Energy Focus, Inc. (EFOI) Q2 2019 Earnings Report, Transcript and Summary

Greetings, and welcome to the Energy Focus Second Quarter 2019 Conference Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Tod Nestor, President and Chief Financial Officer. Thank you, sir. You may begin.

Thank you. Good morning, everyone. Joining me today for our prepared remarks is James Tu, Chairman and Chief Executive Officer at Energy Focus. Before we begin today's call, I need to remind you that we will make certain forward-looking statements. These statements are based upon information that represents the company's current expectations or beliefs. The results actually realized may differ materially. For a discussion of the risks that could affect our results, please refer to the discussion under the heading, risk factors in our most recent Form 10-K filed with the SEC. The company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. Also, please note that during this call and any accompanying press releases, certain financial metrics are presented on both a GAAP and a non-GAAP adjusted basis. Reconciliations of adjusted results to the GAAP results are available in the tables attached to the earnings release, which is posted on our corporate website at www.energyfocus.com in the Investor Relations section. And now I'd like to turn the call over to James.

Thanks, Tod. Good morning, everyone, and thank you for your participation in our second quarter 2019 earnings call. This is the first earnings call since Energy Focus started its re-launch back in April this year when I rejoined the company. And we're excited to share with you what we have been doing on the re-launch and why. While the transformation work undertaking will take some time to complete and is a work in progress, we believe we're on the path to be a leading LED lighting company when it comes to quality, innovation and brand trust. I understand that for those investors that have been with Energy Focus over the years and they'll stick with us, it's been quite a roller coaster and disappointing experience over the past few years. I'd like to thank you for your continuing support and patience with the company. I would not have come back to the company and invested my own money in arguably the toughest moment of this company's history if I don't believe its future. So I'm 100% aligned with you for the company now to comeback from almost failing, but also return to the point where we once again can make significant and positive financial, environmental and human impact as we have always set out to do when I first joined the company as Chairman and CEO in 2013. For those who are new to the company's story we don't promise an easy way out from here, but we surely will put forward our best efforts to build an exciting and different kind of LED lighting company that could reward not only shareholders, but also all the stakeholders involved, be it our customers, channel partners, suppliers or communities we operate in. We will also make sure we communicate our strategy and status in the most transparent and straightforward way as possible. For this call, I will focus mainly on the key goals we have established in transforming the company into the LED lighting industry leader we aspire to be, and our progress towards those goals. I will also share with you briefly our growth plan and our near-term outlook. Then Tod Nestor, our President and CFO, will review our financial results. We will then open up the call for questions. As you are aware of, every aspect of Energy Focus financial and operating performance has been in steady and accelerating decline since I left in early 2017, due to my disagreement with the Board at that time on our global market strategy. During the two years I was away, the company deviated from its customer-centric culture that has contributed to our impactful innovation and rapid growth over the preceding years. It has built an agency network in which no effective effort was made to educate or nurture our agencies, while alienating our most loyal and supportive customers. We also made no technological breakthrough or launched impactful new product, all the while spending millions of dollars in inventories that we could not sell. The result is that during the two year period, the company's sales dropped more than 50%. The company lost cumulative $20 million and the stock lost 85% of its market value. This scenario combined with my experience of growing the company sales from $2 million in 2013 to $64 million in 2015, and I believe what Energy Focus can and should be is why I returned to the company. 13D investor group, which invested $1.7 million in convertible debenture, to replace the leadership that includes senior executives and most of our Directors. Needless to say, it will be a waste of time to explain and discuss everything that went wrong or assign blame for the misfortune the company has experienced over the past two years. The key is what can be done going forward so that we can improve performance and achieve the vast potential in enterprise LED lighting, which Energy Focus has been leading the technological evolution of previously. In addition, after nearly a decade of commercialization, the adoption of LED lighting by public and private enterprises has just surpassed the 10% level and is right on the cusp of rapid expansion. Meanwhile, over the past two years, large incumbent lighting companies, such as GE, Philips and OSRAM have been sounding dramatic retreat from the market that seems to have been commoditized and focusing primarily on prices. Energy Focus has the potential to become an industry leader with its superior technology and product capability. Since 2007, Energy Focus has provided high-quality LED lighting to leading institutions with mission-critical facility such as the U.S. Navy, National Institute of Health, Cleveland Clinic, FedEx, Bridgestone Tires, University of Minnesota and numerous other government health care, education and Fortune 500 organizations. These customers have experienced the most reliable LED lighting technologies available, saving significant costs in energy as well as maintenance. We not only have an industry-leading 10-year warranty for our product, we also have more than 10 years of LED lighting history to support our promise. In addition, our Flicker-Free lamp also produce the most comfortable and healthy lighting available. And we believe over time, Flicker-Free should and will become standard feature of quality lighting. In other words, Energy Focus has distinct potential to become the industry's first choice of quality, innovation and Flicker-Free lighting. Now it's up to us to make it happen. Since April of this year when I rejoined the company, we've been moving swiftly to rebuild the company's foundation for future growth. Our overarching guiding principle for the re-launch plan is customer centricity. Making customers the center of our universe during the history of the company with exception of the past two years under the previous leadership had enabled us to develop impactful