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Edited Transcript of EFOI earnings conference call or presentation 7-Nov-18 4:00pm GMT

Q3 2018 Energy Focus Inc Earnings Call

SOLON Nov 15, 2018 (Thomson StreetEvents) -- Edited Transcript of Energy Focus Inc earnings conference call or presentation Wednesday, November 7, 2018 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jerry Turin

Energy Focus, Inc. - CFO & Secretary

* Theodore L. Tewksbury

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

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Conference Call Participants

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* Allan Snider

* 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

* Jim Fanucchi

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Presentation

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Operator [1]

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Good day, everyone, and welcome to the Energy Focus Third Quarter Fiscal Year 2018 Financial Results Conference Call.. As a reminder, today's call is being recorded for replay purposes through November 14, 2018.

I would now like to turn the conference over to Mr. Jim Fanucchi with Darrow Associates. Mr. Fanucchi, please go ahead.

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Jim Fanucchi, [2]

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Thank you, Devon. Good morning, everyone, and thank you for joining us for the Energy Focus Third Quarter 2018 Earnings Conference Call. With me today are Dr. Ted Tewksbury, our Chairman, Chief Executive Officer and Pres., and Jerry Turin, Chief Financial Officer.

This morning, the news release with the third quarter financial results was issued and is available on the Energy Focus website under the Investor 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 obligated ourselves to publicly release any revision to this forward-looking statements in light of any new information or future results.

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 with that, now I'd like to turn the call over to Ted.

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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.

To quickly summarize our Q3 results, revenue came in at $5.2 million. This was even with Q2 and up 3% year-over-year. Gross margin of 25% was the same as last quarter and up 2 percentage points from Q3 last year. Our net loss in Q3 was $1.9 million versus $1.8 million in both last quarter and the same quarter last year. We ended the third quarter with $7.1 million of cash.

Jerry will provide more detail on our financial results in a moment. But before we do that, I'd like to make a moment to highlight the key takeaways from the quarter and talk a bit about where we are in our turnaround.

Having successfully reduced our operating expenses, revenue growth is now the key to achieving profitability. In Q3, we made progress on several key initiatives that will help drive top line growth. These include legacy product cost reductions, sales of new products and additional new product introductions. Let me touch briefly on each of these.

First, we completed the cost reductions on our highest-volume commercial and military products. While we continue to target customers and applications that value our industry-leading quality and performance, there is a limit to the premium customers who will pay for these attributes, and our uncompetitive product costs were impeding sales.

Over the past 2 quarters, we successfully reduced cost through a combination of product redesign, renegotiation of purchasing agreements and other supply chain efficiencies. This enabled us to reduce the prices of our legacy products without compromising performance, quality or gross margin. We expect lower pricing to catalyze additional design wins starting in Q4 and to contribute to revenue in 2019. Additionally, we have made continuous cost reductions in core elements of our product management processes in order to stay ahead of the incessant price erosion we are seeing in the LED lighting space.

Second, new products introduced since the start of the turnaround in February 2017, reached their highest revenue level to date. New product revenue in Q3 was 70% higher than in Q1 and Q2 combined. While these new products comprise only 9% of total revenue to date, their early ramps suggest that they will be important contributors to future top line growth.

Let me highlight just a few areas where we're seeing new product strength. There is growing demand for our RedCap Emergency Battery Backup Tube, particularly in retail retrofits, where the company has previously struggled to gain traction. We completed pilot retrofits at several midsize retailers with nationwide chains. While the initial deployments are in selected stores, each of these chains has hundreds of stores nationwide, presenting a significant potential recurring revenue stream next year.

We shipped our first T5 High Output tubes for high bay. This product is generating strong interest from marquis customers, particularly in the industrial segment. Due to improved lumens output and (inaudible), LEDs can now be used in high bays, making this one of the fastest-growing segments in LED lighting. We're also seeing increasing interest in our new line of commercial fixtures which, together with our lamps, provides a complete LED solution for customers.

Third, we continue to track to our plan of new product introductions with the release of our new shipboard retrofit kit in Q3. This expands our portfolio of high-quality offerings for military and maritime customers. The retrofit kit is designed for hangar bays and [well] deck spaces where existing fixtures are often 40 to 60 feet in the air, and sailors aren't able to replace the lamps at sea for safety reasons. Current fluorescent lamps have a limited lifespan in the harsh shipboard environment, and high bay tubes frequently burn out at sea. The new Energy Focus retrofit kit solves this safety issue by replacing existing fluorescents with long-lasting LEDs that slash energy consumption in half. The first sales of the new retrofit kits to the U.S. Navy occurred in the third quarter.

