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Edited Transcript of EFOI earnings conference call or presentation 8-Aug-18 3:00pm GMT

Q2 2018 Energy Focus Inc Earnings Call

SOLON Aug 23, 2018 (Thomson StreetEvents) -- Edited Transcript of Energy Focus Inc earnings conference call or presentation Wednesday, August 8, 2018 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jerry Turin

Energy Focus, Inc. - CFO & Secretary

* Jim Fanucchi

* Theodore L. Tewksbury

Energy Focus, Inc. - Chairman of the Board, CEO & President

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Conference Call Participants

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* Amit Dayal

H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst

* Carter William Driscoll

B. Riley FBR, Inc., Research Division - VP & Equity Analyst

* Colin William Rusch

Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst

* Craig Edward Irwin

Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst

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Presentation

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Operator [1]

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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.

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Jim Fanucchi, [2]

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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 non-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.

And now I'd like to turn the call over to Dr. Tewksbury.

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [3]

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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. So we're very excited to have Jerry on the team.

The second quarter of 2018 was one of solid execution on all fronts: Financial, sales, operations and new product. Our sequential progress in each of these areas demonstrates that the restructuring and 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 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's value proposition of flicker-free light, military-tough quality and the industry-leading 10-year warranty. At the LIGHTFAIR trade show in May, the Department of Energy presented a report affirming what Energy Focus has been saying for years; namely, that optical flicker can cause fatigue, eyestrain, migraines, photo epilepsy, anxiety, panic attacks and other deleterious health effects.

The DOE is also establishing standards, criteria and metrics for flicker, which will help differentiate Energy Focus's products from inferior knock-offs. As awareness of the dangers of flicker grows, more and more facilities managers are specifying flicker-free lighting for their buildings. It was exciting to watch visitors to our LIGHTFAIR booth, measuring competitors' products on the exhibition floor with flicker meters and seeing for themselves what a dramatic difference that Energy Focus makes. To learn more about flicker, I encourage you to view our videos on our website, which include a recent well-attended webinar on the causes and effects of flicker.

While I am not going to discuss many details related to specific customers for competitive reasons, let me give you a few examples of where our products are going. In health care, we saw an increase in sales to our well-known Northeast Ohio health care system, which continues to add buildings to their initial project as well as adding facilities in Akron as part of the Phase 2 project. During the quarter, we also completed a 10,000 lamp retrofit for the Russell Medical Center in Alabama. In addition to tubular LEDs, Russell has deployed several hundred of our RedCap emergency battery backup tubes in their operating room.

Nowhere is the quality of lighting more important than in a hospital environment, where patients' health, safety and survival is at stake. You can read more about the Russell Medical Center in our recent press release and case study.

In the education market, we continue to see strong demand from K-12 school as well as higher education, where there is a growing awareness of the adverse effects of flicker on learning and concentration, particularly among individuals on the autism spectrum. While many competitors consider low flicker to be 30% or more, Energy Focus tubes are UL certified to be less than 1% optical flicker. Eliminating flicker is a top priority for many educational institutions, including the Elmore County School District in Alabama, where we completed a 20,000 tube retrofit in the second quarter.

In addition to health care and education, a growing percentage of our commercial revenue is coming from retail and industrial customers with nationwide facilities that offer significant cumulative revenue potential. For example, during the quarter, we completed an additional retrofit for a leading tire company, as well as a new retrofit for a Washington, D.C., museum, both of which provide a foothold for potential additional retrofit opportunities. Military and maritime sales of $2.2 million in Q2 represented 43% of total revenue.

While there were no M1 Intellitube sales during the quarter, sales of our berth, globe and floodlights doubled sequentially. This represents a favorable shift in our composition of our military and maritime revenue toward higher gross margin products. While we saw an uptick in revenue over Q1, on a year-over-year basis, second quarter revenue declined by 32%. Compared with the same quarter last year, military sales actually increased 164% for the reasons just discussed, while commercial sales were down 43%.

The commercial decline was primarily due to the completion of several large retrofit projects in the second quarter of 2017, without sufficient follow-on projects in the pipeline to replace that revenue.

