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 and Projections” 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 and backlog, as well as other significant non-cash expenses such as stock-based compensation and
certain debt-related expenses. 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.
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
Organic Growth Strategy
Our
organic growth strategy for 2019 and 2020 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) rolling out 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.
Our
organic growth strategy 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
are also identifying and assessing one-off strategic alliances (e.g., joint ventures, co-marketing, distribution partnerships)
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
organic growth plan was established with six key objectives in mind:
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1.
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Reduce our reliance on new build facility projects which
generate inconsistent revenue and cash flow;
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2.
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Increase our emphasis on retrofit and expansion opportunities,
especially from multi-facility operators, which typically provide a more predictable and accelerated completion and revenue stream;
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3.
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Establish revenue from “lifecycle” operational
and facility management offerings;
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4.
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Seek to increase our gross margin by shifting our focus
to value-added technology services and proprietary, customized equipment;
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5.
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Operate with more disciplined expense, cash and working
capital management; and
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6.
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Become financially self-sustaining by attempting to
achieve operating cash flow breakeven and profitability.
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Although
we launched our new organic growth plan only six months ago, we have already made measurable progress in achieving several of
the above objectives, as evidenced by the following:
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●
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During the first half of 2019, we entered into
five $1,000,000+ sales contracts with an aggregate contract value of $10,290,000. Three of these contracts, having an aggregate
value of $6,517,000, were with a single multi-facility operator for a retrofit project and a two-phase facility expansion.
During the first half of 2019, we recognized revenue of $2,627,000 on these three contracts, with the remaining value of these
contracts expected to be recognized in the third quarter of 2019. 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 with other multi-facility
operators, we are likely to continue to have inconsistent revenue and operating results quarter-over-quarter.
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We are now offering retrofit consulting work
targeting indoor grow facilities that are operating sub-optimally. While we will initially be targeting multi-facility operators
that have recently acquired indoor grow facilities that may require facility upgrades, our preliminary market research indicates
an even larger retrofit opportunity among the 3,000 – 5,000 indoor grow facilities operated by independent or smaller
growers, which industry surveys suggest about 30% are in need of HVAC or lighting improvements. We are also offering our facility
assessment, analysis and consulting program to expand our retrofit and “lifecycle” opportunities.
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We launched our SentryIQ
TM
sensors,
controls and automation platform in April 2019 and now offer a turnkey, single-vendor HVAC equipment and controls integration
solution to our new build projects. We are also offering our HVAC controls systems to existing facilities in the startup and
operation phases. This product line is a new source of incremental revenue. To date, we have signed three contracts for SentryIQ
TM
control systems sales with an aggregate contract value of approximately $225,000. Two of these contracts are with a
single multi-facility operator to provide chiller plant, boiler and flow controls and energy monitoring to two of their expansion
projects. The other contract is with a larger independent cultivator to provide controls for temperature, humidity, CO
2
evacuation and energy monitoring. We expect these control systems to be installed by the end of 2019. We are also in
discussions and negotiations with a number of prospective customers interested in our new controls platform.
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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.
During the second quarter of 2019, revenue from our custom-designed ducted air handling systems totaled $1.1 million, or 27%
of our total revenue for the quarter.
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Over the last two quarters, we improved our
gross margins by 14 percentage points, from 20.4% in the fourth quarter of 2018 to 27.7% in the first quarter of 2019 to 34.4%
in the second quarter of 2019. Our gross margin was 32.4% for the first half of 2019, compared to 22.3% for the first half
of 2018, an increase of 12.1 percentage points. 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.
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For the second quarter of 2019, we had revenue
of $4,210,000, operating income of $136,000, and net income of $140,000, all quarterly records for us and
the first time
we have ever achieved positive net income in a quarter
. Moreover, we had adjusted operating income of $390,000, a key
management metric and point of focus as we attempt to achieve operating cash flow breakeven on a consistent basis from quarter-to-quarter.
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.
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We
generated $1,672,000 in cash flow from our operating activities in the first half of 2019. Our cash position increased from
$465,000 as of March 31, 2019 to $1,925,000 as of June 30, 2019. We were also able to reduce our working capital deficit by
$445,000, from $1,628,000 as of March 31, 2019 to $1,183,000 as of June 30, 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.