Our nationwide sales force is capitalizing on our innovative new products and more competitive pricing to continue growing the sales pipeline. As you'll recall, the sales pipeline was virtually nonexistent when I started as CEO at the beginning of 2017. By the end of last year, the new sales team was in place, and since that time, they have built a sizable pipeline.

As we've discussed previously, the time to convert these opportunities to revenue, even if successful, is uncertain and can range anywhere from 8 to 18 months due to the lengthy decision-making, budgeting, approval and project scheduling processes of customers in our target market. As we're still within the expected sales cycle time, we expect conversion and continued expansion of this pipeline to drive revenue growth in 2019 and beyond.

Now let me switch gears and discuss where we are in the turnaround of Energy Focus. Turnaround is a complex and lengthy process involving multiple phases. As we've discussed in past earnings calls, the company faced multiple at the beginning of 2017. We're make making considerable progress on the turnaround plan I announced at that time, which can best be understood in 3 phases.

Phase 1 was focused on fixing the root causes of the problems and building the foundation for growth. I'm pleased to say that phase 1 is now done, and we accomplished everything that we set out to do. We built a new executive team of proven industry experts. We expanded from a small, local sales team to a nationwide network with experienced regional sales managers and 45 agencies. We reduced our annual operating expenses by nearly $10 million a year. We closed 3 offices and opened the Silicon Valley Innovation Center to tap into the best hardware and software engineering talent in the industry. We reduced costs of our highest-volume products so that we can price them to sell. And we introduced 5 innovative new products: the RedCap Emergency Battery Backup tube, the T5 High Output tube, our double-ended tube, our new line of commercial fixtures and our shipboard retrofit kit.

Phase 1 took six quarters, about two quarters longer than we had originally hoped. This was largely due to the unanticipated need to redesign legacy products to reduce cost. But with Phase 1 completed, we now believe that we have a solid foundation for growth.

In phase 2, which is partly underway, we are focused on growing revenue and returning to profitability, while in parallel, developing and introducing our smart lighting product portfolio. Top line growth in phase 2 will be driven by 2 factors. First is our expanded and more price-competitive product portfolio, consisting of our cost-reduced legacy products and our Phase 1 new products. Second is the expansion and conversion of the sales pipeline by our nationwide sales force.

In phase 2, we'll be developing and introducing our first connected smart lighting solution. These products will deliver greater value and differentiation to customers. While we certainly don't expect to be the only company with connected, tubular LEDs, we're developing a unique hardware platform that addresses unmet customer needs that are currently impeding the adoption of smart lighting. These products are being developed in our Silicon Valley Innovation Center with the first introduction planned for LIGHTFAIR in May 2019.

The objective of phase 2 is to grow revenue to achieve breakeven. Our current estimate of breakeven revenue is approximately $11 million a quarter. The time line for completion of phase 2 depends on top line growth, which for the reasons just discussed, is likely to remain somewhat volatile and unpredictable in the near term.

In phase 3, by definition, we will be profitable and shipping our first smart lighting products in volume, while simultaneously developing our next generation of products that go beyond lighting to retrofit Internet of Things, or IoT, capabilities into existing buildings. This will transform Energy Focus from a pure-play LED lighting company into a technology company enabling the smart building ecosystem. We expect this elevated business model to drive faster growth, higher gross margins and larger scale. In parallel with these organic initiatives, we will continue to evaluate inorganic options that have the potential to accelerate scale and value creation for our shareholders.

In summary, the success of Energy Focus depends first and foremost on new products. While we were disappointed in the lack of sequential revenue growth in the third quarter, we have made significant progress on new product introductions and sales ramps. Our solid execution in Phase 1 should give investors confidence in our ability to execute successfully in phases 2 and 3.

While we still have work ahead of us to reach our financial goals, we believe the turnaround of Energy Focus is on the right track to grow revenue, improve profitability and increase shareholder value. In closing, I'd like to thank our employees for all their hard work and our investors for their patience as we continue executing on our turnaround.

With that, I'll turn it over to Jerry to elaborate on our third quarter financial results. Jerry?

