ITEM
2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The
following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related
notes included elsewhere in this Quarterly Report, which include additional information about our accounting policies, practices,
and the transactions underlying our financial results, as well as with our audited consolidated financial statements included
in our Annual Report on Form 10-K for the year ended December 31, 2018, as filed with the SEC. In addition to historical information,
the following discussion and other parts of this Quarterly Report contain forward-looking information that involves risks and
uncertainties. Our actual results could differ materially from those anticipated by such forward-looking information due to the
factors discussed under “Cautionary Statements” appearing elsewhere herein and the risks and uncertainties described
or identified in “Item 1A – Risk Factors” in our Annual Report on Form 10-K for the year ended December 31,
2018, as updated from time to time in the Company’s filings with the SEC, and Part II, Item 1A of this Quarterly Report
entitled “Risk Factors.”
Non-GAAP
Financial Measures
To
supplement our financial results on U.S. generally accepted accounting principles (“GAAP”) basis, we use non-GAAP
measures including net bookings, backlog, as well as adjusted net income (loss) which reflects adjustments for certain
non-cash expenses such as stock-based compensation, certain debt-related items and depreciation expense. We believe these
non-GAAP measures are helpful in understanding our past performance and are intended to aid in evaluating our potential
future results. The presentation of these non-GAAP measures should be considered in addition to our GAAP results and are
not intended to be considered in isolation or as a substitute for financial information prepared or presented in accordance
with GAAP. We believe these non-GAAP financial measures reflect an additional way to view aspects of our operations that,
when viewed with our GAAP results, provide a more complete understanding of factors and trends affecting our business.
For purposes of this Quarterly Report, (i) “adjusted net income (loss)” and “adjusted operating
income (loss)” mean GAAP net income (loss) and operating income (loss), respectively, after adjustment for non-cash
equity compensation expense, debt-related items and depreciation expense, and (ii) “net bookings” means new
sales contracts executed during the quarter for which we received an initial deposit, net of any adjustments including
cancelations and change orders during the quarter.
Our
backlog, remaining performance obligations and net bookings may not be indicative of future operating results, and our customers
may attempt to renegotiate or terminate their contracts for a number of reasons, including delays in or inability to obtain project
financing or licensing or abandonment of the project entirely. Accordingly, there can be no assurance that contracts included
in the backlog or remaining performance obligations will actually generate revenues or when the actual revenues will be generated.
Overview
We
design, engineer and manufacture application-specific environmental control and air sanitation systems for commercial, state-
and provincial-regulated indoor cannabis cultivation facilities in the U.S. and Canada. Our engineering and technical team provides
energy and water efficient solutions that allow growers to meet the unique demands of an indoor cannabis cultivation environment
through precise temperature, humidity, and process controls and to satisfy the evolving code and regulatory requirements being
imposed at the state, provincial and local levels.
Headquartered
in Boulder, Colorado, we leverage our experience in this sector of the overall cannabis cultivation industry in order to bring
value-added climate control solutions to our customers that help improve their overall crop quality and yield as well as optimize
the resource efficiency of their controlled environments (i.e., indoor and sealed greenhouses) cultivation facilities. We have
provided consulting, equipment sales and/or full-scale design for over 800 grow facilities since 2006 making us a trusted resource
for indoor environmental design and control management for the cannabis industry.
Our
customers include businesses from small cultivation operations to licensed commercial facilities ranging from several thousand
to more than 100,000 square feet. We have sold our equipment and systems throughout the U.S. and Canada. Our revenue stream is
derived primarily from supplying mechanical engineering services and climate and environmental control equipment to commercial
indoor cannabis grow facilities. Our customers include those growers building new facilities and those expanding or retrofitting
existing facilities. Although our customers do, we neither produce nor sell cannabis.
Shares
of our common stock are traded on the OTC Markets under the ticker symbol “SRNA.”
Our
Growth Strategy
Our
growth strategy consists of a series of inter-related initiatives, including: (i) leveraging our strong brand name, (ii) positioning
and messaging Surna as the “trusted advisor” in environmental controls management, (iii) offering a broader product
and service array, (iv) evaluating first-generation grow facilities as prospects for broader service and product offerings or
retrofit work, (v) selling our new sensors, controls and automation (“SCA”) product offering, (vi) targeting multi-facility
operators that tend to be well-financed and have larger and multiple projects with greater immediacy, and (vii) developing a corresponding
marketing, service and product plan to address facility lifecycle revenue opportunities. With this strategy our goal
is to offer more products and services to address the wider range of our customers’ needs is illustrated by the following
matrix of product/service depth and facility lifecycle participation.
We
also are identifying and assessing strategic alliances (e.g., distribution, reseller, co-marketing and product
development arrangements) and possible acquisitions that we believe are straightforward to implement and execute, can leverage
our brand recognition in the cannabis space, enhance our position as a trusted advisor in the climate control space by expanding
our product and service offerings to indoor growers and, most importantly, scale our business by generating additional revenues
and margins.
