Marcia Miller - CFO James Tu - Executive Chairman, President and CEO

Colin Rusch - Oppenheimer Carter Driscoll - FBR Jed Dorsheimer - Canaccord Amit Dayal - Rodman & Renshaw Martin Yokosawa - Torii Asset Management James Liverman - Wells Fargo Advisors

Good day, and welcome to the Energy Focus First Quarter 2016 Earnings Call. Today’s conference is being recorded. After today’s presentation, there will be a question-and-answer session. [Operator Instructions] At this time, I would like to turn the conference over to Marcia Miller, Chief Financial Officer. Please go ahead.

Thank you, Cynthia. Good morning, everyone and thank you for joining us for Energy Focus first quarter 2016 earnings conference call. Today, James Tu, our Executive Chairman, President and Chief Executive Officer, and I will report on our results for the quarter. The news release and our quarterly report filed on Form 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. We encourage you to review our most recent filings with the Securities and Exchange Commission including our 10-K and 10-Qs for a complete discussion of these factors and other risks that might 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 further events. Now, I’d like to turn the call over to James.

Thanks Marcia. Good morning everyone and thank you for your participation in our first quarter 2016 earnings call. In this call, I will focus on updating with you our business as well as organizational development efforts and progress, and Marcia Miller will discuss our financial results in more detail. We will then open up the call for questions. Our first quarter 2016 financial results symbolize, both an enlivening challenge and a transformational opportunity for Energy Focus. As we announced during our 2015 annual earnings call, we anticipated a tough first quarter due to the dramatic Navy sales slowdown during the fourth quarter of 2015 and into the first quarter of 2016. We did finish the first quarter of 2016 in the upper end of the range of our expected sales. And our gross margins remain above our long-term gross margin target of 35%. With our aggressive grass roots sales effort to all six major naval ports in the country over the past few months, we have started to see significant sales resumption across the board, during the latter part of the first quarter and into the present time, again as we expected. Therefore, we are cautiously optimistic that our military maritime sales will continue to recover from the first quarter sales of approximately $3.8 million and approach our target $8 million to $10 million per quarter run rate by the end of 2016. We’re also very pleased to announce that our military throughput fixture products have just passed the First Article Test in April required by the Naval Sea Systems Command. And we started to participate in bidding for new ship construction opportunities. Although the new ship construction market is not large adds approximately $5 million to $10 million per year. These sales opportunities further provide the revenue potential for us to tap into to maintain a healthy and stable annual sales run rate for our military maritime business. Equally exciting, the new 2-foot fixtures also take us another step further towards being able to meet all the LED lighting needs for the U.S. Navy. The bright spot during the quarter continued to be our commercial sales, which are though lower than the seasonally strong fourth quarter, grew 160% over the same period of 2016. During the quarter, we retrofitted 11 hospital buildings for the Cleveland Clinic, six additional malls for general growth properties and 15 co-department stores. We also retrofitted six school districts, five municipalities and two universities. Also notably, during the quarter, we made our first sale to a military base with the U.S. Coast Guard and through a channel partner, we obtained our first order from HIMA [ph] hospital system from Puerto Rico with 1,100 beds. We also have started working on retrofitting the second 2 million square feet Bridgestone factory. Overall, we continue to gain trust and orders from our large government and business customers as their LED retrofit plans proceed. And we expect their enthusiastic testimonial to help us evangelize in the verticals we focus on, which today improve the public sector, national retailers, healthcare, industrial and education. I’m also pleased to announce that we now have 19 intra world partners or IWPs, which are proven and scalable contracting or installation companies that could bring us over a $1 million per year in business. Since Energy Focus does not provide direct labor for project installations, our goal is to work closely with expand [ph] the sales from and grow the number of our IWP to generate more repeat business and reduce the volatility of our quarterly sales. Needless to say, we plan to continue to actively expand our IWP network in the coming quarters and multiplying our sales opportunities by our IWP.