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

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Thanks, Ted.

Our net sales for the third quarter of 2018 were $5.2 million, consistent with the second quarter and up $200,000 from the third quarter of 2017. Sales of commercial products were $2.3 million in the third quarter compared with $3 million in the second quarter and $3.9 million in the third quarter of 2017. The sequential decline was largely due to a pause between retrofit project rollouts of a major Northeast Ohio healthcare customer, which are expected to resume with their expansion into 2 additional campuses entering 2019.

Sales of military and maritime products were $2.9 million in the third quarter, up 32% compared to $2.2 million in the second quarter and up 73% compared to $1.1 million in the third quarter of 2017. We are currently building -- bidding only on opportunities that value Energy Focus's premium quality, lifetime and durability, while leaving low gross margin commodity business to our competitors. Opportunities in military are also being expended into terrestrial bases, opportunities opened up by our nationwide sales agency model.

Gross margin in the third mortar continued to hold at 25%, consistent with the second quarter, which had seen a jump from 18% in the preceding quarter. Gross margins were 23% in the third quarter of 2017. We continue to view gross margins with caution, given the potential sources of volatility from product mix to timing of majoring customer project deployments, competitive pressures and the more commoditized product areas, timing of our cost reductions flowing through the cost of sales, the global tariff climate and the timing of new product ramps. That said, the new products, and the markets in which we're seeing the most strength, tend to be higher gross margin business and therefore provide us with potential leverage to hold margins in current ranges or even increase gross margins over time.

Our operating expenses for the third quarter were $2.9 million, excluding approximately $280,000 for an executive severance charge in the quarter, compared to $3 million in the second quarter of 2018 and $3.1 million in the third quarter of 2017. Our net loss in the third quarter was $1.9 million, or $1.6 million excluding the same executive severance charge, compared to a net loss of $1.8 million in the second quarter and a similar net loss of $1.8 million in the third quarter 2017.

Shares outstanding were 12 million, a small increase of 100,000 from the prior quarter.

Our adjusted EBITDA, which is intended to provide an indication of cash flow from operating results, and which excludes stock compensation and the severance payment, was a loss of $1.2 million this quarter, an improvement from the loss of $1.8 million in the second quarter. We provide a full reconciliation of adjusted EBITDA to net loss in the tables that accompany the earnings press release filed earlier today.

Moving on to the balance sheet, our cash and cash equivalents were $7.1 million at the end of Q3, compared with $8.6 million at the end of Q2. The net decrease of $1.5 million was primarily accounted for by our $1.2 million adjusted EBITDA of result for the quarter, a proxy for our current quarterly cash usage from operations. We also continue to be debt free.

You may also have noticed we did some housekeeping by filing a new S-3 shelf registration statement to replace the existing shelf, which was due to expire before the end of 2018.

That concludes our prepared remarks. I will 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 Craig Irwin with Roth.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [2]

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First thing I wanted to ask about is progress building the distribution channel. For the past couple quarters, you've shared with us the number of distributors that you've signed up, and some details on the revenue momentum. Can you maybe give us an update and share whether or not you think this is a priority for the company as we go into '19?

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

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Yes. Thanks, Craig. As of last quarter, we reported that we had 36 agencies. We're now up to 45, so we've seen a good increase in the number of agencies. Agency revenue was also up. However, we've stopped splitting that out as a separate reporting metric for the following reason. It's becoming very ambiguous do to the team structure. We have many cases where the agencies will identify an account that has the potential to generate $750,000 or more per year, and we call that a key account. And once that's identified, it gets handed off to our regional sales managers to manage and drive. And so it's become very difficult to try to extract agency revenue growth as a separate metric, so we're not going to do that anymore going forward. We're going to look instead at the aggregate, overall sales. But that said, using the same criteria as we used last quarter, agency sales was actually up.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [4]

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That's really good to hear. So then commercial, I completely understand the headwinds with the pause on this healthcare customer. Can you maybe share with us what they were in the prior quarter or the year ago quarter so we can understand the relative underlying growth of the company?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [5]

