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, 2020, 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, 2020, 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 cancellations 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 sell environmental control and other technologies for the Controlled Environment Agriculture (CEA) industry. The
CEA industry is one of the fastest-growing sectors of the United States’ economy. From leafy greens (kale, Swiss chard, mustard,
cress), microgreens (leafy greens harvested at the first true leaf stage), ethnic vegetables and small fruits (such as strawberries,
blackberries and raspberries) to bell peppers, cucumbers, tomatoes, and cannabis, some producers grow crops indoors in response to market
dynamics or as part of their preferred farming practice. In service of the CEA, our principal service and product offerings include:
(i) liquid-based process cooling systems and other climate control systems, (ii) air handling equipment and systems, (iii) a full-service
engineering package for designing and engineering commercial scale thermodynamic systems specific to cultivation facilities, (iv) automation
and control devices, systems and technologies used for environmental, lighting and climate control, and (v) preventive maintenance services
for CEA facilities. Our customers include commercial, state- and provincial-regulated CEA growers in the U.S. and Canada as well as other
international locations. Customers are those growers building new facilities and those expanding or retrofitting existing facilities.
Currently, our revenue stream is derived primarily from supplying our products, services and technologies to commercial indoor facilities,
operating in the cannabis industry, ranging from several thousand to more than 100,000 square feet.
Headquartered
in Boulder, Colorado, we leverage our experience in this space to bring value-added climate control solutions to our customers that help
improve their overall crop quality and yield, optimize energy and water efficiency, and satisfy the evolving state and local codes, permitting
and regulatory requirements.
All
CEA facility operators are facing multiple headwinds of high energy costs, issues about water usage and waste materials, and, in the
case of cannabis growing, increasingly rigorous quality standards and declining cannabis prices. To be competitive, among other things,
our customers must develop innovative ways to meet the demands of their business and reduce energy costs, 90% of which is typically related
to their HVACD (50%) and lighting systems (40%). HVACD systems have historically been our focus, but in May of 2021, we announced an
initiative to expand our offerings to include most of the technical infrastructure of CEA facilities as well as maintenance services.
We often have the advantage of early engagement with our customers at the pre-build and construction phases and the corresponding opportunity
to build longer-term relationships with our existing customers and their facilities. Going forward, our plan is to leverage our existing
customer relationships and attempt to sell them additional products and services, thereby becoming “stickier” to our customers.
We
have three core assets that we believe are important to our going-forward business strategy. First, we have multi-year relationships
with customers and others in the CEA industry, notably in the cannabis segment. Second, we have specialized engineering know-how and
experience gathered from designing environmental control systems for CEA cultivation facilities since 2016. Third, we have a line of
proprietary environmental control products, which we are in the process of expanding.
We
are an integrated provider of MEP (mechanical, electrical, plumbing) engineering design, proprietary environmental control equipment,
and controls and automation offerings serving the CEA industry. Historically, nearly all of our customers have been in the cannabis cultivation
business. We believe our employees have more experience than most other MEP firms serving this industry. Our customers engage us for
their environmental and climate control systems because they want experts to design their facilities, and they come to us because of
our reputation. We leverage our reputation and know-how against the many local contractors and MEP engineers who collectively constitute
our largest competitors.
Shares
of our common stock are traded on the OTC Markets under the ticker symbol “SRNA.”
Impact
of the COVID-19 Pandemic on Our Business
The
COVID-19 pandemic has prompted national, regional, and local governments, including those in the markets that the Company operates in,
to implement preventative or protective measures to control its spread, but as a result, there have been many disruptions in business
operations around the world, with an impact on our business.
In
our response to the COVID-19 pandemic and the government and business response, the Company took and continues to take measures to adjust
its operations as necessary. In early 2020 the Company took measures to reduce expenses in light of reduced orders and to preserve cash,
many of which were reversed by the end of the year when orders picked up and the overall business climate improved. Because the pandemic
continues in different parts of the world and in different ways in the United States, the Company continues to actively monitor its operations
and sales efforts and will make adjustments to its operations as necessary.
We
are experiencing unexpected and uncontrollable delays with our international supply of products and shipments from vendors due to a significant
increase in shipments to U.S. ports, less cargo being shipped by air, and a general shortage of containers. While these delays have moderately
improved in recent months, we, along with many other importers of goods across all industries, continue to experience severe congestion
and extensive wait times for carriers at ports across the United States. In addition, restrictions imposed by local, state and federal
agencies due to the COVID-19 pandemic has led to reduced personnel of importers, government staff and others in our supply chain. We
have been working diligently with our network of freight partners and suppliers to expedite delivery dates and provide solutions to reduce
further impact and delays. However, we are unable to determine the full impact of these delays and how long they will continue as they
are out of our control.