36: At Energy Focus, we strive to bring our customers the best possible lighting experience that combines the most compelling elements of performance, quality and cost. And Energy Focus tubular LEDs and luminaires are at the pinnacle of simplicity, innovation, durability, embedded in LED adoption. To achieve these goals, we have developed and executed a product roadmap with the introduction of seven exciting new products that further complete our indoor LED product portfolio. Notably, we introduced the industry’s first Network-Ready, control-ready, tubular LED with 0 to 10 volt dimming capability, including our Intellitube Network-Ready and 500D Network-Ready Series, which also comes with the optical efficiency 150 lumens per watt, enabling us to replace a normal 32 watts fluorescent lamp with an 11-watt LED lamp, reducing two thirds of the lighting energy consumption. We also introduced a fully integrated T8 emergency battery backup that provides high lumens for watt performance and supports dimming. By integrating batteries inside the tube, any locations can have emergency lighting added with ease, at a dramatically lower total replacement cost. We also complete our tubular LED portfolio by introducing a T5 replacement tube that incorporates high lumen output, at 26-watt; it’s high output product produces 3,380 lumens to replace a 52-watt, T5 fluorescent lamp. This new offering expands our addressable market potential and moves us yet another step towards becoming the primary source of LED lighting for our government and business customers. As you all know, since our restructuring started in the middle of 2013, Energy Focus has grown tremendously by being extremely focused in carrying out our singular goal to be the most trusted LED lighting provider, both government and business entities for light. With our sales, expanding $4 million in 2013 to $22 million in 2014, to $64 million in 2015. Our organization also grew significantly from 40 people now to about 125 full time employees during the same period of time. Today, after having recruited pivoted and expanded consistently over the past three years with the marquee customers in multiple verticals and we run global and engineering and supply chain operations with the production facility in the U.S. that has expanded four times the size it was three years ago. And today, although we are still as nimble and as passionate as in this early stage of LED lighting adoption, we are more complex optimization with much higher sales, broader product line and quite a number of marquee customers that constantly demand and deserve the best quality of product and services. With a vision to be the most trusted LED lighting partner for our customers, we must continue to transform ourselves to be the most effective, efficient, agile and preeminent company in a rapidly evolving LED lighting industry. For Energy Focus to grow to the next level with absolute excellence and optimal speed, we have recently instituted a broad range of organizational and personnel change. As we announced this morning, we are extremely delighted to have Gail Thakarar join us as our Chief People Officer. Gail brought to us a proven, successful global talent development and human resources functions experience. And we’re excited about the changes and contributions she will be facilitating to help us build our people and cultural foundation, further for the next wave of growth ahead. The reorganization also resulted in the resignation of our ex-President and COO, Eric Hilliard. Eric has contributed to the Company’s growth over the past three years, especially in the Navy market. He remains the friend of Energy Focus and we wish him the best in his future career pursuit. Meantime, we’ve promoted seven proven and highly capable leaders within the Company, to further sharpen our focus to execute our business development plan, in various vertical markets, and further improve our operation. And we are in the process of filling several executive positions to significantly expand our capacity and capabilities to meet our aggressive growth plan in the coming years. These proactive leadership changes, which we estimate will take another three to six months to complete, and to empower our upcoming leaner, faster, stronger teamwork and elevate the level of excellence across all domain expertise to vastly strengthen our high performing culture. For the second quarter, at this point, we are projecting $10 million to $12 million in sales, with gross margin over our long-term target of 35%. We continue to anticipate military sales to grow0 from first quarter level and commercial sales to stay on its strong year-over-year growth track. While it’s too early still for us to provide financial guidance, more than a quarter ahead, as we continue to expand our organization, build our brand awareness in our focused verticals and strengthen our leadership structure, that results in stronger execution and accountability. We believe that we will be able to continue to grow from the low point we experienced during the first quarter of 2016. Now, I’d like to turn the call to Marcia for more specifics on our financial performances of the quarter after which we will be happy to answer any your questions you might have. Marcia?