technologies and acquire marquee accounts by bidding out large incumbent lighting brands. We operate our business based on serving our customers the best we can and better than anyone else in the lighting industry. So with customer centricity in mind, beginning in the second quarter, we have been restructuring the company to accomplish the following key goals. Our first goal is achieving and maintaining streamlined sustainable and agile operation. We rationalized and flattened our organization by eliminating and consolidating processes and investments that will now lead into either gaining customers' trust on our brand or bringing customers a unique Energy Focus experience. Specifically, we reduced about 30% of our staff and implemented cost-control measures during Q2, demonstrated through 30% lower operating expenses in Q2 compared with Q1. We also consolidated our supply chain to lower product costs, almost across-the-board, better manage the tariff uncertainties going forward and leverage additional engineering resources through [tighter] [ph] partnership. We expect to see continuing improvements on our growth and operating margins on a quarterly basis going forward from the second half of 2019. Our second goal is effectively and constantly enlightening and educating our customers. As you well know, and as I have just mentioned, Energy Focus has an equal reliability, quality and innovation record started in 2007 in the LED lighting industry. This is the primary reason we're considered the gold standard of quality by our customers and channel partners, particularly as the industry is becoming extremely fragmented and struggling to find a leadership. The bottleneck has always lied in reaching out to more targeted customers and effectively convey our unique and superior value proposition that results in better environmental, financial and operational performances through LED lighting upgrades. To better educate our customers about our technologies and products, we started upgrading our engineering and training support infrastructure that are made available to all our trade partners as well as our own employees. We also make sure all our sales -- all of our sales and marketing activities are driven and evaluated by end customer understanding and acceptance of our product. We have received very positive feedback about this new direction of approach from our existing and prospective customers, which lead to more quoting activities and shorter lead times to orders in the sales process. And we expect our sales to start growing again in the fourth quarter of 2019. Our third goal is developing impactful and differentiated products and solutions based on LED lighting technology. With customer centricity as our guiding principle, we want to continue to create an industrial technology, products and solutions to best serve our customers current and immediate future needs. Energy Focus has always been leading the LED lighting in retrofit market in innovation, starting from our Navy Intellitube, our Type B tubular LEDs that eliminate florescent ballasts launched back in 2010. Our Flicker-Free lamp, our first-ever certified by the UL and our industrial Downlight T5 replacement lamp and RedCap. Our emergency backup battery integrated LED tube that we just received issue pattern during the second quarter of 2019. We want to reestablish and nurture this customer-centric innovation culture and continue to develop breakthrough and practical products and expand our offerings to our loyal customer base. Since the re-launch in the second quarter, we have seen -- we have been focusing on developing disruptive lighting and lighting control technologies that we expect to launch by the first quarter of 2020. We'll share further info as the products are ready for our customers. We do believe these products will make meaningful and substantial impact to both our brand awareness and financial performances beginning first quarter, first half of 2020. Our fourth organizational goal, most importantly is building the most talented and passionate workforce in the LED lighting industry. And you may know, lighting has been considered an industrial month end [ph] industry and LED lighting is broadly believed to be a fairly commoditized business. We hold a very different view. We believe that LED lighting, especially in the enterprise general lighting market we focus on is right on the cusp of rapid and massive adoption as there is nearly 10 years of incremental penetration and technological evolution. As mentioned previously, Energy Focus today singularly stands as the most consistent brand in product quality and performance with extremely low failure rates, innovative and impactful solutions and high customer loyalty. As we complete our current transformation and market continues to open up for us in the coming quarters and years, we will need to grow in a rapid pace while maintaining our technological edge, customer loyalty and sustainable operation. To do so, we will need to recruit, maintain and incentivize talented individuals that can continue to strengthen our company's culture and elevate the performances in every aspect of our operation. In addition to a number of our team members serving expanded or elevated roles in the company as we recently flattened our organization. We're fortunate to have Tod Nestor, our President and CFO, join us on July 1st. Since then, Tod has already made meaningful and substantial impact, not only on our financing, but also overall operations. Meanwhile, after the initial headcount reduction in the beginning of Q2, we've also started hiring and expanding our sales and engineering organization and our overall employee morale has also improved dramatically. In the end, the company's culture and people are the most important factor in attracting talent and everyday we strive to be the leading example for the people we like to attract. Obviously, these four key goals will take time to start creating significant financial impact. We do believe that as we continue to work towards these goals, which together form a flywheel of organizational and sales expansion forces, we will start seeing financial performance improvement first incrementally and on an accelerated basis. At this point, we expect third quarter sales to be in the proximity of our recent past quarters or around $3 million. And we believe that the company is on path to start growing from fourth quarter of 2019. Before the company achieves breakeven level, which we expect sometime during 2020, assuming no other strategic transaction, we plan to continue to fund the growth through our current inventory, improved growth and operating margins as well as additional capital raises. With a strong re-launch story and there are multiple parties interested in investing in the company to support our growth, therefore, we're optimistic that we will have needed resources to continue to execute our growth strategy and plans in the coming quarters. With that, I'll turn the call to Tod to review our second quarter financials and operations in more detail.