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Multi-Facility
Operator Focus
We
have recently expanded our sales and marketing efforts to include a focus on multi-facility operators. We define these firms as
individual businesses that own and operate two or more cannabis cultivation facilities in either the U.S. or Canada. Thus far,
our initial market research has identified and preliminarily qualified approximately 45 different multi-facility operators that
collectively operate in excess of 250 cultivation facilities. We believe there are more of these firms than now known to
us, and we plan to continue to revise and update our research findings on an ongoing basis so we can improve our sales outreach
in this segment of the market.
Since
2017, we have sold engineering and/or climate control equipment to five multi-facility operators. We are in “contact”
with about 10 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 currently
have active project proposals with two of these multi-facility operators and are attempting to progress and convert these engagements
to new orders.
Our
outreach to the multi-facility operators will remain a top priority for our sales team on an ongoing basis.
We
face multiple sources of competition in our attempt to penetrate the multi-facility operator market.
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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 salesforces.
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We
believe we are positioned better than most of our competitors in the multi-facility operator market for the following reasons:
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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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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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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.
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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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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.
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Our
recent success in signing contracts with a single multi-facility operator, which we were able to convert into revenue over the
time span of two quarters, was a key driver to our record second quarter results and our improved cash position. 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 all of 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 second quarter of 2019, we entered into sales contracts for six new build projects and two expansion projects, each with a
contract value over $100,000, which we refer to as commercial-scale projects. During the first half of 2019, we entered into sales
contracts for 13 commercial-scale projects, consisting of nine new build projects, three 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 second quarter of 2019, we had commercial-scale project bookings (as defined below) of $8,158,000, which consisted of $2,911,000
for new build projects (36%) and $5,247,000 for expansion projects (64%) with a single multi-facility operator. During the first
half of 2019, we had commercial-scale project bookings of $12,677,000, which consisted of $6,044,000 for new build projects (48%),
$5,382,000 for expansion projects (42%), and $1,251,000 for retrofit projects (10%). As part of our new 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 second quarter of 2019, the average contract value for our commercial-scale project
bookings rose to $1,020,000, compared to $904,000 in the first quarter of 2019, $408,000 for 2018, and $332,000 for 2017.
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.
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Number of New Commercial-Scale Project Bookings
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H1 2019
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2018
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2017
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2016
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Canada
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5
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13
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7
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1
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California
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2
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6
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1
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3
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Colorado
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-
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-
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2
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3
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Arizona
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-
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-
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3
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1
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Oregon
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-
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-
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2
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2
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Washington
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-
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3
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1
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3
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Massachusetts
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-
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1
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-
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-
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Ohio
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-
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1
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-
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-
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Alaska
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1
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-
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1
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2
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Rhode Island
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-
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1
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1
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-
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Nevada
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-
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-
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1
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1
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Texas
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-
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-
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1
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-
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Michigan
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3
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4
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-
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-
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New Mexico
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1
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1
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-
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-
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Hawaii
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-
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-
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-
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1
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Wisconsin
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-
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-
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-
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1
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Maryland
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-
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1
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-
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-
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Arkansas
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-
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1
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-
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-
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Oklahoma
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1
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-
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-
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-
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Total
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13
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32
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20
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18
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Our
Bookings, Backlog and Revenue
During
the three months ended June 30, 2019, we executed new sales contracts with a total contract value of $8,522,000. However, during
this same period, we cancelled eight outstanding sales contracts with a total contract value of $3,040,000. These cancellations
included combined contract orders of $1,761,000 that we booked in early 2018 with a multi-facility operator that had put two projects
on hold in states where the current market conditions, including wholesale cannabis prices, were not favorable. The other cancellations
were based on discussions and negotiations with customers who had abandoned their projects. Accordingly, after adjustments for
these cancellations and other change orders, our net bookings (as defined below) in the three months ended June 30, 2019 were
$5,690,000, a quarterly record for us, representing an increase of $905,000 (or 19%) from net bookings of $4,785,000 in the first
quarter of 2019. We did not recognize any revenue from the cancellation of these sales contracts.
Going
forward, we will be focused on gaining a better understanding, during the sales process, of our customers’ challenges and
key milestones to get their new build projects licensed, financed and built. We are also in the process of revising our sales
contract terms to clarify project timelines and options available to us if the customer is unable to perform in a timely manner.