While
the Company is continuing to navigate the financial, operational, and personnel challenges presented by the COVID-19 pandemic, the full
extent of the impact of COVID-19 on our operational and financial performance will depend on future developments, including the duration
and spread of the pandemic, the potential uncertainty related to and proliferation of new strains, and related actions taken by the U.S.
government, state and local government officials, and international governments to prevent disease spread, all of which are uncertain,
out of our control and cannot be predicted at this time.
Our
Corporate Strategy
The
three key pillars of our corporate strategy for growing the Company and increasing shareholder value are:
1
– Pursue aggressive organic growth; and
2
– Seek strategic relationships, mergers, and acquisitions to add to our existing business; and
3
– Pursue an uplisting to a national exchange and seek additional growth capital.
Pursue
aggressive organic growth. We serve a market for the construction and expansion of controlled environment agriculture (CEA) facilities
and businesses that is projected to grow at a 20%+ compound annual growth rate for the foreseeable future. Our primary vertical market
of cannabis cultivation facilities has been joined by the similarly rapidly growing urban vertical farming market to create two market
opportunity segments that we are positioned to serve.
Seek
strategic relationships, mergers, and acquisitions to add to our existing business. We enjoy wide brand recognition in the cannabis
cultivation industry because of our longevity in the market segment (15 years) and the number of cultivation projects (800+, including
over 200 engineering projects for licensed, commercial facilities) we have served. Our core expertise is engineering the environmental
controls of these facilities, which is a sophisticated engineering challenge due to the high humidity (latent heat) and heat load (sensible
heat) within these facilities. Not only are the loads high, but the environmental conditions within these facilities must be held within
limits that the facility’s managers request. Engineering to meet these limits requires us to consider all of the primary components
within the facility: lighting, irrigation, HVACD, fertigation, sensors, controls, CO2 dosing, monitoring and alarms, facility
physical limits such as power availability, and energy consumption. We believe that the expertise gained in working with many of the
primary components provides us with a uniquely well-informed view of the efficacy of the many primary components on offer in the marketplace.
We further believe that this knowledge will help us make wise choices of which products to pursue for strategic relationships, and which
providers to potentially merge with or acquire. For smaller component providers we believe that our publicly traded platform and our
existing sales and marketing reach will make us an attractive partner.
Pursue
an uplisting to a national exchange and a growth-supporting capital raise. In 2019 our revenue grew 60% year-over-year, and we had
our first-ever cash flow positive year. Despite the challenges brought on by the COVID-19 pandemic in the first half of 2020, we believe
that our revenue growth in 2019 and then in the Q3 2020 – Q2 2021 period validates our market opportunity and our business model.
We also recognize that the costs of being a small public company are substantial and require cash that could otherwise be used to sustain
and grow the business. There is only one solution to this issue, we believe: rapid revenue and margin growth. We believe that we have
growth opportunities, but we are capital constrained and must seek outside financing to pursue the growth we believe we can achieve.
We are aware that a capital raise is potentially dilutive to our existing shareholders and options holders, which include our directors,
officers, executives, and all of our employees. The Company has not raised capital in over three years. In that time our management has
operated the business with financial discipline, which included reducing headcount and deferring compensation as needed. Despite this
financial discipline we achieved record revenue growth. With additional capital, we believe that we can achieve much more. Uplisting
to a national exchange will enhance our stock as a currency for both potential investors and for potential acquisition targets, as well
as enhancing our credibility in the eyes of potential customers. Uplisting will require a reverse split of our stock.
Our
Updated Organic Growth Strategy
Our
growth strategy over the last few years had three primary components: increase number of customers by expanding our product line, increase
order size per customer by offering more products our customers need, and increase the number of sales opportunities by engaging in strategic
relationships with other leading technology providers who could bring us customers. While we will continue to conduct these activities,
we have recently updated and expanded our growth strategy in response to market opportunities and will execute it over the coming months.
Since
the Company was founded in 2006 as Hydro Innovations, the story of Surna has been one of growth and change, from a garage start-up in
Texas in 2006 to a publicly traded corporation serving one of the fastest growing industries in the world. Our markets and customers
have likewise changed as controlled environment agriculture has grown to include many plants and types of facilities. As our customers
grow and their needs expand, we intend to grow with them.
