Good afternoon, ladies and gentlemen, and welcome to the Surna Inc. Q4 2018 Earnings Conference Call. At this time, all participants have been placed on a listen-only mode and we will open the floor for your questions and comments after the presentation. [Operator Instruction].

It is now my pleasure to turn the floor over to your host, Surna’s CEO, Tony McDonald. Sir, the floor is yours..

Thank you and good afternoon. Welcome to Surna’s Q4 2018 earnings call. My name is Tony McDonald. I’m the company’s CEO. I am joined today by Tim Keating, the company Chairman.

This is the first earnings call held by the company in many years, but we intend to hold regular quarterly earnings calls in the future to provide our shareholders and members of the investment community with an opportunity to ask questions about our business and the progress we are making on our strategic initiatives which we will outline shortly.

Before we begin, I will read the cautionary statement regarding forward-looking statements. This call may contain statements of a forward-looking nature relating to future events. These forward-looking statements are subject to any inherent uncertainties in predicting future results and conditions.

These statements reflect our current beliefs, and a number of important factors could cause actual results to differ materially from those expressed in this call, including the risk factors set forth in our Form 10-K recently filed with the SEC.

Please refer to our SEC filings for a more detailed discussion of the risks and uncertainties associated with our business.

Today we will cover several topics, including a brief recap of our Q4 2018 results, our strategy for the new Surna and why we are moving in a new direction, the milestones we hope to achieve over the next few quarters and some recent developments which reflect our progress on the new Surna to-date.

Please note that the company filed its Annual Report on Form 10-K and issued a press release announcing Q4 and full year 2018 results on March 19, 2019. These documents can be found at our Web site at www.surna.com/investor-relations.

While we will highlight some key information contained in the press release and the 10-K, the primary focus and purpose of this call is to articulate the company’s strategic growth plan for the future.

Our 2018 revenue of $9.6 million was a record for the company, but our Q4 2018 revenue was $2.2 million compared to $3.3 million in Q3 2018, a 34% decrease. Our revenues from new facility construction projects, which has historically been our primary focus, are inherently inconsistent and unpredictable.

These projects are subject to uncertainties in licensing, permitting, financing and construction-related delays that we do not control. Under our new strategy we plan to complement our new construction projects with recurring revenue streams which we will discuss later.

We also faced gross margin pressure in 2018 due to increased project management cost, which we believe we have largely remedied going forward as a result of our headcount and payroll reduction that was implemented in January of 2019.

In 2018, we also undertook some one-time initiatives that we deemed necessary for a variety of reasons, which adversely affected gross margin. As we progress into Q2 2019 and beyond, we will carefully monitor our targeted gross margin on all revenue streams.

We believe our 2018 and 2017 gross margins of 25.6% and 26.5%, respectively, need to be increased closer to our 2016 gross margin of 30%. We will report on our achievement towards this target margin in each quarter going forward. As we stated in our press release, Surna is not operating profitably or generating positive cash flow from operations.

Our net loss for 2018 and 2017 after excluding non-cash equity compensation and non-cash debt-related items was $2.7 million and $2.1 million, respectively. We cannot continue to sustain these losses and credibly seek to raise equity capital to fund our operations going forward.

Thus, we are doing a top to bottom reset of our business in an effort to turnaround our operating results. We expect this will take time and we will experience setbacks along the way, but we believe we have made progress to-date and we hope that our results for 2019 and beyond will reflect our new strategy.

We would be remiss if we did not mention our bookings and backlog growth in 2018. Our 2018 net bookings, which are defined in our SEC filings, were $13.7 million compared to $9.0 million in 2017. As a result, our year-end backlog increased from $4.5 million at the end of 2017 to $8.5 million at the end of 2018.

While these increases reflect strength in our business, the source of these bookings and backlog are primarily new facility construction projects for which we do not control the timing for completion and consequently when we’re able to recognize revenue.

In the future, while we will continue to report bookings and backlog, we will be emphasizing revenue, gross margin and operating results. Now that we have discussed our 2018 results, we will turn our attention to what is more important; where Surna is heading in the future.

As you may know, we issued a shareholder letter in early March and our annual report last week. Both of these documents have laid out our new vision for Surna. Let me explain our new strategy as concisely as possible.