Thank you, James. I'm excited about partnering with you to drive shareholder value to Energy Focus, and re-launching the company in a manner that places the customers' voice first, which generally is the best way to create innovative technology that can quite often sell itself. Now I'd like to summarize the results for the second quarter of fiscal 2019. Despite not being with the company for the quarter, I have had the opportunity to understand the business drivers for the performance and would like to communicate them now. History is just that, the past, not an indication of the future or how we expect to operate in the future under our re-launch, but we are obligated to explain the performance of the company for the second quarter of fiscal 2019. I would like to refer everyone to our earnings release and 10-Q issued this morning for more details surrounding our results I'm going to summarize shortly. Generally, the second quarter of fiscal 2019 saw significant decline versus prior year in both sales and gross margins, primarily due to a decline in the government sector, but the company also experienced a significantly less decline in the commercial sector. The diversion of government budgets to alternative uses likely contributed to some of the decline in the government sector as well as the lack of sales to a key customer in the commercial sector. Specifically, second quarter fiscal 2019 sales declined by $2.1 million or 40.4% versus same period in 2018. But on a sequential basis comparing the second quarter to the first quarter of fiscal 2019, the sales decline slowed dramatically to a negligible amount of $100,000 or down 3%. A 29% decline in volumes drove this decline in sales year-over-year with a 5.5:1 ratio of military to commercial sales contributing to this decline. Specifically, military sales decreased approximately 55% during the quarter. In addition, overall prices for products that were sold in both second quarter 2018 and 2019 decreased by 4% further contributing to the decline in sales. Slightly offsetting some of these decreases in sales was the introduction of new products in 2019, which averaged a slightly higher price per unit than existing products as well as an increase in sales to one of the company's two largest commercial customers in 2019. Gross margins for the second quarter of 2019 declined by $1.4 million, or 108.4% versus prior year; whereas on a sequential basis second quarter versus first quarter of fiscal 2019 gross margins only declined by about $210,000, which I will explain shortly. The decline in gross margins year-over-year can be explained by two primary business drivers. First, the decline in sales accounted for approximately $525,000 decrease in gross margin versus 2018. Second, due to inventory buildups that occurred during fiscal 2018 and a decrease in sales, the inventory obsolescence reserve net change had a year-over-year contribution to the decrease in gross margins of approximately $420,000. Please note that this is not a recurring type of expense and the increase in the reserve during the second quarter alone decreased the quarterly gross margins by approximately 15%. Upon James arrival to the company on April 1st, 2019, he immediately began to address the operating expenses of the company. Those items are controllable and could be quickly impacted, so James acted immediately. We've maintained these efforts ever since. Specifically during the second quarter of 2019, operating expenses were down $1.1 million or 34.1% versus the second quarter of 2018. In addition, on a sequential basis, second quarter versus the first quarter of 2019, the operating expenses trended down significantly, reflecting these restructuring actions with a dramatic decline of $861,000 or 29.7%. The restructuring plan implemented has been outlined in our previous press releases and explained by James previously. However, I wanted to quantify the primary contributors to the year-over-year improvement, which included a reduction in salaries and wages of approximately $800,000 and $200,000 in professional fees in testing with about a $50,000 reduction in noncash depreciation. As you can see, most of the reductions are cash based. Finally, the loss from operations during the second quarter of fiscal 2019 was somewhat mitigated in the second quarter by these restructuring initiatives and resulted in a loss of $2.1 million versus a $1.8 million loss from operations during the second quarter of fiscal 2018, $300,000 additional loss. In addition, fortunately despite the headwinds from gross margins and lower sales, the immediate actions taken by new management allowed loss from operations to be significantly reduced on a sequential basis from the first quarter to the second quarter in fiscal 2019 by approximately $655,000. Next, we would like to provide some highlights around some of our key balance sheet items. First, regarding cash; I would like to take this opportunity to reset how the company presents cash to investors. Prior senior management had a window-dressing practice where they would maximize borrowings under the working