming what Energy Focus has…

Thanks, Ted. Happy to be here, and I'm looking forward to helping drive the future success of Energy Focus. With such a high quality product set, expert team and technology-driven mindset, Energy Focus is well positioned as a platform for driving scale on the LED space as the adoption of LED lighting solutions continues. And the Energy Focus advanced LED retrofit solutions continually evolve to support the infrastructure and technology needs of the future. As for hearing now, now, our net sales for the second quarter of 2018 were up an 11% sequentially at $5.2 million compared to $4.7 million in the first quarter and compared to $6 million in the second quarter of 2017. Sales of commercial products were $3 million in the second quarter compared to $2.2 million in the first quarter, an increase of 35% sequentially. This reflects progress from our agencies sales channel strategy, our new product introduction and our focus on securing large project business from new and existing customers. Sales of our commercial products were, however, down almost 14% from a very successful second quarter of 2017 and with certain customer projects were completed, but from which we had exited with a relatively small number of new sales opportunities in our pipeline. As Ted mentioned earlier, the team has been working hard to build up the key account pipeline over the last year, such that it now includes 35 opportunities on each in excess of $750,000 in potential. Sales of military and maritime products were $2.2 million in the second quarter compared to $2.5 million in the first quarter. Excluding our low margin legacy M1 product, which has been a spike in Q1, military and maritime increased by $1.1 million as a results of sales of other higher-margin military products, including high-quality globes, berth…

[Operator Instructions] Our first question comes from the line of Colin Rusch with Oppenheimer & Company. Please proceed with your question.

Thanks, so much. Can you guys talk a little bit about the pacing of the sales cycle through the agency business? It's great to see that sort of – kind of opportunity you had identified and moved forward. But we'd love to understand how quickly that might start to convert and start driving some significant sales growth?

Thanks, Colin. Great question. So the agencies enable us to accelerate what we did in environmental sales cycle because they enable us to bypass the lead generation portion of this cycle. Many of these agencies are already calling on customers both in our core markets as well as in retail and in industrial, and other segments that our direct sales force didn't traditionally have access to. So they give us an ability to shortcut that lead generation portion. But the process of getting the products designed in, going through the decision making through the school boards, hospital committees and so forth, that's still there. And that's where you get a lot of the uncertainties around the timing of budgets, multiple decision-making committees and so forth. And that's why I indicated in the prepared remarks that we're still looking at roughly anywhere from eight to 18 months for some of these decisions to get made. And just as a point I referenced, I mentioned in the remarks that, a year ago in Q2 of 2017, we had about four projects, large projects that were nearing completion and relative to that, that's one of the reasons why our year-over-year revenue was down. But since it's noteworthy that one of those opportunities, which was a large above $0.5 million in revenue opportunity, one of that particular opportunity took 24 months to develop from initial customer engagement to that peak revenue. So it's a wide dynamic range of design cycle time. But eight to 18 months is a good rule of thumb. And there's lots of opportunities that are in our pipeline are well along in that process.

Okay, excellent. My follow-up is really around sustainability of gross margins. Obviously, it's a tremendous result to see that sort of movement on the gross margin line and we're pleased to see you're making the investments to reduce costs. But could you walk us through what you're thinking about as sustainable in terms of the manufacturing margins on a go-forward basis?

Well, I think we gave as much color as we can at this point in time. 25% as I said is probably a better frame of reference for our margin structure than last quarter. But there can be a lot of volatility quarter-on-quarter depending on customer mix, depending on the volumes, depending on the dynamic Ted talked about, where we believe we can potentially accelerate revenue growth in some areas with competitive pricing and have the net neutral result based on cost reduction actions and effort, but that's a lot of moving pieces at this point in time. So I had looked to 25%, and maybe our recent margins over – so looking over the last six quarters or so, maybe excluding some outliers. And that's kind of where we are at. And as we execute going forward, maybe there is some leverage in some areas to move out in right direction, but there is also headwinds that we need to be cautious about now, I think.

Okay, brilliant, thanks so much guys.

Thank you. Our next question comes from the line of Carter Driscoll with B. Riley FBR. Please proceed with your question.

First of all nice progress Ted, Jerry on virtually all your metrics. And welcome aboard Jerry. First question, maybe a very high level, just from a strategically – Ted, how do you think about when you determine the kind of new product growth over the pathway? I'm trying to better understand your decision making progress in terms of the factors where you allocate your D dollars among certain things like, does it open up a new segment? You've had recently a commercial segment and having dependence on education and health care for a while. So when you're thinking about new product development, is it about opening new segments, cost versus the size of the addressable market versus your ability to differentiate, or to move laterally into more connected products? If you can kind of prioritize as best as you can those types of factors in that process as you accelerate new product growth.