The
Company’s primary expertise has been the engineering and supply of environmental control technologies to meet the sophisticated
demands of indoor CEA facilities. Most, but not all, of our customers have historically been in the legal cannabis industry and we believe
that we are the oldest and most experienced company providing such services and products to the industry. Mechanical engineering is the
core of our expertise and we maintain our own staff of licensed professional engineers, enabling us to stamp drawings anywhere in the
US and Canada.
In
recent years we expanded our product line and as of this writing we now are selling the following products and services:
Changes
in our business and markets
According
to leading cannabis market research firms like Headset and New Frontier Data, the North American cannabis industry is expected to experience
compound annual growth on the order of 20%-25% over the foreseeable future. More US states are legalizing either medical or recreational
use of cannabis products, and sometimes both. Although the market is well aware of how the cannabis sector is growing, it seems to be
less aware of the non-cannabis CEA market, particularly the vertical farming segment which is growing nearly as fast as the cannabis
market. Since the technical infrastructure and requirements for growing any plant in a controlled environment are similar, we believe
that we can bring our engineering expertise to this other high growth market.
In
light of these market changes we have updated our organic growth strategy which can be summarized as: New Markets, New Products and
Services, New Trade Name.
|
|
1.
|
New
Markets - we will increase the addressable markets we serve – from primarily cannabis
to the broader CEA market, including greenhouse and vertical farming facilities. We have
already worked on several such non cannabis projects.
|
|
|
2.
|
New
Products and Services - we will expand our product and service range – expanding
from exclusively environmental control to include most of the CEA technical infrastructure
(see table below) and from facility selection to full lifecycle support after construction.
In addition, we will increase our product and service range in each product category. We
already provide some of these products and services, as noted below. As we do with environmental
control, we will act as technology-agnostic engineers and assess each customer application,
offering alternative designs and a select range of curated technologies.
|
|
|
3.
|
New
Trade Name – as we announced on May 4, 2021, we have enhanced our branding to Surna
Cultivation Technologies to capture the changes in our capabilities and markets and to make
it easier for prospects to find us.
|
CEA
Facility Technical Infrastructure
Our
primary objective in expanding our service and product offerings is to improve our customers’ operations and sustainability, increase
customer acquisition, and enhance our revenue and revenue recurrence.
Customer
Operations – first and foremost we seek to help our customers build the most effective and efficient facility possible. We
believe that we are uniquely positioned to engineer all of the complex components of a CEA facility into a holistic whole because of
our dedicated engineering staff and our experience in over 800 projects including over 200 commercial facilities. Our 15 years in the
business has provided us a wide network of technology vendors from which we curate a selection of the best products. In addition, we
are the leading experts in applying the most challenging component of the technical infrastructure, the environmental controls, and we
have the knowledge required to engineer the interactions among the required components. A professional engineer (PE) license is not required
for the design of any other component in the facility and this engineering knowledge is one of our greatest strengths.
Sustainability
– indoor cultivation facilities, like data centers, are resource intensive. Several US states have implemented building code
changes that place limits on the energy consumption allowed within cultivation facilities, and we anticipate that more states will do
the same. Among our objectives is to provide our customers with the most energy-efficient alternatives for their infrastructure. Energy
and resource efficiency is a high priority to us as engineers, and our most senior engineering staff hold the LEED (Leadership in Energy
and Environmental Design) credential. Our CEO previously helped build a cleantech company, has been involved in the cleantech industry
for over five years, and published a book on selling energy efficient technologies. We believe that we are in a position to lead the
industry in sustainability initiatives which our customers will highly value.
Customer
Acquisition – By offering Facility Selection & Design services we seek to build relationships with prospects at the earliest
opportunity in the lifecycle of the cultivation business. By expanding our offerings to include nearly every piece of the technical infrastructure
required in a facility we hope to engage at the earliest possible moment with the customer and earn the opportunity to provide all the
products and services required for the facility. Our post-start-up, lifecycle services will help us maintain a relationship with the
customer as long as the facility is in operation. Our observation is that our customers want to grow plants, not maintain the technical
infrastructure of complex systems, and we believe that they will accept our offer to do so, as some already have.
Revenue
and Revenue Recurrence – We believe that our revenue can be expanded by offering most of the primary technical infrastructure
components for a cultivation facility. For example, if we are able to provide all of the primary infrastructure components to a cultivation
facility, our revenue on a project could be up to 200% higher than if we provided the environmental controls systems alone. In the past
we did not have products or services to offer our customers after a facility was constructed. We have recently begun to offer maintenance
services, and we believe that by expanding this service offering we will be able to gain long-term recurring revenue on a subscription
basis.