capital revolver just prior to the end of each quarter to add cash on the balance sheet in order to increase the gross cash balance. We are no longer going to undertake this practice. From a corporate finance perspective, we do not see value in borrowing money that company does not need and pay interest on it. And when we are not earning interest on a cash borrow and having it sit idly on the balance sheet resulting in a true cash cost to the company, the practice simply does not make sense. Frankly, our desire would be to have zero cash on our balance sheet and operationally drawdown from an operating capital revolver with a lot of borrowing capacity and availability to fund our business only when necessary. No longer will the company speak about gross cash as a stand-alone concept. Going forward, the company will speak about cash on a net cash and net debt basis, so tracking out the true financing debt from gross cash to determine the net cash or net debt. After all, all cash on a balance sheet represents this unpaid financing debt. Given this view and approach, our second quarter fiscal 2019 net cash balance was $555,000 with gross cash of $2.2 million and financing debt of $1.7 million. This compares to net cash of $4.1 million in the fourth quarter of fiscal 2018 with the decrease being driven by inventory investments and cumulative operating losses. Accounts receivable was at $1.8 million at the end of the second quarter of fiscal 2019 versus $2.2 million in the fourth quarter of fiscal 2018, a $400,000 decline reflecting the general sales decline. Inventory balances declined from $8.1 million in the fourth quarter of fiscal 2018 to $7.7 million in the second quarter of fiscal 2019, reflecting two primary items. We immediately ceased purchasing any unnecessary inventory as well as the increase in obsolescence reserve I mentioned earlier. Finally, you'll see the accounts payable decline markedly from $3.6 million to $2 million, a significant use of cash over this first six months of the year, reflecting the large build of the inventory done by the prior management during fiscal 2018 and the need to pay those vendors during the first half of 2019. Most other significant balance sheet changes from period-to-period you see in the earnings release are because of our adoption to the new standard for lease accounting. The company has a very high sensitivity regarding its liquidity and monitors it constantly and very closely. We have already described our concept of net cash and net debt to you. We also measure, monitor and assess our availability under our credit line with our financial institution to ensure we have adequate availability. Finally, James and I are actively pursuing financing options on as favorable terms as possible to strengthen our balance sheet and provide additional funding for the re-launch strategy. There is no guarantee we're going to obtain financing, but we're optimistic the re-launch strategy is being well received and as importantly well executed to allow the company for reach its potential. Very quickly, given our use of imports from China, I quickly wanted to address tariffs. We continue to be able to not have tariffs substantially impact our financial results through mitigation plans we have implemented and have not yet needed to pass along the minimum level of tariffs we've incurred to our customers. Our contingency planning includes the consideration of supply chain options outside of China. We will continue to monitor the impact of tariffs closely and respond accordingly. Also, given our very low failure rates, we continue to be able to afford our 10-year warranty for our tubes and afford it financially. Lastly, I would like to begin providing some basic items with this first earnings call. I'm going to start with some basic items around sales and eventually expand the further guidance in the future is again further comfort with the business, the re-launch plan and the processing systems to forecast the business beyond milestones and provide guidance in terms of more detailed financial expectations. For the third quarter of fiscal 2019, we're seeing our re-launch program begin to gain traction and some of our long-term customers returning to Energy Focus, other customers buying additional product as well as some success with new customers in our higher education sector. In addition, we are beginning to see more meaningful traction with our RedCap product, which we believe has tremendous potential. These new opportunities and contracts under the re-launch efforts can take a few months to come to fruition. So we don't expect them to materially impact our Q3 sales results, which James has mentioned and would likely be in the ballpark of Q2 sales. While we'd like to caution our listeners that our quarterly sales are still somewhat unpredictable due to potential order swings and the specific timing and the impact of our re-launch efforts, we do expect to start seeing sequential growth and bottom line improvement beginning with quarter four of this year and onward. With that, we'd like to open up the call to questions.