Yes great question. And actually you hit on most of the key criteria. I made my mantra at Energy Focus to be, every product, a world's first or a world's best or we will not develop it. So we are in a very commoditized industry. However, we believe in the ability to use retrofit to introduce more than just LED lighting into sockets, but to introduce a whole host of new capabilities, including sensors, connectivity, controls and to be able to connect to the Internet of Things. And so it's a lot. And so there was a lot more than just lighting. It's about building automation and smart environment. So that's where we're going. We're going to move up the value chain to higher value-added products. So the criteria are number one, differentiation. Differentiation leads to gross margin, high gross margin. So every product must be significantly differentiated of anything that's currently available We also are putting a high emphasis on customer sponsorship. And what I mean by that is, is not that we are doing custom products that are specified by – for a specific customer on exclusive basis, but we need – we understand our customers applications and systems and we will only develop new products if our technologies enable us to do something radically different and able to help our customers be more successful and implement more effective systems. So RedCap is systems. So RedCap is an ideal example of that. It came from understanding the emergency lighting market and then developing a technology to address that and solving our net customer need. But I'm not taking credit for that idea. That one pervades my comment on board of the company, but that's a great example of a differentiated product that addresses an unmet customer need. And then third, is market size. In the past, we've tended to focus on niche markets. In order to scale our revenue, we really need to focus on larger markets. And at the top of that list is our core markets of health care and education, where we believe that we have a unique advantage as a result of our flicker-free technology, in our high-quality, in our 10- year warranty. But we're looking for products that also have the ability to move laterally, horizontally outside of those two verticals into retail and industrial and other markets. So those are really the four criteria: criteria: Gross margins, differentiation, customer sponsorship, and market stock.

And would it be fair to say that you are some level of your product development will be targeting the retail and industrial segments in 2019, obviously you put out your first tubular solution for highway which as far as I remember is the first major push into the industrial segment. Is that a fair comment?

That’s a fair comment. The T-5 high output has really attracted lot of customers from a lot of interest from the customers in the industrial market. And we expect that the connected lighting and smart lighting products we've got in development. But those products will be introduced in 2019 will address a broad range of applications. But the customers that we’re talking to upfront to make sure that we meet their needs and their systems requirements are primarily focused in the core vertical markets of education and healthcare. So we develop products for those two core markets and then we sell them horizontally into other adjacencies.

You mentioned certainly uncertainly over the brewing and rising tariff war, or for a lack of better phrase, is potentially going to impact you, but maybe not till first half of 2019. Can you talk about either the number or the percent of your material sourcing that comes from China, your ability to find different suppliers not with that – in that jurisdiction. I mean, within that country whether it's Taiwan or Korea or some of the ones that aren't currently covered? And how long do you think it would take if you had to take such actions?

So let me provide some high level color and then I will turn it over to Jerry to expand on the specifics in quantitative detail. There are really 2 categories. There's finished goods, where currently no tariffs have been announced and then there's components, which are subject to the tariffs. So as far as finished goods are concerned, we source fixtures and our commercial tubes from China. So there are 90 [ph] tariffs on those and while we don't know what will happen in the future. Compose from China are used to some extent in new products we manufacture and sold in Ohio. But keep in mind those products are BAA products, which, by definition, use more than 50% domestic components. The remainder do include some components from Asia. However, all those particular components that we source from Asia, we have alternate sources here in the U.S. So we do believe that we are relatively immunized against the tariffs. So I'll let Jerry talk a little bit more about the quantitative details.

Yes it’s a little difficult at this point to be specific in terms of the impact given it's a function of product mix. If we have adequate inventories of related parts for likely through the remainder of 2018, there are decisions that can be made in the supply chain, there's negotiations that can push back on Chinese suppliers to mitigate part of the impact. In fact, the way the currencies have moved implies that Chinese suppliers may have a little bit of wiggle room as well. I think quantitatively, I'd also add that, that specific components we looked at, the cost with me or with tariff is still substantially lower in most cases than procuring not just domestically, but even from our alternative sources. So to the extent, we have achieved cost improvement or cost reduction for the Chinese sourcing that remains a fact that that's still likely going to be the cheapest source of supply for this space, for those components. And in terms of security of supply, if you think about a draconian trade situation between countries, we have the alternative sources of supply.