Our
Commercial-Scale Projects
During
the first six months of 2021, we entered into sales contracts for seven new build projects and one retrofit project, each with a contract
value over $100,000, which we refer to as commercial-scale projects. These new contracts totaled $5,597,000, which consisted of $5,433,000
for the new build projects (97%) and $164,000 for the retrofit project (3%).
Our
Bookings, Backlog and Revenue
During
the three months ended June 30, 2021, we executed new sales contracts with a total contract value of $1,053,000. During this same period,
we had positive change orders of $85,000 and cancellations of $219,000. The cancellations were based on discussions with customers who
have abandoned their projects. After adjustments for these change orders and cancellations, our net bookings in the three months ended
June 30, 2021 were $919,000, representing a decrease of $4,578,000 (or 126%) from net bookings of $5,497,000 in the first quarter of
2021.
Our
backlog at June 30, 2021 was $7,987,000, a decrease of $3,590,000, or 42%, from March 31, 2021. The decrease in backlog is the result
of our lower net bookings and higher revenue in the second quarter. Revenue was higher primarily due to fulfilling orders which had delays
in production and delivery by some of our suppliers in the first quarter. Our backlog at June 30, 2021 includes booked sales orders of
$1,282,000 (16% of the total backlog) from several customers that we do not expect to be realized until 2022, 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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|
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June 30, 2020
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|
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September 30, 2020
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|
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December 31, 2020
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|
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March 31, 2021
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|
|
June 30, 2021
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|
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Backlog, beginning balance
|
|
$
|
8,875,000
|
|
|
$
|
5,592,000
|
|
|
$
|
8,198,000
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|
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$
|
8,448,000
|
|
|
$
|
11,578,000
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|
|
Net bookings, current period
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|
$
|
(1,601,000
|
)
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$
|
4,241,000
|
|
|
$
|
3,637,000
|
|
|
$
|
5,497,000
|
|
|
$
|
919,000
|
|
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Recognized revenue, current period
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|
$
|
1,682,000
|
|
|
$
|
1,635,000
|
|
|
$
|
3,387,000
|
|
|
$
|
2,367,000
|
|
|
$
|
4,510,000
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|
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Backlog, ending balance
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|
$
|
5,592,000
|
|
|
$
|
8,198,000
|
|
|
$
|
8,448,000
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|
|
$
|
11,578,000
|
|
|
$
|
7,987,000
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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 for the Company at each quarter-end, there remains significant uncertainty regarding the timing of revenue
recognition of our backlog as of June 30, 2021. As of June 30, 2021, 26% 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 June 30, 2021, 74% 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 Q2 2021 backlog), using separate time bands, with respect to engineering only paid contracts and partial
equipment paid contracts. We estimate that we will recognize approximately 84% of our Q2 2021 backlog during the remainder of 2021, or
$6.7 million. However, there continues to be significant uncertainty regarding the timing of our recognition of revenue on our Q2 2021
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 generate revenues or when the 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, 2021 and 2020
Revenues
and Cost of Goods Sold
Revenue
for the three months ended June 30, 2021 was $4,510,000, compared to $1,682,000 for the three months ended June 30, 2020, representing
an increase of $2,827,000, or 168%. The increase was primarily due to equipment revenue which included several of our new product offerings
consisting of our custom air handlers, SentryIQ™ controls products, our expanded dehumidifier offering and DX split systems, among
others. The increase was also due to a COVID-19-driven slowdown impacting revenue for the three months ended June 30, 2020.
Cost
of revenue increased by $1,820,000, or 129%, from $1,408,000 for the three months ended June 30, 2020 to $3,227,000 for the three months
ended June 30, 2021. The increase was primarily due to an increase in revenue, offset by an improved gross margin as discussed below.
The
gross profit for the three months ended June 30, 2021 was $1,282,000 compared to $275,000 for the three months ended June 30, 2020, an
increase of 367%. Gross profit margin increased by twelve percentage points from 16% for the three months ended June 30, 2020 to 28%
for the three months ended June 30, 2021 due to a decrease in fixed and variable costs as a percent of revenue as described below, offset
by a decrease in the selling price of our equipment resulting in a decreased equipment margin.
Our
fixed costs (which include engineering, service, manufacturing and project management salaries and benefits and manufacturing overhead)
totaled $357,000, or 8% of total revenue, for the three months ended June 30, 2021 as compared to $283,000, or 17% of total revenue,
for the three months ended June 30, 2020. The increase of $75,000 was primarily due to an increase in salaries and benefits (including
stock-based compensation) of $74,000.