Rebuilding that weak commercial pipeline was the impetus for transitioning to a nationwide agency-based sales organization in the second half of 2017. So let me take a moment to comment on the progress we've made on that front. I'm pleased to report that the agencies' contributions to total revenue was increasing. In Q2, agency revenue grew 6% sequentially, the second consecutive quarter of growth. For the first half of 2018, sales from our 36 agencies represented 67% of commercial and 36% of total revenue, putting us on track to achieve our target of 60% of total sales in 2018.

We are making good progress in diversifying outside our traditional Midwest territory, expanding sales in previously underserved regions such as the West and the Southeast, each of which grew by over 90% from the first half of 2017 to the first half of 2018. In addition, the agencies have built up a 12-month sales opportunity pipeline that is 5x larger than it was a year ago, reinforcing our confidence in being able to deliver sustained revenue growth. Perhaps the most important contribution of the agencies has been the introduction of Energy Focus to more than 35 new key accounts, which are customers with the potential to deliver over $750,000 in annual revenue.

Key accounts are handed off to our regional sales managers, who provide focused customer education, support and development. These key accounts are primarily in our core health care and education markets, but also include a growing number of nationwide retailers with the potential for recurring revenue streams from multiple sites.

While sales cycles for the key accounts can range anywhere from 8 to 18 months, they are expected to become an increasing percentage of our revenue going forward. As we discussed in previous calls, the industry is becoming increasingly competitive, with price erosion on LED tubes of 15% or more per year. Energy Focus's products have traditionally been priced higher than the competition because they were designed for performance and quality, without much regard for cost.

While customers are willing to pay a premium for Energy Focus's value proposition, the price gap is becoming untenably large, and we found ourselves unable to compete for some opportunities at acceptable gross margins. At the beginning of this year, we launched a program to aggressively reduce costs on our legacy products without compromising quality or performance.

We are doing this through a two-pronged strategy of product redesign as well as renegotiation of purchasing agreements with component suppliers. In addition, we have overhauled the company's new product development processes to make cost a top priority in all new product definitions and to require continuous cost reductions over the lifetime of every product in order to stay ahead of the inevitable price erosion. As a result of these initiatives, we were able to lower prices on our 2 highest volume commercial product families in Q2, and we expect this to catalyze additional sales growth.

Longer term, our differentiated new product road map should enable us to drive greater pricing power and higher gross margins.

Turning to new products. Q2 was a prolific quarter with 3 introductions, the double-ended T8 and T5 high-output tubes as well as our commercial fixture family, all of which we talked about on our last call. These new product categories are driving strong interest from customers and segments where the company has previously struggled to gain traction, such as retail and industrial.

All 3 of these new products are now fully released to production and are shipping for revenue.

In conclusion, our second quarter results demonstrated solid execution on all fronts. When compared with the first quarter, we grew revenues across all major account categories: Agencies, key accounts, commercial and military, excluding the low gross margin M1 Intellitube. Gross margins were up, operating expenses were down and our net loss decreased. It was a prolific quarter for new product introductions, surpassing our commitment of 2 new products in 2018 and paving the way to meet our goal of 1 per quarter in 2019.

We're seeing increasing momentum for our advanced LED retrofit solutions from an expanding base of customers across the country, driven by our new sales team. I'm happy with the progress that the Energy Focus team has made so far, and I believe we will see continued improvements in our business and financial performance. Our cost reduction initiatives and the increased pricing power of our differentiated new product road map position us well to overcome the normal pricing challenges we have in our industry.

While we still have work ahead of us to reach our financial goal, the turnaround of Energy Focus is clearly on the right track to grow revenue, improve profitability and increase shareholder value.

With that, I'll turn it over to Jerry to introduce himself and elaborate on our financial results. Jerry?

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Jerry Turin, Energy Focus, Inc. - CFO & Secretary [4]

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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, excellent team and technology-driven mindset, Energy Focus is well positioned as a platform for driving scale in 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 the here and now, our net sales for the second quarter of 2018 were up 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 commercial products were, however, down almost 40% from a very successful second quarter of 2017, in which certain customer projects were completed, but from which we exited with a relatively small number of new sales opportunities in the 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, 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 had seen a spike in Q1, military and maritime increased by $1.1 million as a result of sales of other higher-margin military products, including the high-quality globes, berth lights and floodlights.

