Michael Port - Chief Financial Officer Ted Tewksbury III - Chairman of Board, Chief Executive Officer and President

Kristen Owen - Oppenheimer Carson Sippel - B. Riley FBR Craig Irwin - ROTH Capital Partners Amit Dayal - H.C. Wainwright

Good day, everyone, and welcome to the Energy Focus first quarter 2018 earnings call. Today's call is being recorded. At this time, I would like to turn the call over to Michael Port, CFO. Please go ahead.

Thank you, operator. Good morning. And thank you for joining us for the Energy Focus first quarter 2018 earnings conference call. With me today is Ted Tewksbury, our Chairman, Chief Executive Officer and President. The news release and our first quarter 10-Q have been posted to our website under the Investors section. As a reminder, today's discussion will include forward-looking statements, including predictions, expectations, estimates or other information that might be considered forward-looking. These forward-looking statements are subject to numerous risks and uncertainties and our actual results may differ materially from these statements. We encourage you to review our most recent filings with the SEC, including our 10-K and 10-Q for a complete discussion of these factors and other risks that may affect our future results or the market price of our stock. We are not obligating ourselves to publicly release any revisions to these forward-looking statements in light of new information or future events. Our prepared remarks this morning include non-Generally Accepted Accounting Principles, or GAAP, to explain the impact of our restructuring costs on our GAAP operating results. A reconciliation of these non-GAAP measures can be found in this morning's press release. Now, I'd like to turn the call over to Ted.