While cancellations will always be part of our business, we believe we should be able to identify and evaluate possible project
delays and better manage outcomes with our customers, including re-pricing the contract and/or adjusting delivery requirements.
We also seek to avoid larger cancellations by contracting with well-financed, multi-facility operators and/or pursuing
expansion or retrofit projects that are more short-term in nature.
Our
revenue for the three months ended June 30, 2019 increased $2,439,000 (or 138%) from $1,771,000 in the first quarter of 2019 to
$4,210,000 in the second quarter of 2019.
Our
backlog at June 30, 2019 was $13,023,000, the highest quarter-end backlog in our history, and an increase of $1,480,000, or 13%,
from March 31, 2019. Our backlog at June 30, 2019 includes booked sales orders of $243,000 (2% of the total backlog) from several
customers that we do not expect to be realized until 2021, if at all. We believe the sales orders in this portion of our backlog
may be abandoned by our customer or ultimately cancelled.
The
following table sets forth: (i) our beginning backlog (the remaining contract value of outstanding sales contracts for which we
have received an initial deposit as of the previous period), (ii) our net bookings for the period (new sales contracts executed
during the period for which we received an initial deposit, net of any adjustments including cancelations and change orders during
the period), (iii) our recognized revenue for the period, and (iv) our ending backlog for the period (the sum of the beginning
backlog and net bookings, less recognized revenue).
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For
the quarter ended
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June
30, 2018
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September 30, 2018
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December 31, 2018
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March
31, 2019
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June
30, 2019
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Backlog,
beginning balance
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$
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7,024,000
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|
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$
|
8,883,000
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|
|
$
|
8,886,000
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$
|
8,529,000
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|
$
|
11,543,000
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Net
bookings, current period
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|
$
|
3,867,000
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|
$
|
3,328,000
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|
|
$
|
1,838,000
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|
|
$
|
4,785,000
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|
|
$
|
5,690,000
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|
|
Recognized
revenue, current period
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|
$
|
2,008,000
|
|
|
$
|
3,325,000
|
|
|
$
|
2,195,000
|
|
|
$
|
1,771,000
|
|
|
$
|
4,210,000
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|
|
Backlog,
ending balance
|
|
$
|
8,883,000
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|
|
$
|
8,886,000
|
|
|
$
|
8,529,000
|
|
|
$
|
11,543,000
|
|
|
$
|
13,023,000
|
|
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 June 30, 2019. As of June 30, 2019, 50% 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”),
a 20-percentage point decrease, compared to 70% as of March 31, 2019. This decline in the percentage of our overall backlog
attributed to engineering only paid contracts is largely a result of contract cancellations that occurred in the second quarter
of 2019.
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 June 30, 2019, 50% of our backlog was attributable to partial equipment paid contracts, a 20-percentage
point increase, compared to 30% as of March 31, 2019. This increase in the percentage of our overall backlog attributed to partial
equipment paid contracts is largely a result of contract cancellations that occurred in the second quarter of 2019.
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 Q2 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 57% of our Q2 2019 backlog during 2019,
or $7.3 million. However, there continues to be significant uncertainty regarding the timing of our recognition of revenue on
our Q2 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 June 30, 2019 and 2018
Revenues
and Cost of Goods Sold
Revenue
for the three months ended June 30, 2019 was $4,210,000 compared to $2,008,000 for the three months ended June 30, 2018, an increase
of $2,202,000, or 110%. During the second quarter of 2019, our revenue reflects $2,430,000 recognized from retrofit
and expansion project contracts we entered into with a single multi-facility operator in the first half of 2019. Unless we are
able to obtain these types of projects with similar 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 $1,279,000, or 86%, from $1,484,000 for the three months ended June 30, 2018 to $2,763,000 for the three
months ended June 30, 2019.
The
gross profit for the three months ended June 30, 2019 was $1,448,000 compared to $523,000 for the three months ended June 30,
2018, an increase of 177%. Gross profit margin increased by eight percentage points from 26% for the three months ended June 30,
2018 to 34% for the three months ended June 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,
offset by higher equipment costs.
Our
fixed costs (which include engineering, service, manufacturing and project management salaries and benefits and manufacturing
overhead) totaled $373,000, or 9% of total revenue, for the three months ended June 30, 2019 as compared to $437,000, or 22% of
total revenue, for the three months ended June 30, 2018. The decrease of $64,000 was primarily due to a decrease in salaries and
benefits (including stock-based compensation) of $67,000.