Our
growth plan has six key objectives in mind:
|
1.
|
Reduce
prior reliance on new build facility projects which generate inconsistent revenue
and cash flow;
|
|
|
|
|
2.
|
Increase
emphasis on retrofit and expansion projects, especially from multi-facility operators,
which typically provide a more predictable and accelerated
completion and revenue stream;
|
|
|
|
|
3.
|
Establish
revenue from “lifecycle” operational and facility management offerings;
|
|
|
|
|
4.
|
Increase
our gross margin
by shifting our focus to value-added technology services and proprietary, customized
equipment;
|
|
|
|
|
5.
|
Operate
with disciplined expense, cash and working capital management; and
|
|
|
|
|
6.
|
Become
financially self-sustaining by attempting to achieve operating cash flow breakeven and profitability.
|
Over
the course of 2019, we have made measurable progress in achieving
several of the above objectives, as evidenced by the following:
|
●
|
During
the first nine months of 2019, we entered into five $1,000,000+ sales contracts with
an aggregate contract value of $10,490,000, including subsequent change orders. Three
of these contracts, having an aggregate value of $6,561,000, were with a single multi-facility
operator for a retrofit project and two facility expansions. We recognized revenue
of approximately $6,497,000 on these three contracts in the first nine months of 2019,
representing 57% of our total revenue for this period. Our retrofit and facility
expansion contracts, especially with multi-facility operators, typically generate a more
consistent and predictable revenue stream and allows us to manage our working capital
more effectively. Unless we are successful in obtaining these types of projects on
a regular basis, we are likely to continue to have inconsistent revenue and operating
results quarter-over-quarter.
|
|
|
|
|
●
|
We
now offer retrofit consulting work targeting indoor grow facilities that are operating
sub-optimally. While we target multi-facility operators that may require facility upgrades,
our preliminary market research indicates a large retrofit opportunity among the 3,000
– 5,000 indoor grow facilities operated by independent or smaller growers. Industry
surveys suggest about 30% of existing facilities are in need of HVAC or lighting
improvements. We also offer a facility assessment, analysis and consulting program
as an entry point to expand our retrofit and “lifecycle” opportunities.
|
|
|
|
|
●
|
We
launched our SentryIQTM sensors, controls and automation platform in April
2019 and now offer a turnkey, single-vendor HVAC equipment and controls integration solution
to new build projects as well as existing facilities in the startup and operation
phases. This product line is a new source of incremental revenue. Through September
30, 2019, we signed seven contracts for SentryIQTM control systems sales
with an aggregate contract value of approximately $687,000. Two of these contracts totaling
$125,000 were executed in the second quarter with a single multi-facility operator for
their expansion projects, and we delivered both systems which are currently being commissioned.
During the third quarter, we entered into controls contracts with two other multi-facility
operators which totaled $218,000 and two controls contracts with larger
independent cultivators for $295,000. We believe our expanding controls
business positions us for a more significant role in the technology and automation advancement
of indoor grow facilities. We also are working with other vendors and partners
to integrate our climate controls with their lighting and fertigation controls systems.
|
|
|
|
|
●
|
In
June 2019, we delivered our first custom-designed ducted air handling system, which is now offered as an alternative to our
new and improved ductless fan coil units. Our ability to offer larger capacity air handling systems should provide greater
opportunities for us to work with multi-facility operators. To date, we have entered into sales contracts of approximately
$2,860,000 for our custom-designed ducted air handling systems, of which we have recognized revenue of $2,270,000.
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|
|
|
|
●
|
Our
third quarter gross
margin fell to 28.6%, a decrease from 34.4% in the second quarter of 2019, as we took
advantage of larger project opportunities that included a high proportion of non-proprietary
products. Our gross margin for the first nine months of 2019 was 30.6%, an increase
of 3.5 percentage points over the gross margin of 27.1% for the first nine months of
2018. This improvement was largely the result of our focus on controlling expenses and
better absorption of our fixed production costs due to our increased revenue.
|
|
●
|
For
the first time, we
achieved back-to-back quarters of both positive operating and net income.
For the third quarter of 2019, operating income
was $277,000 and net income was $222,000, each a quarterly record
for us. Moreover, our adjusted operating income was $421,000, a key management
metric and point of focus. Our adjusted operating income (loss) is defined as our GAAP
operating income (loss) after addback for our non-cash equity compensation expenses and
depreciation expense.
|
|
|
|
|
●
|
As
of September 30, 2019, our cash was $2,000,000.
We generated $1,750,000 in cash flow from our operating activities in the first nine
months of 2019. We also reduced our working capital deficit to $771,000 as of September
30, 2019, a decrease over the last six months of $857,000, from $1,628,000
as of March 31, 2019. Our pursuit of business with multi-facility operators, which we
discuss below, and our disciplined cash management continue to be priorities for us as
we attempt to grow the business without accessing the capital markets with equity offerings
at our current stock price.
|
Multi-Facility
Operator Focus
We
have recently expanded our sales and marketing efforts to include a focus on multi-facility operators, which we define
as businesses that own and operate two or more cannabis cultivation facilities in either the U.S. or Canada. Since 2017,
we have sold engineering and/or climate control equipment to six multi-facility operators, and we are in “contact”
with about 16 multi-facility operators, who collectively operate over 100 cultivation facilities. Contact is defined as everything
from a full-fledged, ongoing customer relationship to a past customer with whom we are still in contact, to a new contact to whom
we are proposing business. We believe that most of these firms have immediate or near-term (within one year) plans to expand their
cultivation facilities, and we are aggressively pursuing deepening our relationships and business with these firms.
We
face multiple sources of competition in our attempt to penetrate the multi-facility operator market.
|
●
|
First,
some companies with multiple cultivation facilities have internal staffs with the requisite expertise to manage their environmental
control needs, and who are able to access and engage vendors for both engineering services and equipment providers without
external help.
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|
|
|
|
●
|
Second,
some large, multi-state and multi-national engineering and construction firms, which have deep engineering and construction
management experience and expertise, have entered this market.
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|
|
|
|
●
|
Third,
we compete with other cannabis-focused service providers, that like us promote their industry expertise and experience.