Thank you, James. Net sales for the first quarter were $8.4 million and were near the higher end of our first quarter guidance of $7 million to $9 million, but were down 33% compared to the first quarter of 2015. The decrease was the result of $7 million in lower sales to U.S. Navy due to the slowdown in this market, we discussed on our March 10th earnings call. This decrease was partially offset by 160% increase in commercial product sale to $4.6 million. For the quarter, commercial product sales comprised 55% of the total while military maritime product sales comprised 45% of the total. This shift in product mix resulted in gross margin of 37.3%, a decline of 3.6 points from the first quarter of 2015. We have said that our gross margin would decrease from the level we saw in 2015 when sales of commercial products became a bigger part of our total sales. Operating expenses of $5.1 million increased by $1.2 million from the prior year’s quarter. The increase in product development expenses by $262,000 can be partially attributed to our Taiwan R&D and product development office, which we opened in July 2015. We sourced a significant portion of our commercial products from Asia. And having engineering resources close to our vendor partners allows us to ensure product quality and puts us closer to the technology innovation happening in Asia. Additionally, we added personnel in the U.S. for both military and commercial product development. Selling, general and administrative expenses increased $970,000 from the prior year’s quarter to $4.3 million, although they were down $900,000 from the fourth quarter of 2015 due in large part to lower commissions on military maritime product sales. The increase in SG&A from the prior year is the result of our efforts to build the sales and related administrative infrastructure to support our growth efforts, particularly for our commercial product sales including higher salaries and related benefits, higher tradeshow and travel expenses, and higher consulting services. At the end of the first quarter, we had about 40 sales marketing and sales support personnel compared to 25 at the end of the first quarter of 2015. We did slow down our hiring during the first quarter and had a 123 full time employees at the end of March, about equal to the number at the end of December 2015. We have resumed adding personnel in the second quarter to build our infrastructure and leadership team to support our geographic expansion and market penetration. Including in the quarter is the small expense for various state income taxes. We see operating loss included in the quarter and after the application of the annual limitations under Section 382 of the internal revenue code, we have recorded no provision for U.S. federal income taxes and have a full valuation allowance reported against the deferred tax assets. At December 31, 2015, we had NOLs of approximately $69.1 million. However, due to changes in our capital structure, approximately $14.8 million of this amount is available to offset future taxable income, after the application of limitation under Section 382 of the U.S. tax code. As a result of the annual application of this limitation, in 2016, we expect to have approximately $6 million of the NOL available for use. The loss from continuing operations for the first quarter of 2016 was $2 million compared to income from continuing operations of $1.2 million in prior year’s first quarter. Discontinued operations in the current year’s quarter included legal fees incurred for the arbitration associated with our pool products business we sold in November 2013. We settled this matter during the quarter and released the $300,000 in cash remaining in escrow to the buyer. Discontinued operations in the prior year’s quarter included the results of our former United Kingdom subsidiary, our former turnkey solutions business as well as legal fees incurred in relation to the pool products business. The net loss for the quarter was $2 million or $0.17 per share compared to net income of $1.2 million or $0.11 per diluted share in the priors year’s first quarter. In regards to the balance sheet, our cash position remains strong with $30.1 million in cash and no debt at March 31, 2016. Our inventory balance stood at $11.5 million at the end of March, representing an increase during the quarter of $3.8 million with increases in commercial products to support our anticipated growth in demand and increases in military maritime products due to previously issued purchase commitments. We expect our inventory levels may rise somewhat from where they currently stand, so that we can meet our current commercial customers delivery requirement. Our accounts receivable balance was $6 million at March 31, 2016 compared to $10.1 million at the end of the fourth quarter. Day sales outstanding was 29 at March 31, 2015 compared to 23 at the end of December. Turning to the cash flow statement, net cash used in operating activities was $4.2 million for the first quarter of 2016 and resulted from the net loss as well as increased inventory I just mentioned, lower accounts payable related to inventory purchases and lower accrued sales commissions and bonus incentive. This was partially offset by the decrease in accounts receivable. Net cash used in investment activities was $311,000 and resulted from the implementation of new modules and capabilities for our ERP system. Net cash provided by financing activities for the first quarter of 2016 was $14,000 and resulted from the proceeds received by the exercises of stock option. We have said that our operating expenses are expected to continue to grow, although they did decline in the first quarter of 2016 from the fourth quarter of 2015, due mostly to lower commissions on lower sales. As I said earlier, we are planning to continue to build business development infrastructure and strengthen our management team, and are working toward adding an additional 10 to 15 people in product development, sales and marketing and G&A during the second quarter with continued additions throughout the remainder of the year to support our growth plan. Additionally, in late March, we signed a 64-month lease for a larger office in New York City, replacing our month-to-month lease arrangement. And in April, we signed a new lease arrangement for our solid Solon, Ohio headquarters and manufacturing facility. The new lease consolidated and extended our prior leased agreement to July 2022 and we now have a total of the 116,000 square feet in Solon. We will be holding our Annual Stockholders meeting in Solon on June 15th and invite anyone in the area to join us for the meeting and the demonstrations of our new network ready products. With that I’ll turn the call back to the operator for question.

Thank you. [Operator Instructions] Our will take our first question from Colin Rusch from Oppenheimer.

Guys, can you talk a little bit about the changes in the sales funnel as you’ve made investments in the sales team? What are you seeing in terms of the backlog and the opportunities on that commercial business, kind of specific as we think about not just 2Q but the back half of 2016?

So, Colin, as you know, our businesses don’t run on backlog per se; we ship products pretty quickly after we get orders. This is why we keep inventory. So, the backlog has not been a good indicator of our business momentum, sales pipelines are. And in terms of the sales management team, we have promoted four individual leaders to be in charge of the verticals that we are focusing on, and they are public sectors, the healthcare, industrial manufacturing and we have the national accounts team as well. So, we are expanding into these verticals and having business development individuals for each one of these verticals. So, Marcia mentioned about adding 10 to 15 people this quarter and more in the next few quarters. So, we continue to develop that team further. And again, we’re getting really good reception from our customers. Our brand awareness is growing. So, our expectations as we expand the sales team, we’ll be able to continue to build our sales pipeline, which will translate into sales.

Yes, I mean what I’m trying to get more after something a bit more tangible to hanging our hats on; I fully appreciate this a terms business. So, there isn’t going to be a backlog number. But, since the number of accounts that you’re talking to and the breadth and kind of the depth of those conversations, because it does seem like you’ve made an awful lot of progress with investments that you’ve already made even before these new folks come on line.

Yes, so…

Are there numbers that we can kind of point…

I think one -- again, I made it out during the call in terms of the main customers that are we’re getting orders from during the quarter, Cleveland Clinic, Bridgestone, the Coast. But more reliable indicator going forward at some point -- again, we’re still building the commercial sales team, is the number of intra world partners, [ph] the IWPs I mentioned. These are the customers that are either large end customers and these are usually very large businesses, Fortune 500 type of businesses or the contracting partners that we have that are bringing us projects and orders. So, we expect them to deliver $1 million each on a rolling 12-month period, $1 million or more, some of them could bring multiple million dollars obviously. So, we’re building this network over the past year or so, but really started to accelerate the building over the past six months. And now we 19 of them. These are very dedicated, committed partners, general partners, and customers obviously. So, I think going forward, as we continue to build more IWPs, they will start contributing more stable revenues, more repeat business, over time. But, I think we’re probably few quarters away from really seeing them actually delivering that one plus million type of sales, as they incorporate our products into their projects.