Thank you for that. You mentioned growing pipeline in the commercial size. Is there anywhere you could – I mean, you realize you still have a heavy component of sale of turns to your business? But is there a – either a backlog or pipeline number you could point to? Are you comfortable providing such thing? Or is that i.e.…

We don't disclose the dollar amount of the pipeline or the backlog for that matter. But as I said in the prepared remarks, it's a dramatic increase. That's more than a factor of five over where we were a year ago and where we were a year ago was already higher than where we were when I started back at the beginning of 2017. So the consequence of having a stronger pipeline is that we're going to see more of those opportunities start to convert to revenue over the next 12 months. And in addition, the big benefit we're going to get as a result of having more opportunities in the pipeline is the averaging of large numbers, which is going to hopefully give us more predictability in our revenue and eliminate some of the volatility. And my hope is that's going to eventually lead to a point in time, when I'll be able to start giving some guidance. So it's a very healthy development. And it's all a result of the agencies. Just to comment on the agencies, as I mentioned, we've got 36 agencies across the country. Each agency has roughly 10 agents out on the street calling on the customers and representing the Energy Focus portfolio. So that 360 individuals up from half a dozen or so direct people, when I joined the company. So in the order of magnitude, greater sales presence. Now I should also mention that we are only beginning to leverage the productivity of the agency. As they become more proficient at selling the Energy Focus value proposition and educating customers, they will become more productive. Also as a result of these price reductions, that's going to increase their productivity and their ability to sell. So I think we're seeing only the tip of the iceberg as far as what the agencies are going to be able to contribute. And therefore, I expect to see that sales opportunity pipeline continue to grow and see the growth actually accelerate. So what I will do going forward is report every quarter how much that pipeline has grown, but I don't want to disclose absolute numbers.

When you talk about the premium gap in – reduce your price reductions, can you talk about maybe percent change in that? And then, are you still at a premium on average to your competitors?

Yes we are in a premium. I would say as a rule of thumb, the premium is perhaps 10% to 20%. It depends on the customer. It depends on the opportunities. But if it starts to become much larger than that, if it starts to become 50% to 100%, at that point, we start losing sale. And as I indicated, we just weren't able to lower our prices sufficiently at an acceptable gross margin to compete for some of the business in retail, for example which are very price driven. So we were able to reduce costs significantly. And we look not only at our commercial product portfolio, but also at our military portfolio. And again, I don't want to give absolute dollars, but the price reductions have ranged everywhere from 20% for some of the low-end commercial products, all the way up to nearly 100% cost reduction – not 100%, 50% cost reductions on some of the military products. So it's very significant. And again, we were able to do that because a lot of the products in the legacy portfolio, which were designed five years-or-so ago were really overdesigned relative to market requirements. And we were able to take a significant amount of cost out without any sacrifice to product performance or quality. So that was long overdue. And I think the results are going to enable us to accelerate our sales growth.

So given the – what you have done in terms of pulling out costs, given that is embedded within all product development and given your comments about the improvements you're expecting in the efficiency of the sales agents as the 10-year grows and trying to keep exogenous one-off price declines, the Chinese coming aggressively, will it be reasonable to assume that all things equal, you could maintain a 25% gross margin going forward?

Well, could we? We potentially could. But again, there's a lot of things you are getting a lot of things related to that. We would get as well that could certainly cause headwinds to that. It's the preponderance of those factors aligned from execution to market to customer mix, then it's certainly possible. But it's also certainly possible that at a minimum quarter-to-quarter the season volatility. And again, you have execution needs to be accomplished before it's in the bag and market condition, we can anticipate, and we can be prepared to address, but there's volatility we face in that regard too.

It's all a timing question. I mean, as I indicated, we will see more pricing power from the more differentiated product road map, as we connected lighting and smart lighting products we've got in development. But those products will be introduced in 2019. But that will give us an uplift on gross margins. So it becomes a mix issue with – between the new products and the legacy products. There's also the timing and all the tariffs, and whether or not tariffs are implemented on finished goods. There's a timing of when did the next Navy bid come out for M1 product. If we're able to complete the cost reductions on our M1 prior to the next RFP coming out from the Navy, that's going to bode well for the gross margins. If not, it doesn't bode well. So – and then, there's a whole competitive environment, how aggressive the Chinese competitors are on pricing, and then the timing of the remaining cost reductions. As I mentioned, we completed the cost reductions on our two highest volume commercial product families, but we still have several other cost reductions to complete. So that's a lot of timing that has to line up in order for us to be able to hit the 25%.

