Energy Focus, Inc.

Greetings. Welcome to the Energy Focus Inc. fourth quarter and fiscal year end 2022 conference call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. Please note this conference is being recorded. I will now turn the conference over to your host, Jim Warren, Senior Vice President and General Counsel. You may begin.

Thank you, Operator, and good morning, everyone. Joining me on the call today is Leslie Matt, Chief Executive Officer. Before we begin today's call, I'd like to remind everyone that we will make certain forward-looking statements. These statements are based upon information that represents the company's current expectations or beliefs. The results realized may differ materially from those stated. For a discussion of these risks that could affect our results, please refer to the section under the headings Risk Factors as well as Forward-Looking Statements in our most recent 10-K filed with the SEC. The company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise, except as required by law. Also, please note that during this call and in the accompanying press releases, certain financial metrics are presented on both GAAP and non-GAAP adjusted bases. Reconciliations of adjusted results to the GAAP results are available in the tables attached to the earnings release. which is posted on our corporate website at energyfocus.com in the investor relations section of the site. I will now turn the call over to Leslie.

Thank you, Jim. Good morning, everyone. Q4 was my first full quarter as CEO of Energy Focus after joining the company in mid-September following almost nine months of interim leadership by our lead independent director, Steve Sokoloff. We are grateful for his hard work and dedication towards improving energy focus during his time at the helm. Steve continues to serve as a member of our board and has been a guiding light for me on the company's path. My main focus since joining has been helping the company return to its core, work through significant supply chain constraints and legacy inventory positions, and significant cost cutting and rightsizing to poise the company to move past its troubled operating history. While it's early days for me here at the company, I will be frank that our results for the past year I will review on this call are dismal and is essentially a story of survival from which it's my job to lead us to rebuild. I believe and our strategic investors voted with their dollars in a sign of confidence that there are calmer seas and redemption ahead. Energy Focus entered 2022 with brilliant hopes that our previous ultraviolet C light disinfection, or UVCD, products would transform us into a direct-to-consumer product company and provide us with great opportunities for expansion. We had built an organization in anticipation that growth and expansion from these new products. After evaluating market demand and supply chain challenges from our UVCD products, We revised our business strategy in 2022 to focus back on LED lighting and control products for our military, maritime, and commercial and industrial lighting market with highly concentrated efforts starting in the second half of 2022. As a result of our pivot back to military, maritime, and commercial and industrial lighting and control products, the company has taken great strides in 2022 to streamline expenses and reduce our cash earn, taking an even more aggressive approach in Q4, and we anticipate seeing full results of our efforts throughout 2023. Additionally, we have overhauled our existing inventory, reduced our operating space and restructured our workforce, which included eliminating almost two-thirds of positions. All of this had primed the team to effectively execute and focus on short-term opportunities aligned with our core channels, military, maritime, commercial, and industrial markets. Unfortunately, we continue to face supply chain challenges in Q4 on our best-selling products, combined with market price pressures on current inventory, which has impacted the financial results I'm sharing with you today. Despite the challenges that 2022 presented energy focus, Through our rigorous cost-cutting efforts, we were able to position ourselves for a strategic investment by Sander Electronics in January of 2023. At the time of the investment, Jay Hong, president of Sander Electronics, joined the energy-focused board of directors as chairman, bringing a wealth of industry knowledge, factory sources, and manufacturing experience to a well-positioned board. The funding provided by the Sander investment has contributed to approximately $4.2 million in balance sheet improvements since the start of 2023. We utilize the funding to restructure many of our debts so that we can focus our cash flow back on day-to-day operations and not previous obligations. Some of these activities include a pay down of $1 million in conjunction with a restructuring of our secured inventory line through Crossroads Financial that will reduce our overall cost of this facility in 2023. A pay down of $500,000 in restructuring of a payment schedule with our outstanding bridge note held by Struderville Financial that will better align the timing of the cash burden with what we