Thanks, Michael. Good morning, everyone. And thank you for joining the call today. The first quarter of 2018 marks the one-year anniversary of my employment as CEO. A year ago, revenue was in free fall, company was burning through cash, and it lacked the sales resources, the new products and the execution discipline to drive growth. Recognizing this, the board brought in new leadership to turn the company around. Over the past year, the new team has focused on three critical elements under our control – spending, sales and new product development, all while dealing with the competitive dynamics of the LED lighting industry. With these elements well underway, revenue and profit growth will follow, albeit with a delay. The precise timing of revenue is subject to the vagaries of customer project schedules, approvals, design-in cycles and other factors outside of management's direct control. Q1 was a transitional quarter. The sales force and the new product engine are built. Revenue has stabilized and we believe that we are at an inflection point as our sales opportunity pipeline strengthens. Q1 sales of $4.7 million were roughly flat with the previous quarter. Commercial revenue was a disappointing $2.2 million due to the pushout of nearly $1 million by a regional lighting retrofit company. This revenue is not lost, but is expected to materialize in subsequent quarters. For Q1, sales to our healthcare and education verticals, two markets that highly value our longest-lifetime, flicker-free value proposition, represented 23% and 38% of our total commercial sales respectively. Military revenue of $2.5 million was the highest since 2016, up 43% quarter-over-quarter. We shipped 30,000 of our M1 Intellitubes for the US Navy, the highest level since 2015. We also experienced strong sales of our berth lights and globe lights for the US Navy. In the first quarter, the team continued to focus on the fundamental growth drivers of the business – sales and new products. In sales, we now have, for the first time, nationwide sales coverage, consisting of six experienced regional sales managers and 36 top-tier agencies. Even though the process of onboarding and training the agents was only recently completed, we are already seeing promising results. Agency sales in the first quarter grew 29% over the prior quarter. Agency revenue comprised 23% of total revenue in Q1 and is expected to grow to 60% by the end of 2018. The agencies have enabled us to penetrate new geographies and customers, which we have previously not been able to reach. Sales in previously unserved and underserved regions – such as the Northeast, mid-Atlantic, Southeast, mid-South and Western areas – grew collectively by 174% sequentially. In the critically important Northeast, Southeast and Western regions, sales generated the highest revenue in five quarters – sales agency [indiscernible]. This increasing geographical penetration affirms that the agency model is working and serves as a leading indicator of future revenue growth. On the new product front, we experienced robust customer demand for our game-changing RedCap, which was announced last quarter. This revolutionary product is changing the paradigm for emergency backup lighting due to its ease of installation and the labor and cost savings it enables. Moreover, since RedCap is sold as a kit with matched tubes, we are also benefiting from the pull-through of our TLED. We are still in the very early stages of the RedCap ramp and expect it to be a significant revenue driver throughout 2018. In addition to RedCap, we'll be introducing three new products and technologies at next week's LIGHTFAIR in Chicago. The first of these is a new double-ended ballast bypass or DEBB technology. In contrast to our current single-ended direct-fit tubes, the double-ended configuration can be plugged directly into existing fixtures without the need to replace sockets. Eliminating the steps slashes the average retrofit time in half from about 40 minutes down to about 20 minutes per fixture, thereby reducing installation complexity and cost. This introduction represents the industry's first double-ended ballast bypass technology that is flicker free with a ten-year warranty. The DEBB technology will be deployed across multiple product families, including our T8 and T5 tubes. Our second new product is a T5 high output or HO Tube. This product also uses a double-ended configuration for fast, easy installation. Our T5 HO optimizes lumens output and beam angle in order to maximize the intensity of illumination on the floor of high-base spaces, such as warehouses, conference centers, auditoriums and hotel lobbies. Energy Focus' high quality, reliability and ten-year warranty are vital in these locations where it is difficult and time-consuming to replace tubes. The T5 HO expands our total available market into the high-bay retrofit application, which is one of the most rapidly growing LED segments. Our third new product offering is a family of premier fixtures for commercial and industrial applications. Many LED fixtures on the market today use chip-on-board technology, which have strips of LEDs mounted directly to the fixture. We believe that tube-based fixtures offer a more flexible and future-proof solution because they allow the customer to upgrade or replace the tubes as LED technology improves or use conditions change. The addition of fixtures to our extensive lamp portfolio enables Energy Focus to offer our customers a comprehensive set of lighting solutions for retrofit as well as new construction. Our fixtures also provide a platform for next-generation connected and smart lighting solutions. The fixture product line expands our available market and provides a new revenue stream for Energy Focus. Fixture sales will also benefit the top line by pulling through sales of our existing tubular LEDs. These new product categories advance our mission of being the technology solutions innovator of the lighting industry, building on our military-tough, longest-lifetime, flicker-free value proposition. They exemplify our continuing commitment to expanding and diversifying our product portfolio to better serve our customers' lighting needs and grow our available market. While we were disappointed in our Q1 financial performance, we remain confident that our strategy is working and the turnaround is on the right track. The Energy Focus team has done a superb job of executing on the factors we can control, namely spending, sales and new products. The timing of revenue will continue to be unpredictable until we have sufficient opportunities in the sales pipeline to smooth out the inevitable fluctuations due to changes in customer project schedules and ordering patterns. This is already happening, thanks to the increasing quoting activity and sales opportunities being generated by our agencies. We believe that we're at an inflection point where revenue has stabilized and we're poised to grow throughout the remainder of 2018, driven by our nationwide sales team and the compelling value proposition of our new product offers. With that, I'll turn the call back to Michael to review the financial results.