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I can share -- I don't want to get into the details of the particular customer, which is a well-known Northeast Ohio healthcare provider. I can tell you that the sales this quarter from that customer were the lowest that they've been in about -- or since the beginning of the turnaround. And again, I wouldn't read anything into that. In fact, going forward, the outlook for that customer is very optimistic. They are now expanding into the Akron General campus, and we're seeing orders for those retrofit projects as we speak. And then there is another out-of-state expansion that they're doing, which I'm not at liberty to talk about, but that we expect to see revenue from in Q1. So what we're seeing with that customer is simply a pause, if you will, between retrofit rollouts. In addition, we have a new product that's being introduced this quarter, which is a dimmable downlight, which is scheduled for deployment in their Cleveland buildings.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [6]

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That's good to hear. So then, I guess, to talk about an area of strength for the company, your military sales this quarter were the highest they've been in many quarters. You referenced the new retrofit kits. Can you maybe share a little bit more color? Was the majority of the growth that we saw sequentially from the sales of those retrofits? Are there a other product crosses that are working for you? And should we expect additional products to maybe lift the growth opportunity over the next couple of quarters?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [7]

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Good question, Craig We're very pleased with the progress that's being made in the military segment. We're seeing a very nice recovery, and what's encouraging is that, in the past, the military business has really been dominated by the M1 Intellitube. That was the project that -- the product where we had some margin pressures that caused us not to bid on some of those opportunities. So a couple of things have happened in military. First of all, we're seeing very nice growth of our non-M1 business: the globe lights, the berth lights, dock lights, floodlights as well as this new retrofit kit. Most of those sales are going to the Navy, but we're also seeing some sales to military bases. So that's a very positive development. That's high-quality, high gross margin product, and so the gross margins of our military business are going up as well as the revenue. And as a result of that, we saw over 170% increase in military revenue year-over-year. The second important development has to do with the cost reductions because that's going to get us back into the game on the M1. We have some potential shipments in Q4, and you'll see us back out bidding actively for those opportunities as they arise. But I do want to emphasize and reiterate the comment that Jerry made. There are segments of military that have become highly commoditized due to the aggressively low pricing practices of some of our competitors. We're staying away from those commodity segments and really focusing on segments that really demand and value the Energy Focus value proposition of quality, long life, low flicker and performance.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [8]

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Great. And then last question is really just a housekeeping question. The $280,000 in severance. Was that in -- that was in the third quarter or was that in the year ago quarter you're referencing?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [9]

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That was recorded this quarter. It was CFO transition, which concluded this quarter so, so it was recorded this quarter.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [10]

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Wow. So expenses are actually much lower, so congratulations on the tight expense control and the continued progress.

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Operator [11]

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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 [12]

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In relation to the product cost reductions, are these now completely behind you? Or is there sort of any effort remaining that will show up in, say, the next quarter?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [13]

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The bulk of the cost reductions are behind us. As I mentioned in the prepared remarks, we prioritized the cost reductions by the volume and the revenue opportunity in our forecast. So the M1 cost reductions are completed. The cost reductions on our highest-volume commercial tubes, the 300D and the 500D, are completed. But that said, we are -- as I indicated, we have implemented continuous cost reductions as part of our product management processes. So even the products that we've already introduced, like the RedCap and the T5 High Output tube, are already in a cost-reduction cycle. So we will be continuously doing these cost reductions to make sure that we stay ahead of the aggressive price erosion that we've seen in the markets. But for the most part, the initial cost reductions are behind us. And I must say that with a very R&D intensive project -- and as I mentioned in the prepared remarks, we had to go back and actually redesign some of these products. So it wasn't just a matter of price negotiations with vendors. There was, in the case of the M1, a complete redesign. That intense effort is now completed, thankfully, so that my R&D people can now go back and focus on the next-generation product.

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Amit Dayal, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst [14]

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That's good to hear. I mean, I was just wondering also if -- as part of this effort, were there any products that may have been sort of good opportunities for you that may have been eliminated? Or were you able to sort of work through these cost reductions for all your key offerings?

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

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We didn't eliminate any products. We just picked the highest-volume ones, the ones that we thought had the highest probability of success, and we cost reduced those. And then going forward, as I indicated, our focus is on more differentiated, higher-value products addressing the smart lighting and connected lighting opportunity. So that's what our R&D organization is focused on right now.

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Amit Dayal, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst [16]

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Yes. So my next question was going to be on any color you can provide on what specifically some of these products may be like or what segments or applications you're pursuing? Just any details on even how many of these offerings we might see, say, over the next 12 months would be helpful.