anticipate to be increased cash flows from sales later in 2023. An agreed termination on our accounts receivable lending facility. A conversion of promissory notes totaling $1.5 million to common stock reducing future cash burdens. In addition to the financial improvement, Jay and the Sander Electronics team have been instrumental in addressing the supply chain problems that hobbled energy focus in 2022. I am beyond excited to report that we have sourced new vendors, placed orders with tentative ship dates, and inventory is anticipated for second quarter of this year. Finally, orders for our popular REDCap emergency lighting products continues to build a healthy backlog that was not realized in 2022 because of sourcing challenges. However, we anticipate resuming shipping REDCap to help fill this backlog even before the close of Q2. Our in-focus power line control products continue to gain interest as more customers are educated around this innovative power line control technology as we round out the product offering. We look to improve and expand our in-focus power line control product portfolio so that customers can realize all the wellness benefits of human-centric lighting while being cost-conscious in their retrofit efforts. In my time at Energy Focus, InFocus has received positive feedback from current customer installations, and I'm looking forward to expanding sales in this category in 2023. Staying on the theme of a steady and increased demand, I am pleased to report that the strategic hire that we made in May of 2022 to service our government sales channel continues to build a strong backlog of orders for the military maritime market. Prior to this hire, our military sales pipeline as we entered 2022 was dwindling, and keep in mind that these are long lead times made to order sales. Our new government sales lead immediately went to work shoring up the sales pipeline and continues to drive booked orders. Although supply chain constraints in Q4 of 2022 prevented the company from fully realizing his efforts in the year-end results with some of the orders slipping into the first quarter of 2023, we have resolved these logjams and look forward to sharing what we anticipate being strong sales numbers in this channel in 2023. As a company, we're also looking at other products that we can offer this channel to increase our percentage of winning bids. The standard investment has also allowed for energy focus to think beyond the constraints of lighting products and carefully expand into other energy solution products categories that appropriately align with our current markets and sales channels. In early 2023, we announced our expansion into gallium nitride, or more commonly referred to as GAN, power supplies. These are power supplies for LED lamps, lumineers, and displays that well align with our core business and standards expertise. We believe that working together, we will be able to expand our offering to include components and end products in energy-related fields. Our joint technical cooperation and development will allow us to pursue expected opportunities in the fields of energy conservation, energy storage, and energy management systems. Initially, we plan to offer these items to the lighting industry and tap into our combined team's experience in LED lighting design, manufacturing, and sales. Compared to legacy silicon-based power electronics, our GaN power supply products are expected to be more compact in size, with higher efficiency, and produce less heat from operation. We are also looking at many other what we refer to as energy solution products to expand our portfolio and sales potential. Although it is premature to release all of the details today, I am personally excited as I look at the prospective expansion plans for energy focus. With a promise towards the future, let me now review our financial performance for the quarter and the year. Net sales of 663,000 for the fourth quarter of 2022 decreased 72.4% compared to sales of 2.4 million in fourth quarter of 2021, driven mainly by a decrease in military sales. Both commercial and military sales were heavily impacted by supply chain constraints, and the military channel also suffered from a weak sales pipeline early in the year prior to our strategic hire. When compared to 1.8 million in the third quarter of 2022, sequential net sales were primarily down due to a decrease in commercial product sales. Net sales of our commercial products were 349,000 or 52.7% of total net sales for the fourth quarter of 2022. A decrease as compared to net sales of 1.2 million or 48.6% of total net sales for the fourth quarter of 2021, reflecting our supply chain constraints and the continued long-term impacts of the COVID-19 pandemic due to fluctuations in the timing, pace, and size of commercial projects. Sales of our military products decreased in fourth quarter, mainly due to the supply chain impacts as well as continued delays of government funding available for certain projects and the continued delay timing of orders. Gross loss for the fourth quarter of 2022 was 0.2 million compared with gross profit of 0.2 million in the fourth quarter of 2021, a decrease of 200% year over year. Recall that in 2021, we