Got it, makes sense. And then with military business, obviously you work with a number of partners. Can you talk a little bit about inventory levels in the channel right now and how you that see that playing out as we approach the end of 2Q?

Yes. So, if we look at the end of 2015 versus pretty much today, the inventory level has dropped by 40%. So, that’s a pretty significant drop over the past few months. And so, as I mentioned, we have our business development managers are working tirelessly across the port and they visit shipyards and ship. And now we have a pretty good entail about what’s happening to order run rate by ships, by each ship that we are building our products through. And so, I would say that we’re making pretty good progress. And this is why we’re confident that we’re going to continue to recover from the first quarter low point.

Okay, perfect. I’ve got some follow-ups, but I’ll take them offline. Thanks a lot guys.

And our next question will come from Carter Driscoll from FBR.

So, did you receive your first or I guess fulfilled your first military base order from one of your partners or was that a direct sale? I mean is that evidence of the channel starting to populate for you or is that a direct sale?

That was with an ESCO partner. So, the ESCO partner provides the financing and the labor, and we provide the product.

And you’ve talked about military bases being another avenue of growth for the C&I channel. Can you talk about either other military branches or more specifically within the Coast Guard, the opportunity to expand say, without putting necessarily number around it, but over the course of the year, should we see a more significant piece of the C&I business going forward?

We have also promoted one individual to be the Director of Business Development for federal installation, federal projects that include the military bases, actually primarily the military bases opportunity. And we are expanding the team, the sales team within the federal project vertical, that vertical under public sector. So, I expect to be able to provide more color in terms of the momentum we can be building in the next quarter, two quarters. But right now, the Army and the Navy have opened up for our market, and we’re definitely looking at multiple military bases activities today. We haven’t generated a lot of revenue from the sector yet, but again, it’s a long term process. But, my expectation is that we can start seeing revenues coming in second half of the year.

Outside of Cleveland Clinic, can you talk about some of your progress in other potentially large hospital chains, geographically and where you stand in terms of capturing those businesses?

Sure. We have -- since the end of our first quarter we have got more hospitals signed on with us. And in the second quarter earnings call we will provide more details about the size of that opportunity from these new customers. But, all in all, are working with over 30 hospital systems today. Again, they take time to start generating sales. But, we have as I mentioned about the leadership promotions with promoting one individual to be heading the healthcare sector expansion. So, we are hiring business development individuals in the healthcare sector. That’s a very exciting vertical for us and we are clearly the leader in that field. So, I hope to share -- to be able to share with you next quarter in terms of the new customers, where we are getting orders from. About Cleveland Clinic, as I mentioned, we retrofitted 11 buildings. So, quarterly run rate we are getting between $0.5 million to $1 million, pretty favorably from the Cleveland at this point.

And then just following back up on the military maritime business. So, you obviously saw a nice progress in terms starting to clear that general inventory. If I heard you currently, you are trying to get back to your more historical $8 million to $10 million run rate by the end of the year. Do you think that will be somewhat leaner? And does that -- I am assuming that does not include any new construction business, which probably takes multiple years, similar to the same trajectory it took to the retrofit business, if you could just -- handicap that. That run rate you are expecting second half of the year from your existing retrofit business alone, correct?

Yes. So, obviously, we look at the whole military maritime business as one business and that will include at some point the new construction business.

But this year not necessarily new construction, at least for 2016?

Yes, but I think there might be a chance we can get a little bit revenue this year from the new construction business. Again, we have started [ph] participating in the building for new projects. I want to mention also that we have sold to the new construction market with our broad light [ph] that’s headlock broad light. [Ph] And now we have sold to three DDG ships. But, the 2-foot fixtures obviously is the bulk of the opportunity on ship lighting. That is the market that we just cracked into. So, again, in the next few amounts, I’d like to able to provide our opportunities there. It’s the first time we have put this setting in the bidding. In terms of your question on the ramp up, as I said, the first quarter is probably the lighter [ph] of the military sales; second quarter will be better and third quarter at this point looks even better. But again, it may not be linear per se but $8 million to $10 million is our goal by the end of the year.

Is it fair to say you still have a chance to grow the total business year-on-year, though it me be too early to draw a line in the sand?

It’s probably too early and there are two dynamics playing here. One is that we don’t necessarily want the military sales to be as volatile as it was before. So, we would like to be able to control the quarterly run rate to some extent, so we can maximize our manufacturing efficiency. The second dynamic is obviously our commercial business. And again, we have just instituted reorganization, and it will take some time to build the team aggressively, even aggressively because the lead time with these projects are long. So, I think it’s too early to tell at this point for the full year, as I said in the my script. But again, we want to emphasize again that we believe that the first quarter is the lower point of the year and we’ll grow from there.