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|
|
|
|
●
|
Fourth,
several larger, brand name HVAC equipment manufacturers are now pursuing the cannabis cultivation market directly through
their own sales forces.
|
We
believe we are positioned better than most of our competitors in the multi-facility operator market for the following reasons:
|
●
|
We
are one of the oldest and most experienced specialty engineering firms serving the indoor cannabis cultivation market, and
we believe that multi-facility operators will value the expertise we have gained from our experience in providing consulting,
equipment sales and/or full-scale design to over 800 indoor grow facilities since 2006.
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|
|
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|
●
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Unlike
the local and regional engineering firms operating in the market, we have the capability and experience to perform work across
the U.S. and Canada, thereby matching the facilities footprint of our multi-facility operator prospects.
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|
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●
|
We
believe that the multi-facility operators value the range of experience and expertise that our personnel provide. Our professional
staff has expertise covering the gamut, including commercial agriculture, engineering and facility design, HVAC technology,
applications and controls, energy efficiency, and sustainability.
|
|
|
|
|
●
|
We
have deep networks of cannabis cultivators, HVAC technical experts, AgTech experts, sustainability leaders, and agricultural
resources that we can easily access and bring to bear for the benefit of our customers.
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|
|
|
|
●
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And
finally, our current business with several multi-facility operators provides important validation and enhances our credibility
in the eyes of other multi-facility operators that we are pursuing.
|
Our
recent success in signing three contracts with a single multi-facility operator, which we were able to convert into revenue over
the time span of three quarters, was a key driver to our record third quarter results and our improved cash position. We signed
contracts for two multi-facility operator projects in the third quarter—one for a new build project with our
new Sentry IQTM controls system and one for an expansion project.
We
continue our outreach to these valuable prospects, with two dedicated national accounts representatives now pursuing these opportunities.
Since September 30, 2019, we have booked two contracts with multi-facility operators for new build projects totaling of $1.2 million
in contract value, and we believe we are close to signing at least two other multi-facility operator contracts in the fourth
quarter with an estimated value each in excess of $1 million. Our ability to develop relationships
with, and obtain new business from, other multi-facility operators will be critical to generating consistent revenues quarter-over-quarter.
Notwithstanding our efforts, there is no assurance that we will be successful in growing and maintaining our business with these
multi-facility operators.
Our
Commercial-Scale Projects
During
the third quarter of 2019, we entered into sales contracts for three new build projects and three expansion projects, each with
a contract value over $100,000, which we refer to as commercial-scale projects. During the first nine months of 2019, we entered
into sales contracts for 19 commercial-scale projects, consisting of 12 new build projects, six expansion projects, and one retrofit
project. The California and Canadian markets, together with other states that recently legalized medical or recreational cannabis
use, such as Michigan, continue to show strength in 2019.
During
the third quarter of 2019, we had commercial-scale project bookings (as defined below) of $1,742,000, which consisted of $662,000
for new build projects (38%) and $1,080,000 for expansion projects (62%). During the first nine months of 2019, we had commercial-scale
project bookings of $14,807,000, which consisted of $7,031,000 for new build projects (47%), $6,505,000 for expansion projects
(44%), and $1,271,000 for retrofit projects (9%). These year-to-date values include subsequent change orders for contracts booked
in the first nine months of 2019.
As
part of our growth strategy, we are pursuing expansion and retrofit projects, which tend to have more predictable completion
schedules. In contrast, the timing for completion of new build projects is largely dependent on customer-centric uncertainties—which
are completely outside of our control—such as project-specific financing, licensing and qualification. Future bookings for
expansion projects will be largely tied to our success in penetrating the multi-facility operator market.
Our
recent success in obtaining business from multi-facility operators has also resulted in an increase in the average contract value
for our commercial-scale projects. During the first nine months of 2019, the average contract value for our commercial-scale project
bookings rose to $779,000, compared to $396,000 for 2018, and $332,000 for 2017, each adjusted for cancellations or subsequent
change orders.
The
following table sets forth our commercial-scale project bookings, based on the period the contract was executed and we received
an initial deposit, by country/state, adjusted for prior year projects which were subsequently cancelled.
|
|
Number
of New Commercial-Scale Project Bookings
|
|
|
|
YTD
2019
|
|
|
2018
|
|
|
2017
|
|
|
2016
|
|
Canada
|
|
|
8
|
|
|
|
12
|
|
|
|
7
|
|
|
|
1
|
|
California
|
|
|
3
|
|
|
|
3
|
|
|
|
-
|
|
|
|
3
|
|
Colorado
|
|
|
-
|
|
|
|
-
|
|
|
|
2
|
|
|
|
3
|
|
Arizona
|
|
|
-
|
|
|
|
-
|
|
|
|
2
|
|
|
|
1
|
|
Oregon
|
|
|
-
|
|
|
|
-
|
|
|
|
2
|
|
|
|
2
|
|
Washington
|
|
|
-
|
|
|
|
2
|
|
|
|
1
|
|
|
|
3
|
|
Massachusetts
|
|
|
-
|
|
|
|
1
|
|
|
|
-
|
|
|
|
-
|
|
Ohio
|
|
|
-
|
|
|
|
1
|
|
|
|
-
|
|
|
|
-
|
|
Alaska
|
|
|
1
|
|
|
|
-
|
|
|
|
1
|
|
|
|
2
|
|
Rhode Island
|
|
|
-
|
|
|
|
1
|
|
|
|
1
|
|
|
|
-
|
|
Nevada
|
|
|
-
|
|
|
|
-
|
|
|
|
1
|
|
|
|
1
|
|
Texas
|
|
|
-
|
|
|
|
-
|
|
|
|
1
|
|
|
|
-
|
|
Virginia
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Michigan
|
|
|
5
|
|
|
|
4
|
|
|
|
-
|
|
|
|
-
|
|
New Mexico
|
|
|
1
|
|
|
|
1
|
|
|
|
-
|
|
|
|
-
|
|
Hawaii
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
1
|
|
Wisconsin
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
1
|
|
Maryland
|
|
|
-
|
|
|
|
1
|
|
|
|
-
|
|
|
|
-
|
|
Arkansas
|
|
|
-
|
|
|
|
1
|
|
|
|
-
|
|
|
|
-
|
|
Oklahoma
|
|
|
1
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
19
|
|
|
|
27
|
|
|
|
18
|
|
|
|
18
|
|
Our
Bookings, Backlog and Revenue
During
the three months ended September 30, 2019, we executed new sales contracts with a total contract value of $2,441,000. During this
same period, we cancelled two outstanding sales contracts with a total remaining contract value of $47,000 and had positive change
orders of $250,000. After adjustments for these cancellations and change orders, our net bookings in the three months ended
September 30, 2019 were $2,644,000, representing a decrease of $3,046,000 (or 54%) from net bookings of $5,690,000 in the second
quarter of 2019.