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

Thank you. Good morning, James, good morning, Tod. You guys have a lot on your plate. So I will limit my questions in light of all of the commentary already provided. Just going into sort of how the sales force is going to be reorganized with this new customer-centric focus, can you walk us through how you are going to potentially use the agency channel versus building potentially organically over here?

Sure. I mean, so we do have an agency network, and we have been [reviewing] [ph] the agency network, and we have consolidated the agency network. So we have less than 20 agencies now, and we are working with them. And as I mentioned earlier, we want to be able to educate and nurture these network. We have -- regardless of agency or contractors partner -- contracting partners we work with or directly with large customers. As we mentioned, the customer centricity is what drives our sales activity. So we are channel agnostic, but we want to be able to serve the end customers as best as we can even if we got brought into a new relationship by the intermediary, we want to be able to educate the end customers and help our customers solve their lighting problems. And that's what we're doing every day now. So in terms of the sales organization, we have a direct sales force that also opens other channel partners, as I mentioned, primarily the agencies and the contracting partners, and we're expanding that right now. And in addition, we are also working on inside sales organization, we are building up our inside sales capability. We also have particular specialty distribution partners, again these are considered the agencies of the world, but not necessarily lighting agency. And we have a few leaders in sales organizations, which -- we will be expanding our sales organization pretty aggressively obviously in the next few months. So at the end of the day, the agency network, the contracting network, the end customers, we are organizing our sales force to approach all of them with our product. And we have leaders in different channels to help us to support the sales -- regional salespeople.

So just to build on that a little bit whether we approach them directly or through an intermediary, we're going to partner, and do it through education and with our customer-centric view in a manner so that we're educating them about our products and what they can do. It won't be a hands-off approach, it'll be a very partnership approach.

Are you going to potentially bring in somebody to head this operation? Or are you working with the team in place already?

Both. As the company grows, definitely we will be hiring more leaders. As I mentioned, Tod just joined us last -- this quarter actually -- during this quarter. And we're actually recruiting additional leaders in sales, marketing, every aspect.

Understood. And you highlighted, you've got around 30% of the workforce, but you are also kind of rebuilding on that front. On that perspective, like operating costs, I know you've provided some color, but is this going to ramp aggressively? Or will it be sort of a moderate ramp over the next few quarters?