Our
variable costs (which include the cost of equipment, outside engineering costs, shipping and handling, travel and warranty costs) totaled
$2,870,000, or 64% of total revenue, in the three months ended June 30, 2021 as compared to $1,125,000, or 67% of total revenue, in the
three months ended June 30, 2020. The increase in variable costs was primarily due to: (i) higher equipment costs of $1,887,000 resulting
from an increase of nine percentage points for equipment costs as a percentage of total revenue , (ii) an increase in travel of $49,000,
(iii) an increase in warranty expense of $23,000, offset by (iv) a decrease in excess and obsolete inventory expense primarily related
to a Q2 2020 charge for the delay and potential cancellation of one customer’s project which was subsequently recognized in the
third quarter of 2020 of $202,000, and (v) a decrease in outside engineering services of $14,000.
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 bookings into revenue, and the implementation over time of lower-cost supplier alternatives.
Operating
Expenses
Operating
expenses increased to $1,166,000 for the three months ended June 30, 2021 from $880,000 for the three months ended June 30, 2020, an
increase of $286,000, or 33%. The operating expense increase consisted of: (i) an increase in selling, general and administrative expenses
(“SG&A expenses”) of $176,000, (ii) an increase in advertising and marketing expenses of $73,000, and (iii) an increase
in product development expenses of $37,000.
The
increase in SG&A expenses for the three months ended June 30, 2021 compared to the three months ended June 30, 2020, was primarily
due to: (i) an increase of $93,000 in salaries, benefits and other employee related expenses, (ii) an increase of $80,000 for commissions,
(iii) an increase in accounting, consulting and other professional fees of $65,000, (iv) an increase in investor relations expenses of
$37,000, (v) an increase of $14,000 for facility, office and other expenses, (vi) an increase in loss on asset disposal of $8,000, (vii)
an increase in travel of $7,000, offset by (viii) a decrease in bad debt expense of $61,000, (ix) a decrease in stock related compensation
for employees, consultants and directors of $51,000, (x) a decrease in depreciation of $12,000, and (xi) a decrease in business taxes
and licenses of $4,000.
The
increase in marketing expenses was primarily due to (i) an increase in advertising and promotion of $36,000, (ii) an increase in salaries
and benefits (including stock compensation) of $31,000, (iii) an increase in expenses for trade shows of $12,000, offset by (iv) a decrease
in expenses related to outside services and other marketing expenses of $6,000.
The
increase in product development costs was due to (i) an increase in salaries and benefits (including stock compensation) of $27,000,
(ii) an increase in material costs of $8,000, and (iii) an increase in travel of $2,000.
Operating
Income (Loss)
We
had operating income of $116,000 for the three months ended June 30, 2021, as compared to an operating loss of $606,000 for the three
months ended June 30, 2020, an increase of $722,000, or 119%. The operating income for the three months ended June 30, 2021 included
$71,000 of non-cash, stock-based compensation and $17,000 of depreciation and amortization expense, compared to $107,000 of non-cash,
stock-based compensation and $29,000 of depreciation and amortization expense for the three months ended June 30, 2020. Excluding these
non-cash items, our operating income increased by $674,000, or 144%.
Other
Income (Expense)
We
had other income (net) of $149,000 for the three months ended June 30, 2021 compared to other expense (net) of $8,000 for the three months
ended June 30, 2020. Other income for the three months ended June 30, 2021 primarily consisted of $138,000 related to the Employee Retention
Credit as part of the CARES act and $12,000 for rental income from the sub-lease of a portion of our facility.
Net
Income (Loss)
Overall,
we had net income of $265,000 for the three months ended June 30, 2021 as compared to a net loss of $614,000 for the three months ended
June 30, 2020, an increase of $879,000, or 143%. The net income for the three months ended June 30, 2021 included $71,000 of non-cash,
stock-based compensation and $17,000 of depreciation and amortization expense, compared to $107,000 of non-cash, stock-based compensation
and $29,000 of depreciation and amortization expense for the three months ended June 30, 2020. Excluding these non-cash items, our net
income increased by $831,000, or 174%.
Comparison
of Six Months Ended June 30, 2021 and 2020
Revenues
and Cost of Goods Sold
Revenue
for the six months ended June 30, 2021 was $6,876,000, compared to $3,492,000 for the six months ended June 30, 2020, representing an
increase of $3,384,000, or 97% partially due to a COVID-19-driven slowdown impacting revenue for the six months ended June 30, 2020.