During
the third quarter, we believe certain Canadian prospects delayed new or expansion projects as access to capital has recently tightened
due to current market conditions in that country. Further,
as the cultivation facility market matures and grows, we believe more competitors are and will be entering the market.
We believe this competition will likely come from: (i) large equipment providers who are more aggressively pursuing
the cannabis market, and (ii) local and national engineering firms who have elected to enter the market which they had previously
chosen not to serve because of the nature of the industry.
However,
we continue to pursue several initiatives to drive our bookings and revenue growth. Among other activities, we sharpened and expanded
our marketing outreach in an effort to increase the quantity of qualified sales leads. During the third quarter, we also added
three sales representatives—two regional representatives and one national accounts representative with a deep background
in facilities design and construction in the cannabis industry. Finally, we believe our introduction of several new products to
the market, including custom air-handlers, 4-pipe fan coil units, and our SentryIQTM controls system, will also contribute
to our future growth.
Our
backlog at September 30, 2019 was $10,143,000, a decrease of $2,880,000, or 22%, from June 30, 2019, which was the highest quarter-end
backlog in our history. The decrease in backlog is the result of our lower net bookings in the third quarter coupled with our
record third quarter revenue. Our backlog at September 30, 2019 includes booked sales orders of $619,000 (6% of the total
backlog) from several customers that we do not expect to be realized until 2021, if at all. We believe the sales orders in this
portion of our backlog may be abandoned by our customer or ultimately cancelled.
The
following table sets forth: (i) our beginning backlog (the remaining contract value of outstanding sales contracts for which we
have received an initial deposit as of the previous period), (ii) our net bookings for the period (new sales contracts executed
during the period for which we received an initial deposit, net of any adjustments including cancelations and change orders during
the period), (iii) our recognized revenue for the period, and (iv) our ending backlog for the period (the sum of the beginning
backlog and net bookings, less recognized revenue).
|
|
For
the quarter ended
|
|
|
|
September
30,
2018
|
|
|
December
31,
2018
|
|
|
March
31,
2019
|
|
|
June
30,
2019
|
|
|
September
30,
2019
|
|
Backlog, beginning balance
|
|
$
|
8,883,000
|
|
|
$
|
8,886,000
|
|
|
$
|
8,529,000
|
|
|
$
|
11,543,000
|
|
|
$
|
13,023,000
|
|
Net bookings, current period
|
|
$
|
3,328,000
|
|
|
$
|
1,838,000
|
|
|
$
|
4,785,000
|
|
|
$
|
5,690,000
|
|
|
$
|
2,644,000
|
|
Recognized revenue,
current period
|
|
$
|
3,325,000
|
|
|
$
|
2,195,000
|
|
|
$
|
1,771,000
|
|
|
$
|
4,210,000
|
|
|
$
|
5,524,000
|
|
Backlog, ending balance
|
|
$
|
8,886,000
|
|
|
$
|
8,529,000
|
|
|
$
|
11,543,000
|
|
|
$
|
13,023,000
|
|
|
$
|
10,143,000
|
|
The
completion of a customer’s new build facility project is dependent upon the customer’s ability to secure funding
and real estate, obtain a license and then build their cultivation facility so they can take possession of the equipment. Accordingly,
the time it takes for these customers to complete a new build project, which corresponds to when we are able to recognize revenue,
is driven by numerous factors including: (i) the large number of first-time participants interested in the indoor cannabis cultivation
business; (ii) the complexities and uncertainties involved in obtaining state and local licensure and permitting; (iii) local
and state government delays in approving licenses and permits due to lack of staff or the large number of pending applications,
especially in states where there is no cap on the number of cultivators; (iv) the customer’s need to obtain cultivation
facility financing; (v) the time needed, and coordination required, for our customers to acquire real estate and properly design
and build the facility (to the stage when climate control systems can be installed); (vi) the large price tag and technical complexities
of the climate control and air sanitation system; (vii) the availability of power; and (viii) delays that are typical in completing
any construction project.
As
has historically been the case at each quarter-end, there remains significant uncertainty regarding the timing of revenue recognition
of our backlog as of September 30, 2019. As of September 30, 2019, 49% of our backlog was attributable to customer contracts for
which we have only received an initial advance payment to cover our engineering services (“engineering only paid contracts”).
There are always risks that the equipment portion of our engineering only paid contracts will not be completed or will be
delayed, which could occur if the customer is dissatisfied with the quality or timeliness of our engineering services, there is
a delay or abandonment of the project due to the customer’s inability to obtain project financing or licensing, or the customer
determines not to proceed with the project due to economic factors, such as declining cannabis wholesale prices in the state.