Gross margin in the second quarter was 25.1% compared to 17.5% in the first quarter of 2018 and 25% in the second quarter of 2017. The quarter-on-quarter improvement was primarily due to the mix shift away from the legacy M1 naval product towards commercial and military maritime products with higher margin.

Given our high mix of low-margin M1 products last quarter, to some degree this quarter's gross margin of 25% appears to be a better frame of reference for understanding our current margin profile than the 17.5% last quarter. However, we do caution that gross margins will continue to reflect volatility from quarter to quarter going forward as a result of factors including the variability of our product mix and timing of specific large customer product, the ongoing pricing pressure, related competitive dynamics, potential tariffs on component-level parts in China, which at this time don't -- we don't believe will begin to have an impact around -- until around Q1 in 2019 given our current inventory levels of related parts, the timing of realizing cost reductions Ted's talked about from initiatives underway throughout our portfolio and the cyclical nature of M1 product sales themselves. Our operating expenses for the first quarter were $3.1 million compared to $3.2 million in the first quarter of 2018 and $4.6 million in the second quarter of 2017. Operating expenses in Q2 last year included $1.1 million of restructuring charges. Our net loss in the second quarter was $1.8 million or a loss of $0.15 per share compared to a net loss of $2.4 million or a loss of $0.20 per share in the prior quarter and a net loss of $3.1 million or a loss of $0.26 per share in the second quarter of 2017.

Our share count at the end of Q2 was 11,949,000 shares. Our adjusted EBITDA, which excludes stock compensation and is intended to provide an indication of cash flow from operating results, was a loss of $1.4 million this quarter compared to a loss of $2.1 million in the first quarter, an improvement of $700,000.

We provide a full reconciliation of adjusted EBITDA to net loss in the tables that accompany the earnings press release filed earlier today. From a balance sheet perspective, our cash and cash equivalents were $8.6 million at the end of Q2 compared to $10.2 million at the end of Q1. The net burn of $1.6 million was primarily accounted for by our adjusted EBITDA results for the quarter. We ended the quarter with net working capital of $15 million, a ratio of current assets to current liabilities of 4.6:1, and we continue to be debt-free.

That concludes our prepared remarks. I'll now turn it over to the operator for Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Colin Rusch with Oppenheimer & Company.

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Colin William Rusch, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [2]

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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 get identified and moved forward, but we'd love to understand how quickly that might start to convert and start driving some significant sales growth?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [3]

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Yes. Thanks, Colin. Great question. So the agencies enable us to accelerate what we did in a normal sales cycle because they enable us to bypass the lead generation portion of the cycle. Many of these agencies are already calling on customers both in our core markets as well as in retail and industrial and other [channels] 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 decisionmaking 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 8 to 18 months for some of these decisions to get made. And just as a point of reference, I mentioned in the remarks that, a year ago in Q2 of 2017, we had -- actually, I think we had about 4 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 8 to 18 months is a good rule of thumb. And of course a lot of the opportunities we've got in our pipeline are well along in that process.

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Colin William Rusch, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [4]

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Okay, excellent. And then, 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 investment to reduce cost. But could you walk us through what you're thinking about as sustainable in terms of the manufacturing margins on a go-forward basis?

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Jerry Turin, Energy Focus, Inc. - CFO & Secretary [5]

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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's talked about, where we believe that we can potentially accelerate revenue growth in some areas with more competitive pricing, and how 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'd look to 25% in maybe our recent margins over -- so looking at the last 6 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 that in the right direction, but there is also headwinds that we need to be cautious about now, I think.

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Operator [6]

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Our next question comes from the line of Carter Driscoll with B. Riley FBR.

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Carter William Driscoll, B. Riley FBR, Inc., Research Division - VP & Equity Analyst [7]

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First of all, nice progress, Ted, Jerry, on virtually all your metrics. And welcome aboard, Jerry.

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Jerry Turin, Energy Focus, Inc. - CFO & Secretary [8]

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Thanks, Carter.

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Carter William Driscoll, B. Riley FBR, Inc., Research Division - VP & Equity Analyst [9]

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First question, very high level, just from a strategically -- Ted, how do you think about when you determine the kind of new product growth -- the pathway. I'm trying to better understand your decision-making process in terms of the factors, where you allocate your R&D dollars among certain things like, does it open up a new segment? You've had, at least in the commercial segment, a heavy 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 (inaudible)...