Our
variable costs (which include the cost of equipment, outside engineering costs, shipping and handling, travel and warranty costs)
totaled $2,389,000, or 57% of total revenue, in the three months ended June 30, 2019 as compared to $1,047,000, or 52% of total
revenue, in the three months ended June 30, 2018. The increase in variable costs was primarily due to higher equipment costs as
a percentage of equipment revenue.
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 $1,311,000 for the three months ended June 30, 2019 from $1,941,000 for the three months ended June 30,
2018, a decrease of $630,000, or 32%. The operating expense decrease consisted of: (i) a decrease in selling, general and administrative
expenses (“SG&A expenses”) of $627,000, (ii) a decrease in advertising and marketing expenses of $57,000, offset
by (iii) an increase in product development expense of $54,000.
The
decrease in SG&A expenses for the three months ended June 30, 2019 compared to the three months ended June 30, 2018, was due
primarily to: (i) a decrease of $578,000 in stock-related compensation expense to employees, consultants and directors, (ii) a
decrease of $150,000 in salaries, benefits and other employee-related costs, (iii) a decrease of $39,000 in travel expenses, (iv)
a decrease of $29,000 in accounting and other professional fees, (v) a decrease of $25,000 in facility and office expense, offset
by (vi) an increase of $88,000 in bad debt expense, (vii) an increase of $58,000 for the loss on asset disposal, and (viii) an
increase of $29,000 in sales commissions.
The
decrease in marketing expenses was primarily due to a decrease in salaries and benefits along with 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 $136,000 for the three months ended June 30, 2019, as compared to an operating loss of $1,417,000 for
the three months ended June 30, 2018, a favorable change of $1,553,000, or 110%. The operating income for the three months ended
June 30, 2019 included $207,000 of non-cash, stock-based compensation and $47,000 of depreciation expense, compared to $823,000
of non-cash, stock-based compensation and $41,000 of depreciation expense for the three months ended June 30, 2018. Excluding
these non-cash items, our operating income increased by $943,000, or 171%.
Other
Income (Expense)
We
had other income (net) of $3,000 for the three months ended June 30, 2019 compared to other income (net) of $16,000 for the three
months ended June 30, 2018.
Net
Income (Loss)
Overall,
we had net income of $140,000 for the three months ended June 30, 2019 as compared to a net loss of $1,401,000 for the three months
ended June 30, 2018, a favorable change of $1,541,000, or 110%. The net income for the three months ended June 30, 2019 included
$207,000 of non-cash, stock-based compensation and $47,000 of depreciation expense, compared to $823,000 of non-cash, stock-based
compensation and $41,000 of depreciation expense for the three months ended June 30, 2018. Excluding these non-cash items, our
net income increased by $931,000, or 173%.
Comparison
of Six Months Ended June 30, 2019 and 2018
Revenues
and Cost of Goods Sold
Revenue
for the six months ended June 30, 2019 was $5,982,000 compared to $4,062,000 for the six months ended June 30, 2018, an increase
of $1,920,000, or 47%. During the first half of 2019, our revenue reflects $2,627,000 recognized from retrofit
and expansion project contracts we entered into with a single multi-facility operator in the first half of 2019.
Cost
of revenue increased by $887,000, or 28%, from $3,157,000 for the six months ended June 30, 2018 to $4,044,000 for the six months
ended June 30, 2019.
The
gross profit for the six months ended June 30, 2019 was $1,938,000 compared to $905,000 for the six months ended June 30, 2018,
an increase of 114%. Gross profit margin increased by 10 percentage points from 22% for the six months ended June 30, 2018 to
32% for the six months ended June 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 $677,000, or 11% of total revenue, for the six months ended June 30, 2019 as compared to $843,000, or 21% of
total revenue, for the six months ended June 30, 2018. The decrease of $166,000 was primarily due to a decrease in salaries and
benefits (including stock-based compensation) of $163,000.
Our
variable costs (which include the cost of equipment, outside engineering costs, shipping and handling, travel and warranty costs)
totaled $3,367,000, or 56% of total revenue, in the six months ended June 30, 2019 as compared to $2,314,000, or 57% of total
revenue, in the six months ended June 30, 2018. The decrease in variable costs was primarily due to lower equipment costs as a
percentage of equipment revenue.