In
contrast, after the customer has made an advance payment for a portion of the equipment to be delivered under the contract (“partial
equipment paid contracts”), we typically are better able to estimate the timing of revenue recognition since the risks and
delays associated with licensing, permitting and project funding are typically mitigated once the initial equipment payment is
received. As of September 30, 2019, 51% of our backlog was attributable to partial equipment paid contracts.
We
have provided an estimate in our condensed consolidated financial statements for when we expect to recognize revenue on our remaining
performance obligations (i.e., our Q3 2019 backlog), using separate time bands, with respect to engineering only paid contracts
and partial equipment paid contracts. We estimate that we will recognize approximately 33% of our Q3 2019 backlog during Q4 2019,
or $3.3 million. However, there continues to be significant uncertainty regarding the timing of our recognition of revenue on
our Q3 2019 backlog. Refer to the Revenue Recognition section of note 1 in our condensed consolidated financial statements,
included as part of this Quarterly Report for additional information on our estimate of future revenue recognition on our remaining
performance obligations.
Our
backlog, remaining performance obligations and net bookings may not be indicative of future operating results, and our customers
may attempt to renegotiate or terminate their contracts for a number of reasons, including delays in or inability to obtain project
financing or licensing or abandonment of the project entirely. Accordingly, there can be no assurance that contracts included
in backlog or remaining performance obligations will actually generate revenues or when the actual revenues will be generated.
Net bookings and backlog are considered non-GAAP financial measures, and therefore, they should be considered in addition to,
rather than as a substitute for, our GAAP measures for recognized revenue, deferred revenue and remaining performance obligations.
Further, we can provide no assurance as to the profitability of our contracts reflected in remaining performance obligations,
backlog and net bookings.
Results
of Operations
Comparison
of Three Months Ended September 30, 2019 and 2018
Revenues
and Cost of Goods Sold
Revenue
for the three months ended September 30, 2019 was $5,524,000 compared to $3,325,000 for the three months ended September 30, 2018,
an increase of $2,199,000, or 66%. Our third quarter 2019 revenue includes $3,870,000 from two expansion projects with a single
multi-facility operator. Unless we are able to obtain these types of projects with other multi-facility operators, we expect our
revenue to be inconsistent quarter-over-quarter because our revenue conversion for new build projects is largely dependent on
customer-centric factors—which are outside of our control—such as industry uncertainty, project financing concerns,
and the licensing and qualification of our prospective customers, which makes it difficult for us to predict when we will recognize
revenue on our backlog.
Cost
of revenue increased by $1,716,000, or 77%, from $2,228,000 for the three months ended September 30, 2018 to $3,944,000 for the
three months ended September 30, 2019.
The
gross profit for the three months ended September 30, 2019 was $1,580,000 compared to $1,097,000 for the three months ended September
30, 2018, an increase of 44%. Gross profit margin decreased by four percentage points from 33% for the three months ended September
30, 2018 to 29% for the three months ended September 30, 2019. Our third quarter 2019 gross margin was adversely impacted by larger
projects with a single multi-facility operator involving some of our more standard products.
Our
fixed costs (which include engineering, service, manufacturing and project management salaries and benefits and manufacturing
overhead) totaled $332,000, or 6% of total revenue, for the three months ended September 30, 2019 as compared to $408,000, or
12% of total revenue, for the three months ended September 30, 2018. The decrease of $76,000 was primarily due to a decrease in
salaries and benefits (including stock-based compensation) of $79,000.
Our
variable costs (which include the cost of equipment, outside engineering costs, shipping and handling, travel and warranty costs)
totaled $3,612,000, or 65% of total revenue, in the three months ended September 30, 2019 as compared to $1,820,000, or 55% of
total revenue, in the three months ended September 30, 2018. The increase in variable costs was primarily due to higher equipment
costs as a percentage of equipment revenue and higher engineering costs.
We
continue to focus on gross margin improvement through a combination of, among other things, more disciplined pricing, better absorption
of our fixed costs as we convert our increased bookings into revenue, and the implementation over time of lower-cost supplier
alternatives.
Operating
Expenses
Operating
expenses decreased to $1,303,000 for the three months ended September 30, 2019 from $1,759,000 for the three months ended September
30, 2018, a decrease of $456,000, or 26%. The operating expense decrease consisted of: (i) a decrease in selling, general and
administrative expenses (“SG&A expenses”) of $379,000, (ii) a decrease in advertising and marketing expenses of
$100,000, offset by (iii) an increase in product development expense of $23,000.
The
decrease in SG&A expenses for the three months ended September 30, 2019 compared to the three months ended September 30, 2018,
was due primarily to: (i) a decrease of $441,000 in stock-related compensation expense to employees, consultants and directors,
(ii) a decrease of $23,000 in salaries, benefits and other employee-related costs, (iii) a decrease of $20,000 in travel expenses,
and (iv) a decrease of $16,000 for depreciation, offset by (v) an increase of $38,000 for loss on asset disposal, (vi) an increase
of $36,000 in bad debt expense, (vii) an increase of $25,000 in sales commissions due to increased revenues, and (viii) an increase
of $24,000 in investor relations expenses due to our recent investor outreach initiatives such as conference attendance and advertising.
The
decrease in marketing expenses was primarily due to our efforts to reduce the number of, and be more selective in, the industry
trade shows and conferences we attend.