Next question, once again [ph] what Eric’s primarily responsibilities were outside of the military vertical, if any?

Not really, we have Dave Bina as our Vice President of Military and Maritime business and some of you might have met him. So, he is the in charge of the military maritime business over the past two years, in terms of business development and product engineering and production. On the commercial side, we are hiring a Senior Vice President of Sales, and we have, as I mentioned four vertical leaders now expanding their team. At this point, I’m overseeing the sales before we have a Senior Vice President of Sales hired.

So essentially, he’s responsibilities have been put on multiple parties, is that fair?

Yes. That’s why we said that these promotions are expanding, we’re empowering our leaders. And the decision making will be faster. And there will be more transparency in terms of our order dynamic.

Two last questions from me, any progress you could update us with penetration of -- for Navy and then may be just talk about what you have learned and the calls and running again what your retrofit is so far and potential for that and timing of that order to expand more nationally?

We’ve been working with another country’s Navy for over the past year and our expectation is to be able to get our first order in the next three to six months. And again, I’ll be able to share with you once we are through the order; it’s another exciting opportunity. We’re still working with multiple countries’ Navy. But again the one that we’ll be able to materialize in bases [ph] will be one of the countries that we talk to. And we are also getting more orders from Australian Navy that we’ve announced. In terms of the close opportunity, as I mentioned, we’ve retrofitted at 15 stores in the first quarter and we expect more orders. At this point, we are very, very happy with our products. It is our expectation that they will continue to roll this out across their whole system. So, it’s becoming obviously one of the IWPs where they contribute to our sales on a quarterly basis. And I think the quarterly run rate will pick up actually next year as they push this retrofit out to more stores.

Okay. And maybe just last question, Marcia, on the inventory, I mean the working capital side, what do you think a realistic level to maintain your growth aspiration this year is on dollar basis?

It’s really hard to say. I mean, obviously we’d like our inventory turns to be a little higher than they are right now. But, with some of our longer lead times, we want to make sure that we’ve got inventory on the shelf, obviously meet our customer needs. So, as James said, we’ve got some Fortune 500 customers and we need to make sure that we’re meeting all their expectations. So, from that standpoint, it’s a little difficult to say. I can tell you, our accounts receivable still remains very clean; our DSO was 29. So, we don’t have hard time collecting cash once we ship something outdoor, so.

Well, any new product builds expected in that working capital?

We will like stock, at least sample type quantities for our Network-Ready products, once they become available and then see which one we want to maintain stocking levels at, but we want to manage the inventory that we already have with the new products. And again, the Network-Ready is great for dimming but not necessarily every customer needs dimming, so.

And our next question will come from Jed Dorsheimer from Canaccord.

Hi, thanks for taking my question. I guess, first question, you mentioned that you are the leader in the -- with respect to the Cleveland Clinic. So, I’m assuming that means the hospital market. Could you further elaborate on how you’re defining that?

Yes, one of the opportunities, [ph] actually we’re working with is with very large healthcare product distributor and we’re still on the last stage of negotiation and the terms and everything. But, when we talk about healthcare, we mainly mean hospitals, hospital systems. So, as most of you know that we started working with the clinic in the third quarter and we started to get our first order in the fourth quarter of 2016. So, we are working with them. We are actually expanding our collaboration with them. And it’s more exciting to be able to share as we work on the new projects with them. But all-in-all, we are retrofitting eventually all their 180 buildings in the U.S. and other countries building with them. But, going back to your question, we like to be able to be seen leading LED lighting provider for these hospital systems.

And is your sale based on anything more than energy savings and/or lifetime? In other words, are you selling your products on quality of light or any of those metrics?

It’s all of the above, right? Because we target large entities, business of government, we compete with the largest brands out there, the Philips of the world, GE of the world. So, we have to be honestly so much better, because we are much smaller company with much of brand awareness. So, we provide better performance, better quality; to your point, durability of the products very important. We provide 10-year warranty for most of our products and obviously compelling cost. And obviously we are spending a lot of our time educating the customers about the technology because everyday lighting technology changes very fast and there are most customers just not used to lighting technology changing this fast. So, you have to be much better than -- we have to be much bigger than our competitors when it comes to performance, quality, price, service, all of them.

And our next question will come from Amit Dayal from Rodman & Renshaw.

There is not really much left to ask I guess. Of the $10 million to $12 million, James, like what’s the mix expected to be between government and commercial?

Again, it’s probably little bit early to tell, but based on the pipeline we can predict today is close to half and half. But, again I can’t pinpoint a percentage yet. But, it’s close to half and half.

And in regards to your sales with Navy and Military, have been there any changes in the procurement process that has caused this slowdown. And do you know if there are any other companies that have been qualified for sales to the Navy?