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 36% to $2,724,000 for the six months ended June 30, 2019 from $4,228,000 for the six months ended June 30,
2018, a decrease of $1,504,000. The operating expense decrease consisted of: (i) a decrease in SG&A expenses of $1,457,000,
(ii) a decrease in advertising and marketing expenses of $143,000, offset by (iii) an increase in product development expense
of $96,000.
The
decrease in SG&A expenses for the six months ended June 30, 2019 compared to the six months ended June 30, 2018, was due primarily
to: (i) a decrease of $854,000 in stock-related compensation expense to employees, consultants and directors, (ii) a decrease
of $448,000 in salaries, benefits and other employee-related costs, (iii) a decrease of $187,000 in accounting and other professional
fees, (iv) a decrease of $95,000 in travel expenses, (v) a decrease of $42,000 in facility and office expenses, offset by (vi)
an increase for loss on asset disposal of $58,000, (vii) an increase of $29,000 in sales commissions, (viii) an increase of $27,000
in depreciation, and (ix) an increase of $20,000 in bad debt expense.
The
decrease in marketing expenses was primarily due to a decrease in salaries and benefits along with our efforts to reduce the number
of, and be more selective in, the industry trade shows and conferences we attend.
Operating
Loss
We
had an operating loss of $786,000 for the six months ended June 30, 2019, as compared to an operating loss of $3,322,000 for the
six months ended June 30, 2018, a decrease of $2,536,000, or 76%. The operating loss for the six months ended June 30, 2019 included
$548,000 of non-cash, stock-based compensation and $94,000 of depreciation expense, compared to $1,480,000 of non-cash, stock-based
compensation and $67,000 of depreciation expense for the six months ended June 30, 2018. Excluding these non-cash items, our operating
loss decreased by $1,631,000, or 92%.
Other
Income (Expense)
We
had other income (net) of $25,000 for the six months ended June 30, 2019 compared to other income (net) of $38,000 for the six
months ended June 30, 2018. Other income for the six months ended June 30, 2018 included a change in derivative liability of $21,000
related to certain warrants.
Net
Loss
Overall,
we had a net loss of $761,000 for the six months ended June 30, 2019 as compared to a net loss of $3,285,000 for the six months
ended June 30, 2018, a decrease of $2,523,000, or 77%. The net loss for the six months ended June 30, 2019 included $548,000 of
non-cash, stock-based compensation and $94,000 of depreciation expense, compared to $1,480,000 of non-cash, stock-based compensation,
$67,000 of depreciation expense and $21,000 in debt-related income for the six months ended June 30, 2018. Excluding these non-cash
items, our net loss decreased by $1,640,000, or 93%.
Financial
Condition, Liquidity and Capital Resources
Cash
and Cash Equivalents
As
of June 30, 2019, we had cash and cash equivalents of $1,925,000, compared to cash and cash equivalents of $253,000 as of December
31, 2018, an increase of 661%. The $1,672,000 increase in cash and cash equivalents during the six months ended June 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 June 30, 2019, we had accounts receivable (net of allowance for doubtful accounts) of $391,000, inventory (net of excess and
obsolete allowance) of $611,000, and prepaid expenses of $907,000 (including $751,000 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 June 30, 2019, we had no indebtedness, total accounts payable and accrued expenses of $2,204,000, deferred revenue of $2,606,000,
and the current portion of operating lease liability of $209,000. As of June 30, 2019, we had a working capital deficit of $1,183,000,
compared to a working capital deficit of $1,031,000 as of December 31, 2018. The increase in our working capital deficit was primarily
related to (i) an increase in our deferred revenue of $1,964,000 (which represents cash received from customers in advance of
the performance of services or the delivery of equipment), (ii) an increase in accounts payable and accrued liabilities of $395,000,
offset by (iii) an increase in cash of $1,672,000, and (iv) an increase in prepaid expenses of $780,000.
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 June 30, 2019 and 2018:
|
|
|
For the Six Months Ended June 30,
|
|
|
|
|
2019
|
|
|
2018
|
|
|
Net cash provided by (used in) operating activities
|
|
$
|
1,672,000
|
|
|
$
|
(1,511,000
|
)
|
|
Net cash used in investing activities
|
|
|
-
|
|
|
|
(144,000
|
)
|
|
Net cash provided by financing activities
|
|
|
-
|
|
|
|
816,000
|
|
|
Net increase (decrease) in cash
|
|
$
|
1,672,000
|
|
|
$
|
(839,000
|
)
|
Operating
Activities
We
incurred a net loss for the six months ended June 30, 2019 of $761,000 and have an accumulated deficit of $25,107,000 as of June
30, 2019.