recorded a 0.9 million for the employee retention tax credits as well, though we continue to wait to receive half of those funds. As a percentage of revenue, Gross profit margin was a negative 35.9% in the fourth quarter of 2022 compared to 7.9% in the fourth quarter of 2021. The year-over-year decline in gross margin was primarily driven by higher variable costs as we slowed down inventory on hands. Variable costs increased 57% as compared to the fourth quarter of 2021 to 123%. Adjusting gross profit margin, For excess and obsolete in transit and net realizable value inventory reserve resulted in the non-GAAP adjusted gross margins of negative 55.8% for the fourth quarter of 2022 compared to 14.7% in the fourth quarter of 2021 and 3.2% in the third quarter of 2022. Gross margin was heavily depressed by the impact of fixed costs on low sales levels as well as our inventory reduction program including sell-through pricing, scrap and liquidation activity, and excess and obsolete reserve activity. Based on our levels of fixed costs, if we can again obtain quarterly sales levels greater than $3.5 million, we continue to expect our overall gross margins to be in the mid-20s. As we move forward on these run rates, we anticipate we will begin to approach the high 20s percentage range as we introduce new products and implement more aggressive value-added and value engineering initiatives to accompany our increased sales volume as well as depending on our sales mix and inventory valuations. However, we will continue to see some fluctuations quarter to quarter. Operating expenses in the fourth quarter of 2022 were $1.8 million or 269.4% of sales compared to $2.5 million or 105.8% of sales in the fourth quarter of 2021. The decrease is attributable to reduction in payroll and payroll-related expenses due to our realignment initiatives over the past year, as well as decreased advertising and promotion costs. Sequentially, operating expenses decreased approximately $458,000 from the $2.2 million in the third quarter of 2022, reflecting lower product development and SG&A expense as the company entered its current strategic initiatives. Loss from operations for the fourth quarter of 2022 was $2 million compared to an operating loss of $2.4 million in the fourth quarter of 2021. Sequentially, this compares to a loss from operations of $2.4 million in the third quarter of 2022, an improvement of $383,000. Net loss was $2.3 million, or $0.24 per basic and diluted share of common stock, for the fourth quarter of 2022 compared with net loss of $2.6 million or 50 cents per basic and diluted share of common stock in the fourth quarter of 2021. Sequentially, this compares with a net loss of $2.7 million or 29 cents per basic and diluted share of common stock in the third quarter of 2022. Adjusted EBITDA, a non-GAAP measure which excludes depreciation and amortization, interest expense, stock based and other non-reoccurring charges and or sources of income such as incentive compensation and impairment charges taken against fixed assets with a loss of $1.8 million for the fourth quarter of 2022 compared with a loss of $2.2 million in the fourth quarter of 2021 and a loss of $2.3 million in the third quarter of 2022. Adjusted EBITDA improved from the prior year despite lower sales due to significant cost-cutting initiatives in SG&A. For the full year, net sales were $6 million for 2022 compared with $9.9 million for 2021. Net sales from commercial products were $3.7 million or 62.8% of total sales for 2022 compared with $4.6 million or 47.5% of total net sales for 2021. Net sales from military and maritime market products were 2.2 million or 37.2% of total net sales for 2022 compared with 5.2 million or 52.5% of total net sales for 2021. Growth loss was 0.3 million or negative 5.3% of net sales for 2022 compared with gross profit of 1.7 million or 17.2% of net sales for 2021. Gross margin for 2022 included unfavorable price and usage variances for materials and labor of 0.7 million or 29% of net sales and unfavorable inventory and warranty reserve adjustments of 0.5 million or 8.7% of net sales. Adjusted gross margin was negative 4.8% for full year 2022 compared to 18.8% in the prior year due to higher variable costs from selling higher-priced inventory on hand. We reviewed all six assets and identified any that were disposed or carried a reduced fair value. The recognized loss better positioned the company to reflect current value and focus on future growth. Operating loss was $9.3 million for 2022 compared with an operating loss of $8.7 million for 2021. Net loss was $10.3 million or $1.27 per basic and diluted share of common stock for 2022. This compares with net loss of $7.9 million or $1.73 per basic and diluted share of common stock for 2022 compared inclusive of non-cash pre-tax gains of $1.7 million from the forgiveness of our Paycheck Protection Program loan and other income recorded relating to the Employee Retention Tax Credit. Adjusted EBITDA was a loss of $8.7 million for 2022 compared with a loss of $7.9 million for 2021. The increased adjusted EBITDA loss in 2022 as compared to 2021 was primarily due to gross margin reductions from lower sales and higher costs of goods sold.