The first question, no, there is really no change in terms of how the Navy procures these products. As I stated before, we were selling very aggressively and we didn’t have -- not until about how the products are being moved on the ship level and we now have much better intelligence to every ship, each day and our inventory; we work very closely with our distributors. So, there is no change in policy to ship procure and this is why we have been able to reduce pretty significant amount of our channel inventory over the past few months as we started to build this grass roots business development effort. Second question about the...

Qualification of any other company?

Yes. The answer is no. We have not seen any competitor or qualified competitor in our business. So, I have heard a lot of speculations that there are people there competing with us. We have not seen them, we have not heard about them, we have not been anyone of them qualifying being able to provide LED lighting retrofit to the ship. I don’t know where the rumors come from, but we are not here to clarify rumors. But we have not seen anybody competing with us.

That’s helpful. I think that’s all I have. My other questions have been answered. I’ll take it offline. Thank you.

And our next question comes from Martin Yokosawa from Torii Asset Management.

My question pertains to the competitors in the commercial and maritime markets, and you just answered a little bit about the maritime markets, but who are your best competitors?

If you want to ask my own opinion, I don’t think we have really strong competitors. Our competitor is always ourselves, how can we expand fast enough, how can we stay nimble, launch the products that surprise our customers. We compete with as I said, we compete with GE, Philips, Sylvania. They have products that are not very durable, very not good performance. They are trying to compete on prices. And this is one I guess misconception in the market where you will think that GE, Philips and Sylvania are more expensive and competing with better products and that’s completely untrue. These companies are basically taking their residential products to compete in the business markets where burning the tube or the product at 24-hour kind of daily timeframe, and the product that’s now very good. And to say that I love this industry because it has quality products, so people can build constant in LED lighting. So, we do compete with a lot of different brands but mainly the brands I’ve mentioned, Philips, GE, and Sylvania. And I believe that we have far superior value proposition when it comes to again performance, quality and cost. And fortunately, most of the largest companies that we work with, they obviously vary in quality and performance, not just cost. Do we lose deals? Of course. From time to time, you’ve got customers that really are attracted by lower price, but more often than not, over time they come back to us and we’re seeing a lot of that now. Because they got burnt; they buy the product cheaper and they got burnt. I don’t care what brand they buy, if you don’t have the quality behind it you’ve got burnt. And so, we’re sticking to our premium brand status and positioning, and we’re expanding aggressively. And this is what we mentioned about the organizational changes with the company being of potential ourselves, grow.

Talk to me a little bit about the 10-year warranty history, how many warranty issues have you had, how do you reserve for it, how did you come up with 10 years?

I’ll talk about the 10-year warranty, why we provide that first and then Marcia can talk about warranty cost that we have. So, we started, as a lot of you know, we started developing our tube products back in 2003 with the U.S. Navy. We were probably one of the world’s first LED lighting tube developer in the world. So, we have a lot of experiences with the product and the technologies we’re dealing with. So, since 2007, our military product has been on the ship and there has never been one reported failure. So, obviously we tend to enter this technology into our commercial field and we started selling that product in 2010. So, we have had pretty strong history demonstrating our product performance and quality. Obviously, we run left half to show the numbers but empirical data is there to support our 10-year warranty.

Yes. I mean as James said, in the last fall, we announced True Light Industries, [ph] which has hit a five-year anniversary. It was the first commercial to install; we installed about 1,000 and had two reported failures. So, again, our product quality in the field is very, very high. From a warranty standpoint, we do have a small reserve on our book, it’s not just for tubes but it’s obviously of product that we sell and that we have on our shelves. We’re looking at the impact of the 10-year warranty but don’t believe it’s going to be significant from a financial standpoint. So, we’re good.

In the press release, you said EFOI expects to start taking second half orders, and there is also kind of strong interest from customers and partners. And then during the call you said you’re two quarters away from receiving potential $1 million orders. Can you quantify first thing the strong interest in customer partners; what does strong interest mean and the second half, does that mean fourth quarter.?

Well, first of all, when I said strong interest, we talk to our partners. And again, I keep coming back to this IWP, intra [ph] world partners, these are long-term partners, either very large end customers or channel partners that work with us on a constant basis. And they started to contribute recurring revenue to us and their telling us they would love for us to start selling these products as soon as they’re available. And again, we’re talking about the second half. By the end of the third quarter, we should be able to start selling most of them. And so, our expectation is that we’re going to start seeing the first orders, as early as the third quarter and definitely in the fourth quarter.

So, it seems like that in the third quarter’s going to be maritime orders and then you’re going to add to that in the fourth quarter with more commercial, is that what…

No. I mean as you look at our second quarter -- our first quarter, we did about $4.6 million in commercial orders. So again, that’s 160% growth over the first quarter of 2015. So, our commercial orders are growing and our commercial business is growing, I mean growing already.

Right, but there should be what -- the way explain, there should be even a further bum up potentially in the fourth quarter. Is that correct?