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [10]

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Yes. Great question. And actually you hit on most of the key criteria. I've now made my mantra at Energy Focus to be -- every product the world's first or the 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 -- it's a lot more than just lighting, it's about building automation and smart environments. 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 #1, differentiation. Differentiation leads to gross margin, high gross margin. So every product must be significantly differentiated over 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 an 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 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 predates my coming onboard 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-y 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 and our high quality and our 10-year warranty. But we're looking for products that also have the ability to move laterally, horizontally outside of those 2 verticals into retail and industrial and [other] market. So those are really the 4 criteria: Gross margins, differentiation, customer sponsorship and [working stock].

(technical difficulty)

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Carter William Driscoll, B. Riley FBR, Inc., Research Division - VP & Equity Analyst [11]

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Jim, certainly uncertainty over the brewing and rising tariff war, for a lack of better phrase, that's potentially going to impact you, but maybe not until the first half of '19. 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 you think it would take if you had to take such actions?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [12]

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So let me provide some high-level color and then I will turn it over to Jerry to expound 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 is 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 not yet tariffs on those, although we don't know what will happen in the future. Components from China are used from some -- to some extent in new products we manufacture in Solon, 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, for 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, though I'll let Jerry talk a little bit more about the quantitative details.

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Jerry Turin, Energy Focus, Inc. - CFO & Secretary [13]

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Yes. So 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 it -- 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 specific components we've looked at, the cost (inaudible) 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've achieved cost improvement or cost reductions 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.

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Carter William Driscoll, B. Riley FBR, Inc., Research Division - VP & Equity Analyst [14]

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You mentioned growing pipeline in the commercial side. Is there any way you could -- I mean, I realize you still have a heavy component of sale -- of turns to your business, but is there a -- either a backlog or a pipeline number you could point to? Are you comfortable providing such a thing or is that how you (inaudible)...

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [15]

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We don't disclose the dollar amount of the pipeline, or of 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 5 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, 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 agency. Just to comment on the agencies, as I mentioned, we've got 300 -- we've got 36 agencies across the country. Each agency has roughly 10 agents out on the street calling on customers and representing the Energy Focus portfolio. So that's 360 individuals up from half a dozen or so direct people when I joined the company. So an 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'll do going forward is report every quarter how much that pipeline has grown, but I don't want to disclose absolute numbers.

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Carter William Driscoll, B. Riley FBR, Inc., Research Division - VP & Equity Analyst [16]

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When you talk about the premium gapping 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?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [17]

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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 opportunity. 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 -- I won't give absolute dollars, but the price reductions have ranged everywhere from 20% for some of the lower-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 5 years-or-so ago were really overdesigned relative to market requirement. And we were able to take a significant amount of cost out without any sacrifice to product performance or quality. And so that was long overdue. And I think the results are going to enable us to accelerate our sales growth.

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Carter William Driscoll, B. Riley FBR, Inc., Research Division - VP & Equity Analyst [18]

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So given the -- what you have done in terms of pulling out costs and 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 their tenure grows and trying to keep exogenous one-off price declines if the Chinese come in aggressively, would it be reasonable to assume that all things equal, you could maintain a 25% gross margin going forward?

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Jerry Turin, Energy Focus, Inc. - CFO & Secretary [19]

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Well, could we? We potentially could. But again, there's a lot of things you listed and a lot of things related to that we listed as well that could certainly cause headwinds to that. If the preponderance of those factors align, 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 to see some volatility. And again, 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 is volatility we face in that regard too.

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [20]

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It's all a timing question, right? I mean, as I indicated, we will see more pricing power from the more differentiated product road map with the 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 the -- between the new products and the legacy products. There is also the timing of the tariffs -- and whether or not tariffs are implemented on finished goods. There's the timing of when does the next Navy bid come out for the 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 2 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%.

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Jim Fanucchi, [21]

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Hey, Carter, I'm going to have you hold your -- the remaining questions, right? Let's move on to a couple of other guys and we'll circle back with you.