Thank you, Ted. Total first quarter net sales were $4.7 million, up 14% compared to the first quarter of 2017. For the quarter, sales of commercial and military products represented 47% and 53% of net sales respectively. This compares to a first quarter 2017 product mix of 75% for commercial sales and 25% for military sales. First quarter 2018 military sales was strong as we continued to ship our M1 Intellitube military fixture and military berth light products to satisfy bids for the US Navy. We won these bids during the fourth quarter of 2017 and I'll provide more color on these shipments later in my prepared remarks. Net sales of our commercial products decreased 28% compared to the first quarter of 2017. The decline in commercial sales reflects the timing of our customers' projects and installation schedules, as Ted discussed earlier. Our first quarter 2018 gross margin was 18% compared to 14% for the first quarter of 2017. While we experienced a year-over-year improvement, our gross margins, quite frankly, are not where we expect them to be. There are a few important factors affecting our gross margins that I'd like to address. First, as I previously mentioned, our first quarter military sales included shipments of M1s, fixtures and berth lights for the US Navy. During the fourth quarter, we did these contracts with aggressive pricing in order to liquidate on-hand inventory of these products. Winning these bids not only allowed us to generate cash for potentially excess inventory, but positions us to better compete on future bids at higher margins as we successfully implement our product cost reduction and operating efficiency strategies. Second, our first quarter product mix, with military products representing 53% of total net sales, negatively impacted our overall margin percentage, especially in light of the military pricing decisions I just discussed. Lastly, those of you who follow the LED lighting market know that the industry is experiencing pricing pressures. Energy Focus is no exception. While our superior technology and unique military-tough, longest-lifetime, flicker-free value proposition allows us to charge a premium price for our tubes, we do expect to see some erosion of our gross margin percentages in the short term. As discussed in previous earnings calls, we have implemented an extensive product cost reduction program. However, it's too soon to tell when we will see a positive impact on our margin percentages. Our first quarter 2018 total operating expenses were $3.2 million compared to total operating expenses of $5.1 million for the first quarter 2017. Excluding restructuring income adjustments of approximately $50,000 in 2018 and restructuring expenses of $674,000 in 2017, our first quarter 2018 operating expenses decreased by $1.1 million, representing a 26% decrease from the prior year. Our first quarter 2018 net loss was $2.4 million or $0.20 per share compared to a first quarter 2017 net loss of $4.5 million or $0.39 per share. From a balance sheet perspective, we maintained our focus on managing our cash and inventory balances. Our first quarter cash burn of less than $600,000 was our lowest operating cash consumption in nine consecutive quarters and we ended the first quarter with a cash balance of $10.2 million. As a result of the strategy to reduce potentially excess military inventory balances, our gross inventory decreased by $600,000 since December 31, 2017. As Ted mentioned earlier, we are disappointed with our first quarter commercial revenue of $2.2 million. We are, however, encouraged by the leading indicators of our expected revenue growth, including market penetration into unserved and underserved markets, increased revenue contribution from our agency channel, our continued strength in the healthcare and education markets and our product development activities resulting in the introduction of three new products and technologies at next week's LIGHTFAIR. I'll now turn the call back to the operator for questions.

Thank you. [Operator Instructions]. We'll take our first question from Colin Rusch with Oppenheimer.

Good morning. Thank you for taking our questions. This is Kristen on for Colin. Just wanted to talk a little bit about the pipeline you mentioned that you're building with the new agency business. And can you just talk about how that pipeline is filling out and what you're seeing as far as conversion rates?

Sure. The pipeline is, I would say, on the commercial side, certainly stronger than it's ever been. We are seeing right now, for the second quarter, a list of opportunities that is higher than we had at the same time in the first quarter. So, the two quarters are sort of mirror images of each other. Q1, we started with high backlog mostly due to the military orders. And then, we saw weakness and some opportunities drop out of the pipeline as the quarter progressed. We talked about one of those, a large retrofit company that moved out of the quarter. Q2, we're seeing kind of the reverse where the backlog entering the quarter wasn't as strong as it was in Q1, but we've seen a strengthening of opportunities at high probability as the quarter has progressed. So, at this point in time, we are better positioned than we were at the same time in Q1. More broadly, if you just look at the total funnel and the number of opportunities that we are tracking in aggregate for the year, that number has increased dramatically. And we don't report that number, but we look at the number of dollars that we've got in the funnel that we're tracking for the entire year. It's dramatically higher than we've seen in the past, particularly for commercial.

And as you think about the visibility on that pipeline, how are you seeing the sales cycle trend? Are you seeing that timeframe shorten? What are you seeing on the timing of those?

This is still very much a turns business. We ended the quarter with typically less than 20% backlog coverage. And most of the revenue that we realize in the quarter are orders that are received during the quarter's [indiscernible]. That hasn't changed.

Okay. And then, on the cash…

But the visibility, unfortunately, remains limited.

On the cash management, obviously, working capital, you mentioned working through some of that inventory and that being a benefit to you in the quarter. Do you have other opportunities to manage that working capital? And then, can you talk a little bit about your CapEx expectations for the year?