That’s what we love to see. But again, these are new products. But, again our main growth is not only new products but also more IWPs and more sales of our existing products from these IWPs, and then on top of that you have new products that they can buy. I mentioned about the Cleveland Clinic, so, we have to get new products for them as well. These are all incremental sales up opportunities.

And our next question will come from James Liverman from Wells Fargo Advisors.

Yes, thank you for a very thorough review. And I wanted to get more color with rollout of school area? You have clearly made a lot of progress and I wondered what that sales process and timeframe looks like and how you see that accelerating or do you see that’s being a pretty much of the constant awareness and growth issue?

I would say both. I think the first thing is that we sell to the schools though our trade partners. Because schools like a lot of public sector entities, they don’t have capital budgets to upgrade the LED lighting. So, they very openly utilize the performance contracting mechanism leaders. So, we work with the ESCO and our lighting retrofit contractors that are the lighting contractors for the ESCO, to get into results early. So, we are seeing obviously good momentum on the school side by our trade partners; they could be ESCOs, they could be lighting retrofit companies. We’re getting orders from the lighting retrofit companies obviously, because they have companies that actually can install these lights. So, we are seeing the momentum pick up obviously. And we will be expanding into additional territories. California is going to be big state for us in the next 12, 24 months. So, we have just hired two sales people there, and they are spending aggressively there I would see that schools in big states such as Texas, California to be early adopters of LED lights.

As far as the showcase rollout in the tri-state area with special education classroom, has that begun in the states?

Yes. I believe, so far we have got into 28 schools. And again, these are part charity and part awareness initiatives. And we are actually going to be expanding this program to other territories as well, again helping our ESCO and IWP partners to reach out to the schools. So, I am very excited.

Program?

It’s wonderful, we see pretty clear difference improvement in the special ed classrooms once we -- they retrofit with our lighting. So, as you know we are also a partner with [indiscernible] and we are going to be expanding this partnership in the coming month as well. But very exciting sector for us. Again it’s like healthcare, we have to be able to be the leader for the schools market. And I have to also mention that we are getting good momentum in the higher ed market as well. We have 16 universities we are working on right now. We have got two orders from two universities last quarter, but it’s the beginning, but I think that’s another vertical that we expect to reach.

And our next question will come from Robert Smith Center for Performance Investing. [Ph]

Looking at your 2016 business plan, is it fair to say that will be running for the foreseeable future or depending upon the robustness of the commercial sector and the recovery in naval ship orders?

I hope I understand your question, you are saying that are we burning cash?

Yes. So, with the higher spend level that you have indicated is being undertaken. Is there a point, do you see you have a three or five-year plan where we are going to be back in the blank?

I hope it takes much shorter than that. If you look at our breakeven run rate at this point, it’s probably around $14 million, $15 million depending on how fast we can ramp our organization as well. So, when we get back to that level, about $15 million and then I’ll say that we’re going to be close to breakeven.

At that point, you will not continue to see incremental spending to wipe that out? In other words, we’re going to see profitable operations at this point?

Yes, I mentioned about this in the last call and that this is not the time to maximize operating margin.

No, I understand that. We’re not managing for the next quarter but still…

So, there are two indicators and two goals in our business plan, one is sales growth, the other one is margin discipline. It’s very easy in this business to lose the margin focus because just for another big order and you just have to cut your margin. And that’s not a sustainable way to build a sustainable business….

Right.

We don’t want to do that. On the other hand, we are spending our money on expanding the business development infrastructure. Marcia mentioned about 40 people in the whole sales and marketing infrastructure. We definitely want to see that continue to expand. As I said, our biggest competitor -- is how fast can we spend, we don’t want to overly expense, so we cannot deliver our promise or deliver the service, the product in a way that we believe is in a level excellent. So, this is optimal growth rate that we are having. We want to keep the gross margin at 35%. So, we know this business model is profitable, the rest is really spending the money to invest to expand to build the market -- not necessary market share but growing awareness.

Last question centers on your R&D effort, maybe you can give us a little color on that. And I know that somewhere down the road is this Holy Grail about the residential market, is that any closer or how do you see the future -- your R&D effort?

First of all, we are not in the residential market, we are in the B2B space. We sell to large businesses and government entities. And through our trade partners we sell to small to medium size businesses, but we don’t sell them directly. Okay? So, that’s clear, because the requirement, the performance requirement and the thought process and the buying process, the buying mechanisms are very different between the business world and the residential world. In the business world, everything is based on time business. So, you have to have the reliability and the quality and the cost, all of them are important in the decision making process. We are in that market. We feel our product to be outstanding in that market. Now, in terms of new product development, we said before, we have multiple teams working on different products. I mean obviously you have the Military product, we can build this, expand our product offering. Especially going into the new construction market, our goal is to be able to provide eventually all -- most if not all of lighting needs of the U.S. Navy ships and obviously other navy ships as well. We are working towards that. In the commercial side, we have Vice President of R&D, Vice President of Product Management, and we have pretty growing sizable Taiwan engineering and sourcing office. We are also in the process of hiring a CTO for the Company, as part of the executive expansion plan, and to drive the long-term product roadmap because I mentioned before the lighting is going through not a very fast efficiency evolution pace but also there are going to be more intelligences being built into the light. So, again, it’s a pretty exciting time for being a LED lighting company in the business space. So, we are absolutely spending our R&D effort.