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Operator [22]

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Our next question comes from the line of Craig Irwin with Roth Capital Partners.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [23]

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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've 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 probably knows 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 suggests 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?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [24]

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That's a terrific question. I would add to that list of executives, Larry Fallon, our 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 than the investors see and the customers see, and I want to keep it that way. When we introduced the RedCap emergency battery backup tube, that product was more than 2 years late to market than it had been preannounced back at the 2015 LIGHTFAIR. And I don't want to be preannouncing 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 our current activity, our control 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 the LED lighting industry. So we've got a novel twist on it. And I'm not going to disclose what that is. In 2019, you'll get a chance to see. But we've got a novel implementation that really was the brainchild of Laszlo Takacs, who, as you mentioned, has a outstanding reputation for technology innovation. And so that's what's -- that's the first thing, the technology leadership and my track record of being able to bring those leadership technology ideas to market and make money for investors through them. And the second thing that attracts people to the team is the people that are already here, great people attract great people. And we put together an amazing team of world-renowned technology veterans and salespeople, and that's attracting people to the company because they know that we've got a proven track record for success, and we're going to be able to generate financial rewards for them as well as for the shareholders. As far as the timing and why you're not seeing the results reflected in the top line, I think we're very much on schedule for a turnaround of this magnitude. I've never done a turnaround that generated significant top line results from initial conditions similar to what we had here in anything less than 2 years. So I do think that we're seeing a good momentum on the top line, and I think you're going to see it continue over the next several quarters. And I am anxious to deliver those financial results that our investors are looking for and deserve.

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Jerry Turin, Energy Focus, Inc. - CFO & Secretary [25]

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I'd just emphasize that kind of Ted's point that a turnaround is 2 stages, right? A turnaround isn't righting the ship, right? Turning -- a turnaround is righting the ship and then setting and allocating the resources to a new strategy that takes it to the next level, right? And so you right the ship and then it takes that reallocation of resources and efficiencies and effectiveness to then move it to the next level. So it is in a way a 2-step process.

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [26]

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And just as a point of reference, at IDT, which was another noteworthy turnaround, it took 6 years from the time I walked in the door until we really started to see significant growth due to all the new product categories, wireless charging, [armor], 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 could turn that ship. And that's one of the reasons I came here. So after -- come back after my 2-year anniversary and then we'll have an interesting conversation.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [27]

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So maybe I can ask the question just a slightly different way and you can give us maybe a nod in the right direction. But 5 years from now, 4 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 that touches the lighting space." I mean, is that what we're potentially looking at over the next few years?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [28]

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Our vision is not so much to become a design -- an aesthetics design company and develop luminaries like Acuity 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, the Acuitys of the world, or the Eatons 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 through 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.

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Operator [29]

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(Operator Instructions) Our next question comes from the line of Amit Dayal with H.C. Wainwright.

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Amit Dayal, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst [30]

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

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [31]

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Not quite yet, Amit. We've done the cost reductions, but we still have significant inventory 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.

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Amit Dayal, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst [32]

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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?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [33]

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Yes, absolutely. We've traditionally walked away from a lot of low-margin business, where customers have been unwilling to pay the premium that our products deserve. But 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% flicker. And we're not here to serve those customers. They are just as well served by buying a cheap Chinese tube that might last 3 years. We're -- that's why we're focused on demanding applications, extreme applications like hospitals, educational facilities, industrial environments. And of course, we're seeing increased opportunities in retail because again, I mean 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. I mean, a company can give you a 10-year warranty on a 2-year tube if they're willing to replace the tube 5x during the duration of the warranty. We have a industry-leading warranty that backs up a tube that actually is going to last 10 years in operation. And we're finding that retail is starting more and 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, irregardless of burn hours, no proration, even if it fails in the 9th year of operation. So those attributes are -- we're finding are attractive to an increasing number of customers, not only in our traditional industrial and educational and medical, but also in retail and 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.

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Amit Dayal, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst [34]

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And that's good to hear. I mean, it looks like you're consistent on 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 1 or 2 lines that are providing this feature?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [35]

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Yes. We have a 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.

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Amit Dayal, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst [36]

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Got it. 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 the 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 (inaudible) on these...

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [37]

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Good question. So actually it's -- so we're -- 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 connected and smart lighting products. In fact, Soraa is right down 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'll have a 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.

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Operator [38]

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

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [39]

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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 products and sales is starting to generate top line momentum. Our goal is to show a 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.

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Operator [40]

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