We plan to develop and sell an expanded offering of products and services to meet a wider range of our cultivators’ environmental control needs over the full lifecycle of their facility. We believe this will generate a more consistent and recurring revenue stream for us.

To restate, going forward we are expanding our product and service offerings to meet our customers’ needs across all four phases of the facility lifecycle as compared to the past where we only addressed two of the facility stages. The four stages are what we define as the full lifecycle of a facility.

First, pre-build; second, construction; third, startup; and fourth, operation. We have included a self explanatory and visual matrix in both our Annual Report and press release which illustrates this strategy. We urge you to take a careful look at this matrix.

To help provide further perspective, we are going to spend a few minutes covering some of the specific products and services that we are either offering or pursuing as part of our new strategy.

First, we are in the process of expanding our system offerings to include other HVAC solutions, such as custom air handling units, split systems, packaged roof-top units, self-contained and complex chilled water systems. Previously, we primarily sold modular chilled water systems.

In the second quarter, we expect to rollout two standard sized and customer air handler products which will allow us to meet customer needs in situations where a ducted air handler is the preferred solution. Second, we recently shipped our new Surna-branded fan coil units to two projects with three more under contract.

In response to our customers’ demands, these models offer greater efficiency, design flexibility and control for growers using modular chilled water systems. We believe these proprietary products which cannot be sourced elsewhere will give us greater pricing leverage which should translate to higher margins.

Third, we will be launching our sensors, controls and automation products at the Cannabis Conference in Las Vegas next week.

These products will be able to report with tighter tolerance levels, will include purpose-built computers programmed by us to ensure desired set-points and will provide sensor to control connectivity towards chillers, fan coils and dehumidifiers to direct these pieces of equipment.

We are currently budgeting and quoting these control systems with existing prospects and have recently presented quotes to about 10 potential customers. We also have a beta-site customer that has agreed to install our control products at one of their cultivation facilities.

Fourth, we are focusing more attention on existing first-generation cultivation facilities that are facing serious operational challenges. These retrofit projects present an expanded market opportunity for us and because they do not have the uncertainties associated with new construction projects can generate a more predictable revenue stream for us.

We recently received an over $1 million order to supply equipment following our retrofit consulting work which is expected to generate revenues in the first three quarters of 2019.

Fifth, as part of our strategy to participate in the full lifecycle of new and existing cultivation facilities, we are internally developing a facility assessment analysis and consulting service to assist existing facilities in diagnosing and then solving their environmental control challenges.

We believe these services could be ready by the third quarter of 2019 and could lead to additional equipment sales opportunities. Sixth, we expect to offer a utility rebate consulting service beginning in the second quarter of 2019 to help our new build customers obtain utility rebates.

While this service is not expected to generate significant revenue, our customers will be able to use these rebates to offset some of their capital equipment costs helping us to close business without impacting our margins.

Finally, we are in preliminary discussions with several potential strategic partners that offer complementary products and services such as energy efficient lighting, processing equipment and cloud-based data aggregation platforms. At this point you may be asking yourself why Surna believes it can successfully execute this new strategy.

Allow me to explain. First, our customers must develop innovative ways to meet the demand of their business and reduce energy costs, 90% of which is related to their HVAC and lighting systems.

HVAC is our focus and we have specialized engineering knowhow and experience gained from the over 200 licensed commercial cannabis facilities that we have designed. Second, we have the advantage of early engagement with our customers at the pre-build and construction phases.

In the past we delivered one-and-done environmental control engineering/design and equipment packages as part of a facility’s initial construction. Through this work we developed multiyear relationships with customers and others in the industry.

Going forward, our plan is to capitalize on our existing customer relationships and attempt to become stickier to our customers seeking to generate incremental and recurring revenue. And third, we have a line of proprietary environmental control products.

To our knowledge we are the only integrated provider of proprietary environmental control equipment and engineering services in the cannabis space. We will leverage our reputation and knowhow against the local contractors and mechanical engineers who collectively constitute our largest competitor.

At this time, I’d like to introduce our Chairman, Tim Keating, who will discuss our cash situation and our capital raising plans..