We don't believe that the costs will ramp significantly. Yes, we are rebuilding our staff -- but we believe that we can leverage the existing staff and grow significantly from here without adding a lot of overhead. I would say that the operating expenses will be relatively flat, but obviously trending up over time as we hire more people, but we expect sales to -- top line to grow faster, much faster than the operating expenses.

I would say that the compensation structures are much more rational too, and they'll be much more aligned. The line of sight will be much more aligned with pay-for-performance as well. So the bases are much lower than they were historically even as we add people.

Understood. Yeah, I think that's all I have for now. I will take my other questions offline. Thank you so much.

Thanks Amit.

[Operator Instructions] Our next question comes from the line of Allan Snider with Oppenheimer. Please proceed with your question.

Hello?

Yes, good morning Al.

I have a couple of questions that are brief. I noticed in the literature that you provided recently, you showed a couple of big-box stores, mentioned some other hospitals, these are the kind of things that create interest on the part of investors. Could you give me an indication of the time frame that is generally involved to go beyond a minimal involvement to one of major consideration with this type of facility, be it a hospital, big-box store or schools, universities as an example. You've mentioned a number of those as well. What do you foresee in that area because that represents an exciting area to an investor? They can smell that, they can taste that; that looks like dollars in the bottom line. So it's a long-winded question, but I just wonder how you feel about that.

Sure. So as you know our primary vertical that we have been focusing on are government, military, health care, higher education and K-12, these are pretty much contributing most of our sales today, and it's still very, very early in penetration. If you look at, there are 5,000 hospitals across the country, there are about 5,000 colleges and universities across the country, there are 12,000 school districts across the country. They are very, very penetrated in LED lighting and I can -- you can go back to your kids and your grandkids and look at their schools, the hospitals just not LEDs, LED is still very much on the new construction side. On the retrofit side, it's very, very lowly penetrated. So we want to be able to [indiscernible] the partnership that we have achieved. I would say that one thing that is notably different today versus say three, four, five years ago when we first started out, was that in the past we have to sell against fluorescent lighting, and we have to sell against, because of our quality positioning, sell against the large incumbent brand and both these two major, I guess, barrier to getting new customers have been removed. Today, there is no doubt that every facility manager wants to do LED lighting, and we're also not being the GE and the Philips of the world. And they're not considered so-called the premium lighting anymore. Obviously, watching the whole industry, they have been -- all been bought out or retreated and much smaller today. So those we're focusing on the institutions that value quality and performance. I think we have a very good odd these days to actually turn a new prospect into a customer within a few months. If you look at that back in 2013, '14, '15, it takes us a year to two years to - from the initial introduction to get...

Sure. That's understandable.

And now we're talking about a few short months. And that's because customers are much more educated on LED lighting now. They have all tried LED lighting products before, and they've all got bad experiences because -- and that's the fundamental misconception in the market where the enterprise lighting functions need much more rigorous quality on the lighting. And that is very different from the residential market. So we believe that the timing is very good now, and as we have mentioned we are seeing more activities. We are seeing faster -- much faster lead times, which is why it is important for us to build marketing and sales force to approach the market today that is very ready for us.

I will add one item to what James said. I think the customer-centricity approach, the customer referrals we do receive and the track record we have established with quality goes a long way too in accelerating that sales cycle. So when they talk to each other, it closes a deal for us. And I mentioned that early in my comments, those referrals help a lot and our quality and track record helps a lot.

Well, that's the way it should be ideally. And hopefully, the time frame for getting these orders will be narrowed a bit as the increase in the word gets passed around about who you guys are and what you do. I know competitively it must be awkward at times to run into a wall where someone is adamant about some other known quantity, and they're not familiar with you. And you have to have people who can speak up and make your case, and as I assume what you are doing and hopefully, may be sooner than later that we see some really good results and I'm hoping that's the case. And that's all I have to say, and I appreciate your time.

Thank you. Mr. Tu, it appears we have no further questions at this time. I would now like to turn the floor back over to you for closing comments.

Thank you, everybody, for your participation on the earnings call. And we look forward to talking to you again in the third quarter 2019 earnings call. Have a good day.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.