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

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Well, I give you some broad parameters, but I don't want to get into specifics in order not to tipoff my competitors as to what we're doing. As you know, there are a number of companies that are focused on smart lighting and IoT, and we see it as a major growth opportunity. We have an architecture that we believe is highly differentiated, and it's basically focused on using sensors, controls and wireless connectivity to adapt lighting and the quality of lights to the activities of people within buildings and reduce energy consumption. As you know, LED lighting already enables 150% reduction in energy consumption over conventional lighting, and by using some of these smart lighting techniques, detecting ambient light and adjusting the intensity, you can reduce energy consumption by another factor of 50%. So there's a very significant energy savings. But in addition to that, you have the opportunity to really tune lighting to the activities of people in buildings and enhance their comfort, their health, their well-being and their productivity. One example would be automatically tuning the color temperature, the correlated color temperature of lighting in buildings, to adapt to circadian rhythms, for example. This is something that's of great interest to a number of our healthcare clients. So these are just some of the directions in which we're going. Again, they're not entirely unique to us, but what is unique to us is the platform approach that we've taken to address some of these opportunities. And I don't want to get into more detail there in order not to tip our hand. So you'll have to be patient until LIGHTFAIR 2019, which is in May 2019, and our plan is to show our first product at that show. And then finally I'll just to finish up by saying that our plan remains to introduce, on average, one new-product family per quarter throughout 2019, and it might be more than that, it might be less. I actually said we would introduce 2 new products in 2018, and we beat that. We introduced 3 or 4. So my hope is that we'll beat the average of one per quarter in 2019, but that's what we've got in the plan right now.

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Amit Dayal, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst [18]

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That was very helpful. Thank you. Just one last one for me. The semiconductor and the electronics space is undergoing various types of component shortages that we are hearing about on other earnings calls. Is any of this impacting you or the margin?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [19]

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We haven't seen any changes, Amit. I mean, we're accustomed to very long lead times on components, and our planning process takes that into account. But we haven't seen any recent changes.

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Operator [20]

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(Operator Instructions) Our next 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 [21]

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Can you talk about the supply chain's preparedness to support these new products and growth and any potential limitations there are, not so much around specific electronic components, but just the overall transition of the supply chain and how ready you guys are to make a steady cadence forward on growth?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [22]

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Well, yes. In terms of supply chain, the RedCap, the T5, [HL] and the commercial fixtures are all sourced in China. We are not, by the way, overly concerned about tariffs because the tariffs are not being applied to finished goods at this time, and we haven't seen any significant impact. But in terms of preparedness for demand, I've instructed my team to make sure that there is sufficient inventory on any new product introduction that we can respond rapidly to any quick turn on of demand, which we kept placing with new product introductions. And because of that, if you look at our inventory, inventory was actually up a little bit this quarter, and that's the reason. We needed to make sure that we had the inventory on the shelf to satisfy the really -- the rapidly increasing demand we're seeing, particularly for RedCap and the T5 High Output tube. RedCap, by the way -- and I think I mentioned this -- is really the tip of the spear as far as getting into retail. This company in the past, has aspired to serve retail, but didn't quite have the -- well, didn't have the right sales force in place and didn't have the right products in place. We're seeing tremendous demand for the RedCap, and what very encouraging is a lot of the demand is coming from nationwide -- stores that have nationwide footprints. And those can turn on pretty quickly. You get a pilot as [high] as we've gotten, and suddenly a customer decides they like the product and they want to roll it out in multiple stores across the country. We've got to be prepared to respond to that, and so we have built a little bit more inventory in Q3 in order to be able to manage that.

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Colin William Rusch, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [23]

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And then just in terms of following up on Craig's questions around the OpEx. What sort of incremental investments and infrastructure do you need to really support multi-year growth? And more specifically what do you really need to support your plan over the next 12 months?

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

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Well, really over the next 12 months, we think we can finance our efforts within our existing operating cost base. We believe we have the expertise in-house. It's not capital-intensive. We've managed to allocate resources into the key areas where we believe having the right technical capabilities, tapping the San Jose market -- we've been able to position that, perhaps adding a technical resource or 2 could support that, but we would likely be able to accomplish that allocating existing resources. As we move out beyond a 12-month period, and if we're successful in seeing an initial, significant ramp and scaling up, perhaps there might be a few resources added to support that, but that wouldn't be to enable the new products or the introduction. That would be after the scaling takes place.