Thank you, Tony, and thank you all for participating in this call. Tony has just outlined our past results and the future strategy. Coupled with that, we also have a financial plan to position us for the future. Management has already taken steps beginning in the fourth quarter of 2018 to preserve our cash resources to the best of our ability.

With our new business strategy, we will need to raise capital sometime in 2019 in order to execute on this strategy, improve our working capital and drive our growth. Over the last four months, we reduced payroll costs and other personnel-related expenses to better manage our cash burn rate.

These cuts represent a nearly 30% reduction in our annualized payroll-related costs or $900,000 annualized savings. We made these cuts because despite our revenue growth, we were not able to generate enough incremental margin to cover our increased operating expenses. As a result, our net losses continued to widen in 2018.

Now, we are more focused on our working capital management. One factor contributing to our current cash position was the addition of manufacturing partners for our new proprietary products. As we continue our new product initiatives, some of these products may require advanced payments and/or require us to stock inventory.

At this time, the only way to improve our cash flow and working capital position is to add revenue and margin to grow out of our current situation. While Tony has identified many opportunities as part of our new business plan and strategy, there is significant work ahead and there’s no assurance that we will be successful.

As of December 31, 2018, we had cash of $253,000. This is insufficient to operate our business on an ongoing basis, but we are carefully managing every aspect of our business and finances to preserve our cash resources. As I mentioned earlier, we will need to raise capital sometime in 2019 to support our business and growth.

However, we have no immediate plans to do so. The timing of a future capital raise is dependent on a number of factors but let me identify several. First, our ability to effectively manage our working capital needs. Second, our success in improving quarter-over-quarter operating results and achieving cash operating breakeven.

Third, how well we can execute our strategic initiatives and find some joint venture partners that complement our business in the near term. And lastly, an evaluation of the type and amount of capital potentially available to us along with the terms and conditions relative to our stock price and other considerations.

As and when the Board determines to initiate fund raising efforts, we will carefully assess the reaction we receive from the capital markets and make adjustments as necessary. Thank you. I’ll now turn it back to Tony..

This concludes today’s prepared remarks. At this time, I would like to ask our operator to provide instructions for the Q&A session and open the floor for questions..

Thank you. Ladies and gentlemen, the floor is now open for questions. [Operator Instructions]. .

And as we wait for people to enter the queue, I will field some questions received by email and the webcast. Okay. So let’s begin with a handful of questions that were pre-submitted by mail. So, Tony, the first question is the following. Can you please discuss the highlights of Mr.

Bechtel’s tenure as CEO and explain how the new strategy was developed? Was the new strategy a continuation of Mr.

Bechtel’s and/or developed by you? What role did the Board play in new strategy?.

Mr. Bechtel was instrumental in leading several equity capital raises while he was CEO. He was also CEO when the company commenced several new product initiatives. When I became CEO, the first thing our senior management team did was a top to bottom review of our business and created a vision for the company over the next two years.

The current business strategy was developed based on this vision. Our focus is to provide more products and services to our customers over the complete facility lifecycle and attempt to diversify beyond the one-and-done new facility construction. The fiscal objective is quite simple.

We must identify new revenue streams that are more consistent and predictable. Since my hire as CEO, the Board has provided us with feedback on our vision, strategy and objectives..

Tony, the second question that was submitted in advance is the following. Q4 2018 revenue was about $2.2 million.

Do you have any guidance on Q1 2019 compared to Q1 2018 revenue?.

We do not provide guidance on future earnings in revenue. However, we will be filing our 10-Q by May 15 and we’ll have another Investor Call to discuss our Q1 results and the progress we are making on our strategy..

The next question submitted in advance was the following.

Are you currently working on any projects with larger publicly traded vertically integrated cannabis companies?.

Our target market is not large publicly traded cannabis companies. Instead we focus our efforts on cultivators that have anywhere from 10,000 to 100,000 square foot facilities. However, we believe there may also be retrofit opportunities with even larger facilities..

Tony, thank you. And just to provide some perspective, we now have the fourth out of seven questions that was submitted in advance.

So question number four is, how many retrofits can Surna perform at one time?.