Cost
of revenue increased by $2,488,000, or 90%, from $2,761,000 for the six months ended June 30, 2020 to $5,249,000 for the six months ended
June 30, 2021 primarily due to the increase in revenue.
The
gross profit for the six months ended June 30, 2021 was $1,627,000 compared to $731,000 for the six months ended June 30, 2020, an increase
of 123%. Gross profit margin increased by three percentage points from 21% for the six months ended June 30, 2020 to 24% for the six
months ended June 30, 2021 primarily due to a decrease in fixed costs as a percent of total revenue, offset by a decrease in the selling
price of our equipment resulting in a decreased equipment margin and, an increase in other variable costs as a percent of total revenue
as described below.
Our
fixed costs (which include engineering, service, manufacturing and project management salaries and benefits and manufacturing overhead)
totaled $694,000, or 10% of total revenue, for the six months ended June 30, 2021 as compared to $582,000, or 17% of total revenue, for
the six months ended June 30, 2020. The increase of $112,000 was due to an increase in salaries and benefits (including stock-based compensation)
of $120,000, offset by a decrease in fixed overhead of $8,000.
Our
variable costs (which include the cost of equipment, outside engineering costs, shipping and handling, travel and warranty costs) totaled
$4,555,000, or 66% of total revenue, in the six months ended June 30, 2021 as compared to $2,179,000, or 62% of total revenue, in the
six months ended June 30, 2020. The increase in variable costs was primarily due to higher equipment costs as a result of higher revenue.
The reduction in the selling price of our equipment resulted in lower equipment margins. Other factors included: (i) an increase in warranty
of $103,000 which was partially the result of a reimbursement in 2020 from a customer for costs incurred in 2019 related to a failure
later deemed to be non-warranty, (ii) an increase in travel of $35,000, offset by (iii) a decrease in excess and obsolete inventory of
$222,000 primarily related to a charge in 2020 for the delay and potential cancellation of one customer’s project which was subsequently
recognized in the third quarter of 2020, (iv) a decrease in outside engineering services of $51,000, (v) a $30,000 decrease in other
variable costs, and (vi) a decrease in shipping and handling of $16,000.
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 $2,197,000 for the six months ended June 30, 2021, from $2,283,000 for the six months ended June 30, 2020, a decrease
of $87,000, or 4%. The operating expense decrease consisted of: (i) a decrease in selling, general and administrative expenses (“SG&A
expenses”) of $192,000, offset by (ii) an increase in advertising and marketing expenses of $101,000 and (iii) an increase in product
development expense of $4,000.
The
decrease in SG&A expenses for the six months ended June 30, 2021, compared to the six months ended June 30, 2020, was due primarily
to: (i) a decrease of $192,000 in stock-related compensation expense to employees, consultants and directors, (ii) a decrease in bad
debt expense of $61,000, (iii) a decrease in accounting, consulting and other professional fees of $27,000, (iv) a decrease of $24,000
for depreciation, (v) a decrease of $23,000 for cash fees paid to directors, (vi) a decrease of $20,000 in travel, offset by (vii) an
increase in commissions of $70,000, (viii) an increase of $50,000 in salaries, benefits and other employee related costs, (ix) an increase
of $25,000 for investor relations expenses and (x) an increase in facilities, office and other expenses of $10,000.
The
increase in marketing expenses was primarily due to (i) an increase in advertising and promotion expense of $52,000, (ii) an increase
in salaries and benefits (including stock compensation) of $45,000, (iii) an increase of $9,000 for web development, (iv) an increase
for expenses related to trade shows of $6,000, offset by (v) a decrease in outside services and other marketing expenses of $11,000.
The
increase in product development costs was due to an increase in materials costs of $24,000 offset by a decrease in salaries and benefits
(including stock compensation) of $20,000.
Operating
Income (Loss)
We
had operating loss of $570,000 for the six months ended June 30, 2021, as compared to an operating loss of $1,552,000 for the six months
ended June 30, 2020, a decrease of $982,000, or 63%. The operating loss for the six months ended June 30, 2021 included $131,000 of non-cash,
stock-based compensation and $33,000 of depreciation expense, compared to $298,000 of non-cash, stock-based compensation and $58,000
of depreciation expense for the six months ended June 30, 2020. Excluding these non-cash items, our operating loss decreased by $791,000,
or 66%.