Cash
provided by operations for the six months ended June 30, 2019 was $1,672,000 compared to cash used in operations of $1,511,000
for the six months ended June 30, 2018, a decrease in cash usage of $3,183,000. The cash provided by our operations during the
six months ended June 30, 2019 was primarily attributable to: (i) an increase in cash resulting from a decrease in our inventory
(before allowance) of $507,000, an increase in our deferred revenue of $1,964,000 (which represents unearned customer deposits),
an increase in accounts payable and accrued liabilities of $395,000, and our non-cash operating items of $547,000 (consisting
primarily of stock-related compensation), offset by (iii) a decrease in cash resulting from our operating loss of $761,000, an
increase in our prepaid expenses of $780,000 (primarily attributable to deposits for inventory purchases), and an increase in
accounts receivable of $191,000.
Investing
Activities
Cash
used in investing activities for the six months ended June 30, 2019 was $0, compared to cash used in investing activities of $144,000
for the six months ended June 30, 2018. During the six months ended June 30, 2018, we had payments for property and equipment
of $227,000, 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 six months ended June 30, 2019 was $0, compared to cash provided by financing activities
of $816,000 for the six months ended June 30, 2018. During the six months ended June 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 June 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 fourth quarter of 2019 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 limited options to reduce expenditures further without adversely affecting our business and our ability to execute our
recently implemented organic growth plan. 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 half 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. As we stated in our first quarter report, the only way to improve our cash flow and working capital position
was to add revenue and margin to “grow out” of our current situation. We were successful in increasing our second
quarter revenue and cash position by $2,439,000 and $1,460,000, respectively, compared to the first quarter of 2019. While we
can point to several positive developments to date, there is significant work ahead for us to execute on our organic 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.
Acquisitive
Growth
Last
quarter, we stated that our long-term financial sustainability requires us to organically grow our business to $20 to $40 million
in annual revenues. We also acknowledged that we face hurdles in achieving cash operating break-even, 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 announced last quarter the initial launch of an acquisition strategy to complement our organic
growth plans.
Our
plan is to identify and pursue acquisitions of companies or assets within the cannabis ancillary products and services sector
complementary to our current business offerings. Our objective is to consummate one or more acquisitions that would add in the
range of $10 to $20 million in annual run-rate revenues by the end of 2020. We believe with our current revenue position and our
public company status, there are a number of private companies, and even smaller public companies, that would be interested in
partnering with us. If we are able to engage in a roll-up type acquisition strategy, using our public status and our stock as
all or partial acquisition consideration, we believe we can “scale up” our operations to support the expenses of the
day-to-day operations of the company, on a combined basis, and be able to better cover the costs of maintaining our public company
status.
To
date, 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), software (procurement and supply chain management platforms), and consumables
(such as packaging, growing, facility and lab supplies). We have identified several companies in these verticals. There is no
assurance that we will be able to consummate any acquisitions in furtherance of this strategy.
Our
goal is to create an AgTech-focused, end-to-end solution offering hardware (equipment, sensors and controls) and software (purchasing
and IoT platforms) to indoor growers. We envision a “penetrate and radiate” strategy: get into the grower, especially
multi-facility operators, in any way that we can, become a trusted vendor (penetrate), and then sell as many products as possible
to them, whether manufactured, proprietary, branded or distributed (radiate). Our success will be measured by the percent of the
grower’s overall capital expense wallet share we can obtain. In this rapidly changing market landscape, we believe a platform
that can tailor specific solutions to meet our customers’ needs to optimize quality, efficiency, costs and delivery times
could be attractive to possible acquisition targets.
We
believe acquisitions and related capital infusions of growth equity, combined with the proper execution of our organic growth
plan, can accelerate our progress towards cash operating profitability and lower overall operating expenses. If we successfully
execute both our organic growth plan and our strategic acquisition and associated capital raise initiative, our goal is to 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 June 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 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 June 30, 2019, we had no off-balance sheet arrangements. During the
three months ended June 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 June 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.