A retrofit project may consist of assessment and consulting services and/or equipment sales. While we currently have resources to provide the service component, we are not actively marketing these services due to our limited personnel resources.

We will be in a better position to determine and articulate our retrofit capacity capabilities by the end of the third quarter..

Tony, the fifth question is the following.

How does the new go-to-market strategy affect the manufacturing facility in Colorado? Is it obsolete?.

The manufacturing facility which recently upgraded is fully operational for our assembly and warehousing needs. We also have manufacturing partners in both the U.S. and China and will continue to expand our relationships as we implement our new strategy..

Tony, question number six is the following.

Is there a plan on how to penetrate the retail trade either via acquisition, merger, joint venture or licensing?.

We are currently at the early stages of developing a retail strategy and execution plan which reflects our growing product line. We expect to have this fully implemented by Q1 2020, but we’ll update you as developments occur..

Okay. And the final question that was submitted in advance is the following.

What advice would you give to a shareholder who has been holding the stock for four years?.

We believe we have a comprehensive strategy in place to build revenue and get the operations to cash flow breakeven in the future. But as with any strategy, we will experience setbacks along the way. We have discussed today some of the progress we have made in terms of both cost reductions and new products and services.

We will continue to provide you updates along the way and we hope that our expected progress will build your trust and patience in our plan going forward. That concludes the pre-submitted questions.

Operator, are there any questions from the lines at this time?.

Yes. Our first question today is coming from James Williams. Please announce your affiliation, then pose your question..

Hi, guys. I’m from Newbridge Securities. We did a raise for you guys a couple years ago. I’ve got a question for you. In the past even though you’ve done some small raises since then many internally, now basically you mentioned several times that you are going to need cash in the future, some type of raise that way.

And also in the past you basically had said that you weren’t looking to do any type of reserve split on the stock. Now back then the stock was maybe 100 million shares less than where it is today.

In the future if you are going to have to do some capital raises, what’s your feeling about doing some type of reverse split or keeping everything the way it is? What’s your feeling about that?.

Sure. Thank you for the question. This is Tim Keating and I’ll respond to it.

I think the short answer is we’re going to do a comprehensive capital market strategy that starts with the bottom of business plan, assess what we’re trying to accomplish, what the capital needs are and certainly and absolutely in conjuncture with that we’re going to look at the capital structure. It has been cleaned up over the years.

Currently, the company has no debt outstanding. And so we do plan to communicate all of those particulars as and when we articulate a full capital raise plan. So I think at this point suffice it to say duly noted and will absolutely be comprehensively addressed in the future..

So the reverse split question, though, where are we on that? Before you’ve said you didn’t want to ever have to do that.

Will that be on the table in the future or no?.

The honest answer is we haven’t even looked at or discussed it, but it will certainly – we’ll absolutely look at the total number of shares outstanding, look at our stock price, look at what might be required over time for listing upgrades; so all of that will be considered.

But the very short answer is there have not been any discussions about that in the Board. Thank you..

Okay. Thank you..

You’re welcome..

Thank you. Our next question today is coming from Alan Brochstein. Please announce your affiliation, then pose your question..

It’s Alan Brochstein from 420 Investor and cannabis [indiscernible].

Tim, how’s it going?.

Alan, I think it’s been 30 – it’s been a long time since we last spoke at the kid or Peabody training class in New York in 1986. Nice to hear your voice again..

You as well. Tony, it’s nice to meet you. I’ve been following this company for five years and it’s been obviously very disappointing to see where you guys are right now.

I want to understand better kind of what you think your core value is, because the thing I’ve seen over time is that you guys definitely have been able to penetrate the industry and have a strong sales force, but you don’t have a lot of product depth and that seems to be the problem.

And I just want to know, Tony, since you’re running the company now what is it you think Surna really brings to the table?.

Well, thanks for the question, Alan. It’s a good question and one that we’ve asked ourselves either with considerable depth when I alluded to an early management meeting to review the company and think about it top to bottom. And I think very plainly our strength is a couple fold.

First is, we believe we’re the most experienced player in this space and have done more of these facilities on a commercial scale than anybody else. So we believe we have engineering depth that is unrivaled in the industry. So that is number one far and above everything else. What flows from that is that we have a brand that’s so recognized.