Other
Income (Expense)
We
had other income (net) of $42,000 for the six months ended June 30, 2021 compared to other income (net) of $100 for the six months ended
June 30, 2020. Other income for the six months ended June 30, 2021 primarily consisted of income of $138,000 related to the Employee
Retention Credit as part of the CARES act, $12,000 for rental income from the sub-lease of a portion of our facility, offset by $107,000
in expense related to the settlement of litigation with a former employee.
Net
Income (Loss)
Overall,
we had net loss of $528,000 for the six months ended June 30, 2021 as compared to a net loss of $1,552,000 for the six months ended June
30, 2020, a decrease of $1,024,000, or 66%. The net loss for the six months ended June 30, 2021 included $131,000 of non-cash, stock-based
compensation, $67,000 of other stock-based expense (related to the settlement of litigation with a former employee), and $33,000 of depreciation
expense, compared to $298,000 of non-cash, stock-based compensation and $58,000 of depreciation expense for the six months ended June
30, 2020. Excluding these non-cash items, our net loss decreased by $899,000, or 75%.
Financial
Condition, Liquidity and Capital Resources
Cash,
Cash Equivalents and Restricted Cash
As
of June 30, 2021, we had cash and cash equivalents of $1,643,000, compared to cash and cash equivalents of $2,285,000 as of December
31, 2020, a decrease of 28%. The $641,000 decrease in cash and cash equivalents during the six months ended June 30, 2021, was primarily
the result of cash used in our operating activities of $1,141,000, offset by proceeds from a note payable of $514,000. Our cash is held
in bank depository accounts in certain financial institutions. During the six months ended June 30, 2021, we held deposits in financial
institutions that exceeded the federally insured amount. During the six months ended June 30, 2021, the Company transferred a balance
of $180,000 into a new bank account which was to be used for the sole purpose of paying certain warranty claims. The balance on this
restricted bank account as of June 30, 2021 was $0.
As
of June 30, 2021, we had accounts receivable (net of allowance for doubtful accounts) of $234,000, inventory (net of excess and obsolete
allowance) of $444,000, and prepaid expenses of $1,987,000 (including $1,873,000 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 continue
to pursue larger projects.
As
of June 30, 2021, we had total accounts payable and accrued expenses of $1,910,000, deferred revenue of $4,056,000, accrued equity compensation
of $109,000, other current liabilities of $37,000 and the current portion of operating lease liability of $261,000. As of June 30, 2021,
we had a working capital deficit of $2,063,000, compared to a working capital deficit of $2,220,000 as of December 31, 2020. The decrease
in our working capital deficit was primarily related to (i) an increase in prepaid expenses of $949,000, (ii) an increase in accounts
receivable of $201,000, (iii) an increase in inventory of $117,000, offset by (iv) a decrease in cash of $641,000, (iv) an increase in
deferred revenue (which represents cash received from customers in advance of the performance of services or the delivery of equipment)
of $332,000, and (v) an increase in accounts payable and accrued liabilities of $125,000.
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 approximate cash flows for the six months ended June 30, 2021 and 2020:
|
|
|
For the Six Months Ended June 30,
|
|
|
|
|
2021
|
|
|
2020
|
|
|
Net cash used in operating activities
|
|
$
|
(1,141,000
|
)
|
|
$
|
(1,241,000
|
)
|
|
Net cash used in investing activities
|
|
|
(14,000
|
)
|
|
|
-
|
|
|
Net cash provided by financing activities
|
|
|
514,000
|
|
|
|
554,000
|
|
|
Net decrease in cash
|
|
$
|
(641,000
|
)
|
|
$
|
(687,000
|
)
|
Operating
Activities
We
incurred a net loss for the six months ended June 30, 2021 of $528,000 and have an accumulated deficit of $27,972,000 as of June 30,
2021.
Cash
used in operations for the six months ended June 30, 2021 was $1,141,000 compared to cash used in operations of $1,241,000 for the six
months ended June 30, 2020, a decrease of $100,000.
The
decrease in cash used in operating activities during the six months ended June 30, 2021 was primarily attributable to: (i) a decrease
in net loss of $1,024,000, (ii) a decrease of $840,000 in non-cash operating charges, and (iii) an increase in cash used to fund working
capital of $84,000.
The
significant change in non-cash operating charges was due to (i) a decrease in share-based compensation of $710,000, (ii) a decrease in
the provision for excess and obsolete inventory of $202,000, and (iii) an increase in other share-based compensation of $67,000.