Sure. This is Michael. So, as a company, we are not very capital-intensive. Most of our capital that we spend is relatively small dollars. As far as the opportunity to manage working capital, there's a few different levers we can push. We're constantly looking at our inventory and looking for opportunities – opportunistic opportunities – to manage our inventory balances. Especially in light of the product development strategy that we have, we need to make sure that we manage our inventory balances to coincide with new product introductions. So, that's a key for us to be able to manage and focus. As far as the military opportunities, they come and go because they are pretty big bid processes, so we can't really manage that to the extent we can on some of our commercial opportunities. But I think for the most part, we do have a little bit more inventory that we can look to move opportunistically. But that is dwindling as we manage our inventory balances.

If I could just go back quickly to your earlier question about the nature of the pipeline, in addition to seeing an increase in the quantity of opportunities in the pipeline, we are seeing a shift in the composition of the opportunities. They not only include the traditional education and healthcare facilities where we've dominated in the past, but we're seeing more opportunities outside of those segments, particularly in retail, big box retailers, warehouses, things of that nature. So, we are not ready to report on names right now, but, going forward, you'll be hearing more about the diversification of the pipeline.

Great. That's helpful color. Thank you so much.

We'll go next to Carter Driscoll with B. Riley FBR.

Hi. This is Carson Sippel on Carter Driscoll. Do you mind commenting more on the component pricing and any general ASP pressure or pricing headwinds that you're seeing right now?

It's hard to quantify. I'd love to be able to give you a percentage price erosion. I think it's a little bit early for us to try to do that. One of the benefits that we are getting from the agencies is we're getting more market intelligence. As we get more of that, we'll be able to give you those numbers. But I think if you've listened to any of our competitors' earnings calls or you call the LED market in general, and I'm sure you're already well aware of the erosion of pricing in the marketplace. In our case, we mentioned several quarters back that we had begun a gross margin improvement plan to improve our product costs. In the past, before I came on as CEO, our products were developed and designed purely for performance, and we succeeded in doing that. We had by far the highest quality, the highest reliability and the highest performance of any product on the market, but no expense was spared in achieving that performance. And so, having come out of the semiconductor industry, I'm extremely cost conscious. And the first thing I did was to launch a cost reduction program, so that our margins don't get squeezed. So, our objective is to maintain our reputation of being the quality and reliability and performance leader and the technology leader in the market, but we do have to reduce our cost commensurate with the price erosion that the overall market is experiencing.

Great, thank you. And I know you commented on this earlier, but can you just assess one more time how the sales reps you think are performing and if you think the transition overall is going well?

Well, I think it's going extremely well. You've got to keep in mind that we didn't even start hiring agencies until around the same time last year. It was around LIGHTFAIR day [indiscernible] came on and started hiring reps. Took a couple of quarters to get them in place. We've got all the reps trained pretty much by the end of Q3, extending into Q4. We had our first agency revenue in Q4 and then 29% growth from Q4 to Q1. So, in my mind, that's outstanding performance. Now, we are, in addition to focusing on the agencies, are also shifting to key accounts where we have more direct contact with the customers. Key accounts are accounts that we think we can generate $750,000 or more of revenue per year from. So, these are like the Cleveland Clinics or some of our large LED retrofit contractors. And so, we've increased – largely as a result of contacts that we've got through the agencies, we've increased the list of key accounts to well over 30. And you'll be hearing more about those accounts as the year progresses, but, overall, the agency transition has gone extraordinarily well.

Great, thank you. I'll get back in the queue.

We'll go next to Craig Irwin with ROTH Capital Partners.

Most of my questions have really been answered already. But, Ted, was hoping maybe you could give us a little color what you are going to be highlighting for your customers next week at LIGHTFAIR in Chicago. Where do you think people are going to be most excited? What new products are you going to be focusing on?