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Operator [25]

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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 [26]

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Have you considered, as a way to either increase the education process and/or maybe make some inroads into some of the lateral commercial opportunities, to emphasize on energy auditing practice? Could be a potentially good lead-in for some of the newer, more divergent products you're developing. Or do you see this as something that others provide? Just trying to get a sense of your efforts in this area and whether you think it is almost a lead generator to some extent.

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [27]

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Good question. We actually used to do energy audits, and we also used to do installations and a little bit of -- we were starting to explore the financing model. That was before I came here. When I came, I deliberately stopped doing those things because what it was doing is setting up a competitive situation with the [SCO]s and the lighting retrofit contractors whose business model is based on doing those things. So we were scaring some of those customers away. And so we stopped doing audits, and instead we work with the SCOs and the LRCs. When the customers get the audits, they get the installations and the financing through the SCOs. And the SCOs are comfortable buying from us, so it's actually increased our business with those accounts. In fact, one of our biggest growth clients in Q3 was a lighting retrofit contractor down in Texas who does a lot of the audits and the installations for schools. We had 3 major school districts in Q3 that were retrofit through that contractor. And again, they probably wouldn't have worked with us if we were doing our own audit.

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Carter William Driscoll, B. Riley FBR, Inc., Research Division - VP & Equity Analyst [28]

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Okay. I know this is a difficult question to posit. The commercial sector, as I think you've communicated, is the engine you expect to drive the return on your phase 2 to obviously top line growth, reaching breakeven and then executing into the third strategy, the third phase of the strategy. What gives you confidence? Because you've had a couple of quarters where you've had some of the newer products out there. I realize it's mostly [a turns] businesses. You can't set a backlog figure. But what internally are some of the measures that maybe you could share at a qualitative level that give you comfort that, even if it's a volatile maybe two steps forward, one step back progress over the next few quarters, that you are going to gain that acceptance, especially given the aggressive pricing that I realize is not necessarily a favorable comparison, but the aggressive pricing by some of your competitors that may be at least reduces those expectations and may be puts pressure on margins. Trying to get a sense between a backlog that's not really accurate versus pricing pressure you're seeing and your evolution to get from Phase 1 to Phase 3 over time.

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [29]

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Sure. Good question. And before I answer that, let me just go back to your previous question and issue a caveat to that. I think you understand that our sales model is based on -- it's a hybrid between agencies and our regional sales managers who handle our key accounts. Our key accounts are our customers like Cleveland Clinic, and in some of those cases, we actually do audits. But when it comes to the agencies interfacing with the SCOs and going after the rest of the nonkey accounts, we do not do energy audits for those, so just wanted to clarify that. We actually do a limited amount of audits. Now addressing your question about what gives us confidence in the revenue increasing as we go forward, it's really important in a turnaround to measure the right metrics at the right time. And in phase 1, the key metrics were new product introductions, the number of agencies, the team, the operational improvements, the cost reductions, the operating expense reductions. Now that we're in phase 2, the leading indicators of revenue growth are really the key metrics that we want to measure, and those are things like the sales pipeline, the number of opportunities that have been identified by the sales force, both in the RSMs as well as the agencies, and the total revenue opportunity that has the potential to convert to revenue within the next 12 months. So that's the sales pipeline. We track that. The second thing we track -- and that's increasing. I can't tell you exactly what that number is. I know what the number is, but I don't want to report it externally because then you'll try to interpret it and come up with an estimated 2019 forecast, which unfortunately, you can't do because I can't tell you what the conversion ratio of those opportunities is into actual revenue. Now at some point, we'll know that number. Today we don't have enough history to know what the conversion ratio is. And then the second thing we track is design wins. Of that pipeline of opportunity, how many customers have actually said, yes, we're going to use your product in this particular building or this particular campus, and we're going to make a -- issue a PO at this particular point in time. That's a design win, so we track that as well. And on the basis of those two metrics, the sales opportunity pipeline and the number of design wins, we have a good deal of confidence that we're going to see growth from the Phase 1 new products and the cost-reduced legacy products. And then in addition, we're continuing to introduce new products every quarter, which will continue to layer on top of that. But as a big picture, what should give you confidence and what should give our investors confidence is the fact that we laid out a very aggressive phase I plan, and we did exactly what we said we were going to do. So I think you can count on us to do exactly what we say we're going to do in phase 2.