The
significant changes in working capital related to: (i) an increase in prepaid expenses of $949,000, (ii) an increase in accounts receivable
of $201,000, (iii) an increase in inventory of $117,000, offset by, (iv) a decrease in cash of $641,000, (iv) an increase in deferred
revenue (which represents cash received from customers in advance of the performance of services or the delivery of equipment) of $332,000,
and (v) an increase in accounts payable and other liabilities of $125,000.
Investing
Activities
The
$14,000 cash used in investing activities during the six months ended June 30, 2021 was related to the purchase of property and equipment
of $15,000, offset by proceeds from the sale of property equipment of $1,000. The Company undertook no investing activities during the
six months ended June 30, 2020.
Financing
Activities
During
the six months ended June 30, 2021, the Company entered into a note payable with its current bank in the principal amount of $514,200,
for working capital purposes. During the six months ended June 30, 2020, the Company entered into a note payable with its current bank
in the principal amount of $554,000, for working capital purposes.
Going
Concern
Our
condensed consolidated financial statements for the six months ended June 30, 2021, 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, 2020, a
statement that there is substantial doubt as to our ability to continue as a going concern, and our consolidated financial statements
for the year ended December 31, 2020 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 continuing to generate sales and 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.
Based on our current assessment of our business, there is 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 for the six months ended June 30, 2021, are issued. Our condensed
consolidated financial statements do not include any adjustment that might result from the outcome of this uncertainty.
The
Company is subject to a number of risks similar to those of other similar stage and situated companies, including general economic conditions;
its customers’ operations and prospects for and ability to obtain project financing; market and business disruptions, that include
the effects of the COVID-19 pandemic and government response; dependence on key individuals; successful development, marketing and branding
of products; uncertainty of product development and generation of revenues; dependence on outside sources of financing; risks associated
with research, development; dependence on third-party suppliers and collaborators; protection of intellectual property; and competition
with larger, better-capitalized companies. Ultimately, the attainment of profitable operations is dependent on future events and obtaining
adequate financing to fulfill Company business development plans and activities and generating a level of revenues adequate to support
the Company’s cost structure.
The
Company also will be affected by constraints on the availability of capital to its customers and customer prospects who have commenced,
or are contemplating, new or expanded cultivation facilities. The extent to which COVID-19 will impact the customer and Company business
activities and financial results will depend on future developments, which are uncertain and cannot be predicted. Other factors that
will impact the Company’s ability to continue operations include the market demand for the Company’s products and services,
the ability to service its customers and prospects, potential contract cancellations, project scope reductions and project delays, the
Company’s ability to fulfill its backlog, the management of working capital, and the continuation of normal payment terms and conditions
for purchase of the Company’s products. The Company believes its cash balances and cash flow from operations will be insufficient
to fund its operations for the next twelve months. If the Company is unable to increase revenues, or otherwise generate cash flows from
operations, there is substantial doubt about the Company’s ability to continue as a going concern for a period of one year from
the date the financial statements are issued. These 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 increase revenues or otherwise generate cash flows from operations, we will need to raise additional funding to continue as
a going concern. We will need to obtain financing in order to continue our operations and achieve our growth strategies. 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 can downsize or reorient
operations 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.
There
can be no assurance that the Company will be able to raise debt or equity financing in sufficient amounts, when and if needed, on acceptable
terms or at all. The Company’s ability to raise equity capital is also limited by the Company’s stock price, and any such
issuance could be highly dilutive to existing shareholders.
Inflation
In
the opinion of management, inflation has not had a material effect on our operations to date. Due to the pandemic, however, there is
the possibility that we will face inflationary pressures in certain aspects of our business operations, such as equipment cost, in the
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, 2021, 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.
During
2020, the Company entered into an agreement with its landlord to apply its rent deposit of $52,600 to rent payments due during the period.
The deposit required on the lease was reduced to approximately $32,000 and is payable in 12 monthly installments from January through
December of 2021. As of June 30, 2021, approximately $16,000 has been paid toward said deposit. Further, the landlord also agreed to
defer payment of fifty percent of the three months of lease payments (base rent only) for the period July to September 2020. The deferred
lease payments amount to approximately $30,000 and are payable in 12 monthly installments from January to December 2021. As of June 30,
2021, approximately $15,000 of the deferred rent has been paid back to the landlord.
Commitments
and Contingencies
Refer
to Note 7 – 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, 2021, we had no off-balance sheet arrangements. During the six months
ended June 30, 2021, 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 7 of our condensed consolidated financial statements.
Recent
Developments
Refer
to Note 12 - 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, 2021.
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.