Operating
Income (Loss)
We
had operating income of $277,000 for the three months ended September 30, 2019, as compared to an operating loss of $663,000 for
the three months ended September 30, 2018, a favorable change of $940,000, or 142%. The operating income for the three months
ended September 30, 2019 included $113,000 of non-cash, stock-based compensation and $30,000 of depreciation expense, compared
to $574,000 of non-cash, stock-based compensation and $46,000 of depreciation expense for the three months ended September 30,
2018. Excluding these non-cash items, our operating income increased by $463,000, or 1092%.
Other
Income (Expense)
We
had other expense (net) of $55,000 for the three months ended September 30, 2019 compared to other income (net) of $19,000 for
the three months ended September 30, 2018. Other expense for the three months ended September 30, 2019 consisted of one-time charges
related to certain leased equipment.
Net
Income (Loss)
Overall,
we had net income of $222,000 for the three months ended September 30, 2019 as compared to a net loss of $644,000 for the three
months ended September 30, 2018, a favorable change of $866,000, or 135%. The net income for the three months ended September
30, 2019 included $113,000 of non-cash, stock-based compensation and $30,000 of depreciation expense, compared to $574,000 of
non-cash, stock-based compensation and $46,000 of depreciation expense for the three months ended September 30, 2018. Excluding
these non-cash items, our net income increased by $389,000, or 1667%.
Comparison
of Nine Months Ended September 30, 2019 and 2018
Revenues
and Cost of Goods Sold
Revenue
for the nine months ended September 30, 2019 was $11,506,000 compared to $7,387,000 for the nine months ended September 30, 2018,
an increase of $4,119,000, or 56%. Our revenue for the first nine months of 2019 includes $6,497,000 from retrofit and expansion
projects with a single multi-facility operator.
Cost
of revenue increased by $2,602,000, or 48%, from $5,385,000 for the nine months ended September 30, 2018 to $7,987,000 for the
nine months ended September 30, 2019.
The
gross profit for the nine months ended September 30, 2019 was $3,518,000 compared to $2,002,000 for the nine months ended September
30, 2018, an increase of 76%. Gross profit margin increased by four percentage points from 27% for the nine months ended September
30, 2018 to 31% for the nine months ended September 30, 2019. This increase was due primarily to a decrease in fixed costs from
our personnel reduction plan that was implemented in January 2019 combined with better absorption of our fixed costs based on
higher revenue.
Our
fixed costs (which include engineering, service, manufacturing and project management salaries and benefits and manufacturing
overhead) totaled $1,009,000, or 9% of total revenue, for the nine months ended September 30, 2019 as compared to $1,251,000,
or 17% of total revenue, for the nine months ended September 30, 2018. The decrease of $242,000 was due to a decrease in salaries
and benefits (including stock-based compensation) of $242,000.
Our
variable costs (which include the cost of equipment, outside engineering costs, shipping and handling, travel and warranty costs)
totaled $6,978,000, or 61% of total revenue, in the nine months ended September 30, 2019 as compared to $4,134,000, or 56% of
total revenue, in the nine months ended September 30, 2018. The increase in variable costs was primarily due to higher equipment
costs as a percentage of equipment revenue and higher engineering costs.
We
continue to focus on gross margin improvement through a combination of, among other things, more disciplined pricing, better absorption
of our fixed costs as we convert our increased bookings into revenue, and the implementation over time of lower-cost supplier
alternatives.
Operating
Expenses
Operating
expenses decreased by 33% to $4,027,000 for the nine months ended September 30, 2019 from $5,987,000 for the nine months ended
September 30, 2018, a decrease of $1,960,000. The operating expense decrease consisted of: (i) a decrease in SG&A expenses
of $1,836,000, (ii) a decrease in advertising and marketing expenses of $243,000, offset by (iii) an increase in product development
expense of $119,000.
The
decrease in SG&A expenses for the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018,
was due primarily to: (i) a decrease of $1,295,000 in stock-related compensation expense to employees, consultants and directors,
(ii) a decrease of $470,000 in salaries, benefits and other employee-related costs, (iii) a decrease of $190,000 in accounting
and other professional fees, (iv) a decrease of $115,000 in travel expenses, (v) a decrease of $45,000 in facility and office
expenses, offset by (vi) an increase for loss on asset disposal of $96,000, (vii) an increase of $57,000 in bad debt expense,
(viii) an increase of $54,000 in sales commissions due to higher revenues, (ix) an increase of $37,000 in investor relations expense
due to our recent increase in investor outreach efforts, (x) an increase of $18,000 in business taxes and licenses, and (xi) an
increase of $12,000 in depreciation.
The
decrease in marketing expenses was primarily due to a decrease in the number of the industry trade shows and conferences we attend.
Operating
Loss
We
had an operating loss of $508,000 for the nine months ended September 30, 2019, as compared to an operating loss of $3,985,000
for the nine months ended September 30, 2018, a decrease of $3,477,000, or 87%. The operating loss for the nine months ended September
30, 2019 included $661,000 of non-cash, stock-based compensation and $124,000 of depreciation expense, compared to $2,054,000
of non-cash, stock-based compensation and $113,000 of depreciation expense for the nine months ended September 30, 2018. Excluding
these non-cash items, our operating loss decreased by $2,095,000, or 115%.
Other
Income (Expense)
We
had other expense (net) of $30,000 for the nine months ended September 30, 2019 compared to other income (net) of $57,000 for
the nine months ended September 30, 2018. Other income for the nine months ended September 30, 2018 included a change in derivative
liability of $21,000 related to certain warrants.