And our next question will come from Ken Tynan, a [ph] private investor.

Good morning. Thank you for taking my call. I just have one quick question, after participating the LED show last month, from a competitive standpoint, what do you see as your biggest challenges and opportunities from both the technology and energy standpoint?

I think, in terms of the existing technology, we believe that we are still ahead of the curve in terms of value proposition. The products that we introduced again take us further -- a step further being the most competitive and reliable brand in the business space or retrofit obviously; we’re not in the new construction market yet, and the retrofit space where I believe that we’re still the most compelling company out there. In terms of what are competitors that are meeting or competing technologies, I don’t think we have seen a lot of new competitors there. There are obviously a lot more companies from Asia that are presenting that had the show -- in the show, if you look at two to three years back, I think companies from Asia probably now have half of [indiscernible] So, that’s a pretty dramatic change. On the other hand, most of the companies play in the residential market. But, the people that are -- but the companies that are focusing more on business, they are providing mostly fixtures again for a new construction market or for renovation market, we’re focusing on the retrofit side. One thing that obviously is happening in the lighting market is more control. But again, we are building the ability now in our crew to be able to work with control for dimming or [indiscernible] there are the same functions. But, I think there is just a lot of height in terms of how technologies do, what technologies could do. And, I think people don’t pay enough attention, what people want to pay for. I think affordability is important when it comes to ROI. You still have a lot of new functions but nobody want to pay for it, and it’s especially important in the business lighting market where the businesses make decision based on again ROI. And you have -- any new features have to have compelling ROIs in the retrofit market. And I think that’s one thing that all the investors need to realize. When it comes to a new construction market, there is really a budget issue because you have your budgets made, scheduled or allocated for new construction. In a retrofit market, you have no budget, which is why it’s a very tough market to crack, but it’s a very large market, and that’s what Energy Focus has been focusing on doing. This is why ESCO is such a big potential for us because they are capable to issue with the performance contracting mechanism. This is why large companies are also one of our main pockets because they have capital to do these retrofits. It’s the long answer to your question, but I hope I answered your question.

Very well. Thank you very much.

And our next question will come from David Herman, [ph] a private investor.

I’ve got a question, you touched on it a little bit, but this is I see in the future. You had a trade show in Taiwan, was unusual you are not targeting any market there, but you mentioned today you were looking for some partners to do something. Could you expand on that?

We have a Taiwan office, we actually -- we accessed [ph] the business in the Taiwan lighting show as well but that’s not the Light Fair I talked about, the Light Fair I talked about was the one that happened at the end of April in San Diego. That’s the largest lighting conference show you in the U.S. So, in Taiwan, we are not doing business there, it’s the sourcing and engineering office.

Right, I just thought I saw in your PR, you had a lighting show in Taiwan and then you mentioned something…

We have, yes. We participated there, because as you know Taiwan like China, there are lot of LED lighting manufacturers. So, we participated in the show just to connect with the industry. We work with a lot of OEM component suppliers there, but for not business.

Okay, not for business. yes that my question was. I didn’t know Communal was going to start picking up with the new product in the connected one?

No, there was no and the agreement was already terminated. That was before I stepped into the management role when we had it. Yes. So, it has been terminated. But in terms of the new market, we are exploring some select international markets. I mentioned about Puerto Rico, our first big order from Puerto Rico last quarter. The country has a lot of -- the territory rather has a lot of financial difficult issue but which is why it gets attracted to provide, if you can provide the financing for the projects, which is why our channel partners is doing to provide the financing. So, these large hospitals or big retailers can take at a length that you are -- the savings by LEDs, our lighting LED lighting. So, we have been exploring selectively in some countries but nothing to talk about yet in terms of the scale of the business.

Well, that’s what I wanted to hear. And I just have one other question. I’m glad to see that you are taking California. I guess, my question is could you explain a little bit like California -- I think they have some strict regulations on retrofitting and the business -- and I think that plays into your hand; doesn’t it?

They didn’t before but it just happened, so they left it -- they expanded the interpretation what can be retrofitted and what’s allowed and all our products now qualify to retrofit buildings there in California and in most cases get the rebate. So, this is actually a title change -- a business change in terms of -- for our tubular LED products there. And so we’re seeing a lot of opportunities there especially when we had the show there this past month in San Diego. So, we expect that California -- it’s now open for us obviously and we’re expanding there.

Okay. Well, very good. And I’m disappointed with the news but patience pays off I guess. Thank you.

Thank you.

At this time, we’ve reached the end of our hour. I’ll now turn the call back to management for any closing or additional remarks.

Okay. Thank you very much again for your participation in our call. And we look forward to be talking to you in the next earnings call. Have a great day.

That does conclude today’s conference. Thank you for your participation. You may now disconnect.