Hey, Carter, I'm going to have to hold your – the remaining questions. Okay, let's move on to a couple of other guys, we'll circle back with you.

Sure. Thanks.

Thank you. Our next question comes from the line of Craig Irwin with ROTH Capital Partners. Please proceed with your question.

Good morning and thanks for taking my questions. So most of what I was thinking about has already been asked. But just to step back and ask a high-level question, Ted, when you came to the company, a lot of investors were pretty excited. Given your track record, things that you've accomplished, you're very well known in the investor community. Over the last handful of months, you brought on board some fairly high-profile, well-respected technology investor – executives, right? Investors know Satish Rishi from his time he was CFO of Rambus. Anyone that follows lighting or technology will probably know Laszlo Takacs, your CTO from his days at Soraa and then Jerry Turin. I remember a good dialogue with you at Intematix. I think your track record speaks for itself as well. Attracting this kind of talent sort of suggest that there's something really exciting going on at Energy Focus, but it's not something that's really playing out in the financial results yet. Is there something sort of going on in the background, something in the bigger picture that these technology executives are attracted to? And is everything sort of out in the light at the moment? Or do we have potential surprises to come over the course of the next few quarters?

That's a terrific question. I would add to that list of executives, Larry Fallon, VP of Sales and marketing, who is best of breed and very well known in the lighting industry and also Bill Wright, who is our VP of Operations. We have assembled an all-star team, and it's a completely new team from those who were here, when I started. And we have – we are truly reinventing Energy Focus. And, obviously, there's a lot more below the surface then the investors see and it comes to receive and I want to keep it that way. When we introduced the RedCap in order to see battery backup tube, that product was more than two years late to market than it had been preannounced back at 2015 LIGHTFAIR. And I don't want to be pre-announcing a lot of the technology developments that we're working on, because all it serves to do is tip off my competitors and allow them to catch up. But there's a lot going on here. And what's attracting these top-notch executives is several things. First of all, I have a reputation in the industry of developing game-changing novel new technologies that can transform industries. I mean, I think you saw when I was at IDT. I put the company in wireless charging and it made IDT a pioneer in that business. We're going to do the same thing here at Energy Focus. I call the class of products that we're working on advanced LED retrofit solutions, and that umbrella covers, not just lighting, as I mentioned, but also on the current activity on controls and sensors. And that's nothing new, you hear that all the time from other companies in the industry. That's a trend, that's going to grow lighting and revive new life into…

I just emphasize you that kind of Ted's point that, our turnaround is two stages, right? A turnaround isn't riding the ship, right? Turning – a turnaround is riding the ship and then setting and allocating the resources to a new strategy that takes it to the next level, right. And so you're right, the ship is going to take – it takes that reallocation of resources and efficiencies and effectiveness, and then move it to the next level. So it is in a way a two-step process.

And just as a point of reference at IDT, which was another noteworthy turnaround. It took six years from the time I walked into the door until we really started to see significant growth in all of new product categories, the wireless charging, RF, power management, all the new stuff that I started at that company. Here, we're going to be able to do it more quickly, because it's a smaller company. We can turn this boat more quickly than I can turn that ship. And that's one of the reasons I came here. So after – come back after my two-year anniversary and then we'll have an interesting conversation.

So maybe I can ask the question just in a slightly different way and you can give us maybe a not in the right direction but five years from now, four years from now, do you think investors will look at Energy Focus and say, wow, that's a company with a great channel, beautiful lighting fixtures and great design attributes. Like people say for the prototypic leader in different lighting segments? Or do you think given the team of technologists you put together, their talents will result in the reaction being more like wow, what an amazing transformation into a leading technology company in the touch as the lighting space. I mean, is that where we're potentially looking at over the next few years?

Our vision is not so much to become a design – let's say, a design company and to develop luminaires like a QE for architectural design purposes. That's not our strength. We aspire to be the technology leader of the lighting industry. And our technologies will be used by all of those companies QEs of the world, EVs of the world or smart home companies of the world. Anybody that's doing building automation systems or IoT systems or lighting – architectural lighting will come to Energy Focus to obtain the innovative technology that they need to implement their system. So that's really where we're going. We want to be the technology leader.

Great, thank you for that. Congratulations on the strong progress. And it’s always good to see the tight management of operating expenses and obviously working capital on the balance sheet.