Net
Loss
Overall,
we had a net loss of $539,000 for the nine months ended September 30, 2019 as compared to a net loss of $3,928,000 for the nine
months ended September 30, 2018, a decrease of $3,389,000, or 86%. The net loss for the nine months ended September 30, 2019 included
$661,000 of non-cash, stock-based compensation and $124,000 of depreciation expense, compared to $2,054,000 of non-cash, stock-based
compensation, $113,000 of depreciation expense and $21,000 in debt-related income for the nine months ended September 30, 2018.
Excluding these non-cash items, our net loss decreased by $2,029,000, or 114%.
Financial
Condition, Liquidity and Capital Resources
Cash
and Cash Equivalents
As
of September 30, 2019, we had cash and cash equivalents of $2,000,000, compared to cash and cash equivalents of $253,000 as of
December 31, 2018, an increase of 689%. The $1,747,000 increase in cash and cash equivalents during the nine months ended September
30, 2019 was the result of cash provided by our operating activities. Our cash is held in bank depository accounts in certain
financial institutions. We currently have deposits in financial institutions that exceed the federally insured amount.
As
of September 30, 2019, we had accounts receivable (net of allowance for doubtful accounts) of $107,000, inventory (net of excess
and obsolete allowance) of $936,000, and prepaid expenses of $693,000 (including $548,000 in advance payments on inventory purchases).
While we typically require advance payment before we commence engineering services or ship equipment to our customers, we have
made exceptions requiring us to record accounts receivable, which carry a risk of non-collectability especially since most of
our customers are funded on an as-needed basis to complete facility construction. We expect our exposure to accounts receivable
risk to increase as we pursue larger projects.
As
of September 30, 2019, we had no indebtedness, total accounts payable and accrued expenses of $2,022,000, deferred revenue of
$2,275,000, and the current portion of operating lease liability of $213,000. As of September 30, 2019, we had a working capital
deficit of $771,000, compared to a working capital deficit of $1,031,000 as of December 31, 2018. The decrease in our working
capital deficit was primarily related to (i) an increase in cash of $1,747,000 and, (ii) an increase in prepaid expenses and other
of $568,000, offset by (iii) an increase in our deferred revenue of $1,633,000 (which represents cash received from customers
in advance of the performance of services or the delivery of equipment), and (iv) an increase in accounts payable and accrued
liabilities of $213,000.
We
have never declared or paid any cash dividends on our common stock. We currently intend to retain all available funds and any
future earnings for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the
foreseeable future.
Summary
of Cash Flows
The
following summarizes our cash flows for the six months ended September 30, 2019 and 2018:
|
|
For
the Nine Months Ended September 30,
|
|
|
|
2019
|
|
|
2018
|
|
Net cash provided by (used
in) operating activities
|
|
$
|
1,750,121
|
|
|
$
|
(1,716,916
|
)
|
Net cash used in investing activities
|
|
|
(3,043
|
)
|
|
|
(150,849
|
)
|
Net cash provided
by financing activities
|
|
|
-
|
|
|
|
816,448
|
|
Net increase
(decrease) in cash
|
|
$
|
1,747,078
|
|
|
$
|
(1,051,317
|
)
|
Operating
Activities
We
incurred a net loss for the nine months ended September 30, 2019 of $539,000 and have an accumulated deficit of $24,885,000 as
of September 30, 2019.
Cash
provided by operations for the nine months ended September 30, 2019 was $1,750,000 compared to cash used in operations of $1,717,000
for the nine months ended September 30, 2018, a decrease in cash usage of $3,467,000. The cash provided by our operations during
the nine months ended September 30, 2019 was primarily attributable to: (i) an increase in cash resulting from a decrease in our
inventory (before allowance) of $213,000, an increase in our deferred revenue of $1,633,000 (which represents unearned customer
deposits), an increase in accounts payable and accrued liabilities of $213,000, a decrease in accounts receivable of $60,000,
and our non-cash operating items of $751,000 (consisting primarily of stock-related compensation), offset by (ii) a decrease in
cash resulting from our operating loss of $539,000, and an increase in our prepaid expenses of $568,000.
Investing
Activities
Cash
used in investing activities for the nine months ended September 30, 2019 was $3,000, compared to cash used in investing activities
of $151,000 for the nine months ended September 30, 2018. During the nine months ended September 30, 2018, we had payments for
property and equipment of $232,000, primarily related to leasehold improvements, offset by proceeds from the payment of the tenant
improvement allowance on our building lease.
Financing
Activities
Cash
provided by financing activities for the nine months ended September 30, 2019 was $0, compared to cash provided by financing activities
of $816,000 for the nine months ended September 30, 2018. During the nine months ended September 30, 2018, we received $1,210,000
from a private placement of common stock and warrants and $18,000 from the exercise of options and warrants, which was offset
by payment of $400,000 for the repurchase of common stock from a related party, $5,000 to purchase an option to purchase preferred
stock held by a related party, and $7,000 on a note to a related party.
Going
Concern
Our
condensed consolidated financial statements for the quarter ended September 30, 2019 have been presented on a going concern basis,
which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Our independent
registered public accounting firm included in its audit opinion on our consolidated financial statements for the year ended December
31, 2018, a statement that there is substantial doubt as to our ability to continue as a going concern. Our consolidated financial
statements for the year ended December 31, 2018 were prepared assuming that we would continue as a going concern. We have determined
that our ability to continue as a going concern is dependent on raising additional capital to fund our operations and ultimately
on generating future profitable operations. There can be no assurance that we will be able to raise sufficient additional capital
or eventually have positive cash flow from operations to address all of our cash flow needs. If we are not able to generate positive
cash flow from operations or find alternative sources of cash, our business and shareholders will be materially and adversely
affected. The foregoing factors raise substantial doubt about our ability to continue as a going concern for a period of one year
from the date our condensed consolidated financial statements are issued. Our condensed consolidated financial statements do not
include any adjustment that might result from the outcome of this uncertainty.