Now I'd like to turn to the balance sheet.

Cash was $52,000 as of December 31, 2022, as compared to $2.7 million as of December 31, 2021. As of December 31, 2022, the company had total availability of $107,000, which consisted of $52,000 of cash and $55,000 of additional borrowing availability under its credit facilities. This compares to total availability of $4.4 million as of December 31, 2021. Recall, we had just completed an equity raise at the end of December 2021 as reflected in our cash and availability balances. As a reminder, total availability is a non-gap measurement of our access to cash at any given point in time and we believe is a much more relevant metric than simply looking at the cash balance or even the net debt on the balance sheet. Excess borrowing availability in our credit facilities represents the difference between the maximum borrowing capacity of the credit facilities and our actual borrowings under these credit facilities. The access availability under our credit facilities was $55,000 at the end of the fourth quarter 2022 and $169,000 at the end of the third quarter 2022 and $1.7 million at the end of the fourth quarter 2021. During the fourth quarter 2022, cash used in operations was $472,000, of which a net loss from operations used $2.3 million of cash but that was offset by a source of cash attributable to working capital of $1.6 million while cash used in investing activities was $16,000 and the company generated $4.1 million in cash from financing activities. Our net inventory balance of $5.5 million as of December 31, 2022 decreased $2.4 million over December 31, 2021. With that, We would like to open the call to questions.

Thank you.

At this time, we will be taking a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Our first question comes from the line of Samir Joshi with HC Wainwright. Please proceed with your question.

Thanks. Good morning, Leslie. Thanks for taking my questions. In terms of the recovery of top line returning to previous levels, should we expect 2023 to revert to say 2021 levels or could you reach the 2020 levels reached of excess of 15 million?

Thank you for your question, Sameer. My expectation is to at least reach the 2021 levels, if not exceed. Okay, okay, okay.

And then in terms of the distribution between commercial versus military, I know you've provided commentary on a military backlog or at least pipeline expanding. How should we look at the mix going forward during the rest of the year and contribution from military over the year?

Thank you. Yes, we have attributed a large backlog as we headed into 2023. And I anticipate our mix to be around 50-50 as we continue throughout the year with a larger amount in Q1 because of that slippage that we reported in Q4 of 22.

Yes, yes. And are the margins, how is the margin profile? And will you just give us a high level on the type of products that are going to commercial versus military and the margin differences there?

Yeah, so there are large margin differences between our commercial and our military products. Through our cost reduction efforts, We are hopeful to improve our margin levels on both commercial and military lines as we move forward throughout 2023. And our partners, Sander Electronics, are helping us improve those margin levels, which we hope to report in future quarters.

Got it. And just on the InFocus module, I think it was being proved out in the last quarter, in 4Q, I mean, and product launch was expected around the end of last year. Is that rollout underway for the InFocus module?

Yes. Unfortunately, our InFocus rollouts were delayed due to some supply chain challenges in 2022 and beginning at the start of this year as well. We are hopeful to resume those activities and launch those products in 2023. Okay, okay.

And on the, just going back to the military, how should we, like what is the visibility? Meaning these are long lead time activities. revenues, but how much visibility do you have, like one year out, two year out?

How should we think about it?

Great question.

As we look at military sales, historically we start to build our pipeline and backlog on military two to three quarters out before those sales are due to the military. So we have been rebuilding throughout the end of 22 into the beginning of 23 a significant portion of military pipeline that we will realize here in 2023.