Thank you.

Thank you. [Operator Instructions] Our next question comes from the line of Amit Dayal with H.C. Wainwright. Please proceed with your question.

Thank you. Good morning, guys.

Good morning, Amit.

In regards to some of these costs down efforts, has any of that started reflecting in the product that are already in the market?

Not quite yet, Amit, we’ve done the cost reductions, but we still have significant inventories that we need to burn-off of the old product. And we have started to place orders for some of the new lower cost product, but there's a lead time of perhaps 12 weeks before we'll start seeing that impact in the financial.

Understood. And in regards to your gross margin commentary, are you targeting certain floor on the gross margin side? Are you willing to sort of walk away from teams that don't fit your margin profile?

Yes, absolutely. We traditionally walk away from a lot of low-margin business, where customers have been unwilling to pay the premium that our products deserve. There is a class of customers that simply wants the lowest-cost product and doesn't really appreciate a product that can last 10 years or a product that's virtually indestructible or a product that has less than 1% CAGR. And we're not here to serve those customers. They are just as well served by buying a cheap Chinese tool that might last three years. That's why we're focused on demanding applications, extreme applications like hospitals, educational facilities, industrial environments, and because we're seeing increased opportunities in retail, because in retail stores also really want to have a 10-year warranty. And there are other companies out there that have 10-year warranties on paper, but their products don't actually last 10 years, and that's the distinction. There's a difference between a 10-year product lifetime and a 10-year warranty. Maybe a company can give you a 10-year warranty on a two-year tube if they're willing to replace the tube five times during the duration of the warranty. We have a industry-leading warranty that backups two that actually will last 10 years in operation. And we're finding that retail is starting more to appreciate that value. There are other companies that are offering warranties that restrict the burn hours, for example, to 18 hours a day of burn. Our warranty is 24 hours of burn. And you will see warranties out there that are prorated, where if the tube burns out halfway through its 10-year life, you only get reimbursed for 50% of the value of the tube. We will replace the tube, no questions asked, in regardless of burn hours, no proration, even if it fails in the ninth-year of operation. So those attributes are refining our attractive too and increasing number of customers, not only in our traditional industrial, and educational and medical, but also in retail and other – in other segments. But if a customer doesn't need those attributes that we offer that are unique, we're not going to lower our prices and take low margins just to make the sale.

That’s good to hear. I mean it looks like you’re consistent in that side. In terms of the product profile that you mentioned, we have less than 1% optical flicker is this true across all product lines? Or is it a certain one or two lines that are providing this feature?

Yeah, we have family of products that is flicker-free, not all of our products are flicker-free. All of our products, I would say, are low flicker, but not all of our products are less than 1% flicker. But they're certainly all among the lowest that you'll find in the industry.

And in terms of your discussion a little – with the previous caller's questions around technology et cetera it looks like margin expansion for this industry potentially comes from more software being added to hardware component of things. So in line with that, are you hiring more people to fill those types of roles within the company? Could you give us some background on how you are setting it up to potentially bring on these.

Actually this is the first earnings call that we've had from our Silicon Valley Innovation Center. So Jerry, Jim and I are sitting here today in downtown San Jose, where we have a new office. And the reason we're here is that, Silicon Valley is the place where we can hire the hardware and software engineering talent we need to develop these next-generation connectors and smart lighting products. In fact, Soraa has right talent in the hall here in this building we actually hired a engineer out of Soraa to do product definition on our next-generation product. So we are hiring – we’ll be hiring a couple of more people here. We will have team of probably half a dozen doing advanced development here in the Silicon Valley Innovation Center. We still want to keep a cap on our R&D expenses until we reach profitability. So I'm doing some downsizing in other areas. We've already done that, in order to make room for these additional heads. So you won't see our R&D going up. I'm a strong believer of having a few of the right people rather than an army of the wrong people. And I think we've got the right people on board now.

That is I have guys, thank you so much.

Thank you. Ted Tewksbury, there are no further questions at this time. I'll turn the floor back to you for final comments.

Thanks, Melissa, and thank you, all for joining us today. We believe the foundational work done by the Energy Focus team over the past year on cost reductions, new product and sales are starting to generate top line momentum. Our goal is to show steady financial progress every quarter and that’s exactly what we did in Q2. We look forward to reporting our results to you next quarter. Until then, thank you, and enjoy the rest of your day.

And this concludes today's teleconference. You may now disconnect your lines at this time. Thank you for your participation.