Capital
Raising
We
believe our cash balances and cash flow from operations will be insufficient to fund our operations for the next 12 months. If
we are unable to substantially increase revenues or otherwise generate cash flows from operations, we will need to raise additional
funding to continue as a going concern. Based on management’s estimate for our operational cash requirements, we may need
to raise financing as soon as the first quarter of 2020 in order to continue our operations and achieve our growth targets. There
can be no assurance that we will be able to raise the necessary financing, when and if needed, on acceptable terms or at all.
If our operating results do not meet management’s expectations, or additional capital is not available, management believes
it has the ability to reduce certain expenditures. The precise amount and timing of our financing needs cannot be determined accurately
at this time, and will depend on a number of factors, including the market demand for our products and services, management of
working capital, and continuation of normal payment terms and conditions for purchase of our products and services.
During
the first nine months of 2019, we took a number of steps to reduce our cash burn rate to a minimum level while still being able
to support our current operations. We continue to focus on improving our operating cash flow and working capital position by adding
revenue and margin. We were successful in increasing our third quarter revenue and cash position by $1,314,000 and $75,000, respectively,
compared to the second quarter of 2019. While we can point to several positive developments to date, there is significant work
ahead for us to execute on our growth plan and achieve fiscal self-sustainability. Historically, we have not been able
to generate consistent revenues quarter-over-quarter. While we are pursuing new business opportunities with multi-facility operators
as well as for expansion projects, there is no assurance we will be successful booking any sales related to these opportunities
and converting such bookings into cash and revenue. We also may not be able to achieve our growth and financial goals until 2020
or later, if at all.
Strategic
Plan
We
expect to face hurdles in achieving cash operating
break-even on a consistent basis, including controlling our operational costs as we attempt to grow our top-line,
having the financial resources to invest in marketing, product development and staffing, and being able to cover the costs of
being a public company. So, to address some of the issues we face as a smaller, publicly reporting company, we have
identified several business verticals, or silos, that we believe could be logical and natural complements to our climate
control business, including: lighting, fertigation (automated process of delivering nutrients and water to plants), benches
(customized systems to optimize use of the growing space), cultivation management technology (software), consumables
(growing, packaging, facility and lab supplies), and operational improvement analytics (modeling, data aggregation and
artificial intelligence). Initially, we will seek strategic alliances, such as distribution, reseller, co-marketing or
product development agreements, with select companies which are consistent with our strategic direction. Through at
least the first half of 2020, our strategic focus will be to establish these types of strategic alliances.
Over
time, it is possible that some of these strategic alliances may evolve into acquisition targets. Under the right circumstances
and at the appropriate time, we believe
acquisitions and related capital infusions of growth equity, combined with the proper execution of our growth plan, can
accelerate our progress towards consistent cash operating profitability. Our goal for 2021 is to add $10 to $20
million of annual revenues through acquisitions, obtain a Nasdaq listing and implement an aftermarket support program that
will result in a widely held, actively traded, and fully valued public company.
Inflation
In
the opinion of management, inflation has not and will not have a material effect on our operations in the immediate future. Management
will continue to monitor inflation and evaluate the possible future effects of inflation on our business and operations.
Contractual
Payment Obligations
As
of September 30, 2019, our contractual payment obligations consisted of a building lease. On January 2, 2018, the leased space
was expanded to 18,600 square feet and the monthly rental rate increased to $18,979 and beginning September 1, 2018, the monthly
rent will increase by 3% each year through the end of the lease. Refer to Note 2 – Leases of the notes to the condensed
consolidated financial statements, included as part of this Quarterly Report for a discussion of building lease.
Refer
to Note 6 – Commitments and Contingencies of the notes to the condensed consolidated financial statements, included
as part of this Quarterly Report for a discussion of commitments and contingencies.
Commitments
and Contingencies
Refer
to Note 6 – Commitments and Contingencies of the notes to the condensed consolidated financial statements, included
as part of this Quarterly Report for a discussion of commitments and contingencies.
Off-Balance
Sheet Arrangements
We
are required to disclose any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect
on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures,
or capital resources that are material to investors. As of September 30, 2019, we had no off-balance sheet arrangements. During
the three months ended September 30, 2019, we did not engage in any off-balance sheet financing activities other than those included
in the “Contractual Payment Obligations” discussed above and those reflected in Note 6 of our condensed consolidated
financial statements.
Recent
Developments
Refer
to Note 9 - Subsequent Events of the notes to condensed consolidated financial statements, included as part of this Quarterly
Report for certain significant events occurring since September 30, 2019.
Critical
Accounting Estimates
This
discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial
statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America.
Certain accounting policies are particularly important to the understanding of our financial position and results of operations
and require the application of significant judgment by our management or can be materially affected by changes from period to
period in economic factors or conditions that are outside of our control. As a result, they are subject to an inherent degree
of uncertainty. In applying these policies, management uses their judgment to determine the appropriate assumptions to be used
in the determination of certain estimates. Those estimates are based on our historical operations, our future business plans and
projected financial results, the terms of existing contracts, observance of trends in the industry, information provided by our
customers, and information available from other outside sources, as appropriate. Actual results could materially differ from those
estimates. Key estimates include: allocation of transaction prices to performance obligations under contracts with customers,
standalone selling prices, timing of expected revenue recognition on remaining performance obligations under contracts with customers,
valuation of intangible assets, valuation of equity-based compensation, valuation of deferred tax assets and liabilities, warranty
accruals, accounts receivable and inventory allowances, and legal contingencies.