Understood. And just a couple questions on operating expenses and inventory levels, actually. Is the inventory that you have... mostly mark to market in terms of what you expect from sales or should we expect negative gross margins from this going forward at least in the next few quarters?

So we anticipate Q1 to have similar let me pause for a moment So my apologies.

Yes, it is marked market. That is why we took the large E&O reserves at the end of 2022. So that way we started with a clean slate for 2023 and could have better margins moving forward.

Understood. Good to hear that. On the operating expense front, two-thirds of the headcount reduced last But in terms of dollars, how should we look at it? I think your OPEX was around 1.8 million total gap OPEX this quarter. Is that the run rate or should we expect further reduction?

There are further reductions that have been happening.

And we expect to realize some.

Our Q4 number is pretty close. but we have reduced our payroll expense significantly over the prior year.

Right, right. Does the 4Q number have any severance costs that may not recur in 1Q and moving forward?

No, there were no severance costs.

Okay. In terms of cash availability, I know you spoke at length about the 4Q, I mean December 31st balance sheet. $107,000 in available cash, including $52,000 in cash on hand. What is the level currently, and throughout the year, how do you plan to fund the operation and any rollouts of new products?

This is Jim Warren.

Leslie spoke to restructuring our secured lending facilities following that strategic investment. Looking ahead to 2023, I think we'll be rebuilding our working capital and financing structures. We're working off of cash collections largely at this point, but we've significantly reduced our borrowing costs as we do that. Working with our supply chain partners to kind of restart the engine there.

Got it. And last question, supply chain issues have been lingering. Is there any particular item or items that are a cause of the issues and how do you expect these issues to be resolved over the next few quarters?

Sure. So our supply

ICs are still a large component issue that we have been impacted by and our industry has been impacted by as a whole. As that continues to right itself, that will also free up our ability to bring those products in. Additionally, our REDCap product is a very unique product in its design and structure, so we have had some challenges ensuring that we can source the right component tree specific to that patented product. That we believe our sources have been able to restart their pipeline, which will allow us to restart our pipeline.

Got it. Yeah, no, I think the GAN power supply and other power products looks promising. Looking forward to updates on that. The turnaround on military looks promising as well.

Good luck, Jim. Good luck, Leslie.

Thank you so much.

Our next question comes from the line of David Radulescu, a private investor. Please proceed with your question. Hi, Leslie.

David Radulescu. Thank you very much. First question, I love the comment about, and we just heard it just briefly, on looking into product development using gallium nitride power supplies. And I guess what I'm asking is, is there any sort of insight that you can give us into the specific application of those and potentially what type of turnaround if those things are going into commercial products? Are these things that are going to be able to be introduced in the coming year, or is it more longer term?

Sure. Thank you, David, for your question. In regards to the GAN products, we're looking at working within the lighting industry first because that is where our expertise lies. Some of the opportunities that we are looking to go after may or may not be realized in 2023 and are more of a long-term strategic play just because – will involve additional development processes with potential partners. However, we are looking to be able to also supply within the lighting display market a module here, hopefully, before the end of the year. So some products will be a little bit easier than others, and we are hopeful that we will be able to start launching those here before the year is out.

Thank you. Other question, given my background, can you provide any comment on the – I know that Energy Focus has a reasonably large patent portfolio. Can you provide any comment on whether or not the company is looking into ways to monetize or to potentially squeeze some value out of its portfolio, which goes back a number of years, and given that you're turning back to your roots, at least from what I hear based on the UVC comments, has there been any thought into trying to exploit the patent position?

Great question. We currently look at all of our assets and continue to look at different ways to move our best foot forward as we continue to grow. Right now, my focus is on generating sales, but that's something that we could put for the future.

Thank you. That's all I had. And continued good luck, by the way.

Thank you.

And we have reached the end of the question and answer session, and I'll turn it back over to Leslie Mack for closed remarks.

Thank you, Operator. Again, thank you, everyone, for joining us today, and we look forward to providing you with more information as we turn the corner in 2023. Thank you again.

And this concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.