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Carter William Driscoll, B. Riley FBR, Inc., Research Division - VP & Equity Analyst [30]

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No, that's helpful. And then if you could -- maybe just last question. Of the -- remind me again of the timing of when you're going to introduce your first smart lighting product and the engagement process from a sales perspective. Will this be through the agency side of the business or direct? Any kind of contrast with what you view the upsell will be versus some of your newer product introductions, if there is a difference?

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

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Yes. A couple questions there. So the first, announcements or introductions will be made concurrent with LIGHTFAIR in May 2019. The pricing will be higher because these products have higher value to customers and they're going to result in a higher reduction in energy cost. So we expect gross margins to expand over time. I don't think we should get ahead of ourselves in building that into our model because we introduce these products in mid-2019, we're not going to see significant revenue ramps until probably early 2020, when we'll be driving design wins through both our agencies as well as our regional sales, our direct regional sales managers, in the second half of 2019. So we expect to see revenue growth from those products in 2020 at higher gross margin.

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Operator [32]

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Our final question comes from the line of Allan Snider with Oppenheimer.

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Allan Snider, [33]

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I just have a couple of things. I believe that I've already gotten the answers. I know you've been out to about 4 or more tradeshows recently, and I just wanted to know, how did they go? And I assume they went well.

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [34]

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We've had very good response at all the tradeshows that we've done. We haven't done as much outreach as I would like because our focus -- in phase 1, understandably, our focus was internal on operations, fixing the problems, building the foundation.

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Allan Snider, [35]

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Sure

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [36]

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Now that we've gotten beyond that, we will start increasing our investor outreach and attending more conferences and trade shows.

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Allan Snider, [37]

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Okay. Okay. Unrelated in a way, but there's a competitor public company which has been consistently missing its earnings estimates, and they've now stated that they want to go private. But there was a conference call that they came out with a couple of months ago. They were anticipating, I believe it was a military contract related to LED lighting for airport runways, and they mentioned that there's only one other qualified company, which I believe was Energy Focus. Do you have any comment on this?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [38]

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Yes. Well, first of all I don't want to comment on (inaudible) business. As far as the airport runway project, that's not something that we're working on.

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Allan Snider, [39]

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Okay. That's fine.

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [40]

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Specialized (inaudible)

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Allan Snider, [41]

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Of course though.

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [42]

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No, I should say that despite the -- some of the troubles that my competitors are seeing in the industry, I think this helps to emphasize why Energy Focus is in such a position of strength. We still see the LED market as being a high-growth opportunity. It's a big available market, only 10% to 13% penetrated today. And I think what you're seeing is that the -- some of the lower-quality competitors are starting to by the wayside. And the reason we continue to win business is because, first of all, we've been in the LED lighting industry for 32 years. Customers know that we're here for the long haul. They know that we're a technology leader going all the way back, the Intellitube, now the RedCap. And we stand for quality, long lifetime, high performance, low flicker, and if a retail outlet or a big institutional customer or a hospital is going to invest the money and the time in doing a retrofit, they want to make sure that those tubes last and that they continue to perform at the highest level for 10 or more years. And so I think we're starting to separate from the competition and make it very clear that we're the quality provider in the industry.

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Allan Snider, [43]

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No, I appreciate that. I appreciate that. Just a couple more things I wanted to mention. I was looking at an obscure reference from the World Intellectual Property Organization, WIPO, and it came across my computer at work that on November 7, there was a patent. It appeared that it was issued to Energy Focus for -- and they mentioned a circuit that mitigates electric shock. And John Davenport was listed as one of the inventors. Are you free to discuss this at all?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [44]

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I don't want to get into discussions of (inaudible)

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Allan Snider, [45]

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Okay, okay. Okay, just struck me as -- I saw it, and I was curious about that. And then the other thing I wanted to ask, the fact that there's a GE buyout here domestically, are you in a position to pick off some people?

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [46]

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Every time a customer is going through changes, that's an opportunity for us to selectively recruit people.

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Operator [47]

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Ladies and gentlemen, we have reached the end of our question-and-answer session. And I would like to turn the call back over to Ted Tewksbury for closing remarks.

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Theodore L. Tewksbury, Energy Focus, Inc. - Chairman of the Board, CEO & President [48]

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Thank you all for joining us today. 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 [49]

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