Yeah. So, Craig, I'm not sure that you caught the prepared remarks, but there are basically four products that I think are going to be receiving a lot of attention at LIGHTFAIR this year. The first is, of course, RedCap. RedCap was just introduced in Q4. It's been very enthusiastically adopted by customers. And it's really a gamechanger in the industry. So, that will certainly be a highlight of the show. And then, we've got our three new products that we just – we'll be introducing simultaneously at LIGHTFAIR. The first being the double-ended ballast bypass. That's going to be of great interest to customers because it's going to enable them to have the same flicker-free, ten-year lifetime – ten-year warranty, rugged construction. But it has a double-ended configuration, so you don't have to install or doesn't have to pull out the sockets, the so-called tombstones, the little plastic receptacles in the fixture. In the previous version of our tubes, those had to be pulled out, which takes a little bit of extra time. So, the DEBB technology will greatly reduce the installation time. And so that's going to be, I think, a topic of great interest. The T5 HO it provides the highest luminance on the floor of a high-bay space. And as you're well aware, the high-bay segment of the LED lighting industry is one of the most rapidly growing. So, we think that's going to be a very successful product. And then, our fixture line is, we think, top of the line and is really going to be an enabler for our next-generation connected lighting road map. So, a lot going on. Four new products, all of which are leadership, technology innovation and aesthetics. And we are expecting a very enthusiastic response.

Great. Thanks again for taking my question. And really impressive tax management in the quarter once again. Thanks.

Thank you.

We'll go next to Amit Dayal with H.C. Wainwright.

Thank you. Good morning, Ted.

Hi, Amit.

Most of my questions have been asked. On the military side and the navy side, I guess, are we still pursuing opportunities related to the ships or are there opportunities with bases, et cetera, that are also in the pipeline potentially for us?

Very much so. All three of the above. Q1 was a strong quarter for the ship retrofits. We shipped 30,000 tubes. There was not very much base activity in Q1, although there was a little bit of new ship construction. We shipped some fixtures for new ships. And we believe that both of those will continue to grow, particularly with the approval of the $700 billion military budget by the president. So, we expect that the base revenue and the new ship construction revenue, in particular, will be a bright spot in the future. Now, as far as the retrofits of existing ships, we've been pretty clear in the past that we think that that's a finite and rapidly saturating market. We think there's about 550,000 sockets remaining out there, probably a $20 million total available remaining opportunity. So, it's finite. We will continue to participate actively, but it's hard to forecast when we will actually see those opportunities. Typically, the process is that the Defense Logistics Agency solicits bids and they typically do that without much more notice. And then, all of the competitors scramble to bid for those opportunities. Since there were some large opportunities recently granted, we expect that it's probably going to be a bit of a delay before there's another one coming. But we just don't know the timing.

Understood. That's good to hear, though. On the geographic diversification, are you seeing more revenues or the pipeline building in new territories outside of where you have traditionally seen strength?

Absolutely. And that, I think, is one of the leading indicators of the success of the agency model. Remember, in the past, we were primarily a Midwest-based company. I mentioned in one of the previous calls that the bulk of our revenue came from Ohio and Texas. So, there was a huge untapped opportunity in the rest of the country. So, now we're seeing – as I mentioned in the prepared remarks, if you look at just the Northeast, the mid-Atlantic, the Southeast, the mid-South and the Western areas, those collectively grew by 174% from Q4 to Q1. And then, if you look at the Northeast, the mid-Atlantic and the West – I'm sorry, the Northeast, the Southeast and the Western regions were the highest in five quarters. So, those are very positive indicators. Now, that growth is off a small base because we never really participated in those regions before, but I think it's very promising that we are seeing that untapped opportunity starting to grow as a result of the agencies.

Understood. Thank you. That's all I have.

Thanks, Amit.

Thank you.

And with no further questions in the queue, I would like to turn the call back over to Ted Tewksbury for any additional or closing remarks.

All right. Thank you very much, operator. And thank you all for joining us today. The Energy Focus team will be at LIGHTFAIR in Chicago next week. And we hope to see you at our booth where we can introduce ourselves and show you our new product innovations. Thanks again and enjoy the rest of your day.

This does conclude today's conference. We thank you for your participation. You may now disconnect.