As I meet with customers, as I go to trade shows, people frequently cite to me, hey, I know plenty of mechanical engineers but I’m talking to you guys because of your reputation in the industry and that’s happened to me repeatedly. We also have a unique product line.

We are the only player out there to the best of our knowledge with our own proprietary product line of HVAC environmental control products designed to address the problems inherent in these types of facilities.

And coming from a bit of an HVAC background, I’d say that these cultivation facilities are a very sophisticated and difficult mechanical engineering problem. And both our engineering knowhow and our products are designed to address these very difficult problems that are posed by these types of facilities..

Okay. I think this just echos on my sentiment which is that you guys have a lot to offer but the business itself has not been sustainable and it appears to be possibly not able to become sustainable.

And this leads to my second question which is, have you guys considered merging into another company? When you were stronger I hoped that you would maybe broaden your product offering set to be able to use your sales force and the strong reputation to leverage your internal resources better.

But at this point it seems like you’re swimming against the current.

And I’m just curious if you thought about – because your market cap is extremely low and you have sales and you have a good reputation and I’m just wondering if this is something the Board has considered?.

Alan, I’ll hail that one and I think it’s a very fair observation and I appreciate that you asked the question. And the short answer is we are considering everything and anything and we are cognizant of a couple of things. We obviously know what our market cap is relative to our revenue.

We’re also very aware of what our ongoing expenses are being part of a public company. So when we look at that numerator relative to either the revenue in the denominator or the market cap in the denominator, something just obviously is out of whack and doesn’t make sense. And so the short answer to your question is yes.

The Board has actively discussed that and we’ll continue to explore that fully. And I think we owe it to the shareholders to keep any and all options on the table. So suffice it to say that that’s definitely part of the toolkit and menu that we’re considering broadly..

Okay, I appreciate that answer.

And then my final one in that same genre is, even if you don’t want to sell the whole company or aren’t able to or don’t plan it to be feasible, it just seems like telling everybody that, oh, we’re going to have to raise capital is not a good way to be posturing yourself? Yes, it’s obvious we need to raise capital but have you had any talks with strategic investors and if this were the route you would go, what amount of money would make it so that Surna could be on a sustainable path?.

Alan, again great questions and I think here to be as direct and as blunt as possible, we’re trying to balance our disclosure needs as a public company and make sure everything is kind of fully out there. But the points that you raised are all excellent ones and I think we should, must and will explore anything and everything that’s out there.

And so on the one hand we’ve got very robust disclosure that says our cash – that we do need to raise capital. On the other hand we’re saying plainly and directly that we’re considering any and all options.

So the point of that message is meant to be quite encouraging that the Board is wide open to consider anything that makes the most sense and maximizes value for Surna shareholders. So in that regard we certainly welcome suggestions and input from you, other stockholders and anyone who might have an interesting idea.

So we look forward to engaging with you and thanks very much for asking that direct question that’s on a lot of peoples’ minds..

Okay. Thank you. I really appreciate you guys hosting this call and taking the questions and wish you the best this year..

Well, Alan, equally we also thank you and thanks for great questions. And we encourage everyone to ask very direct and hard questions so they’re all open. So I think we do have a few that’s come in via the Web and maybe we’ll just flip – I think there’s a few of those right now..

Yes, I’ll jump in. This is Tony. I’ll jump in and we have a question by Daniel Westering [ph] and he inquires has Surna considered developing aquaponic technology. And aquaponic technology to my understanding is essentially a technology to feed plants.

So the readings I’ve seen are essentially where you either immerse the roots of a plant in water or otherwise spray water and nutrients on the roots of a plant. That’s way outside our wheelhouse. We are facility and mechanical engineering and environmental control peoples.

And we’ve seen some folks out there who have some pretty compelling technologies in that area. So the short answer to that is no. That’s not in our wheelhouse. Second question posed by Mark Wilkins [ph], you alluded to an expanding equipment line. What can we expect? I think we’ve spoken to that a bit, Mark.

We are expanding our HVAC product line to new fan coils. We are now providing air handlers as opposed to just a fewer ductless systems. So we have got several other products out there and I would encourage you to look at our matrix of our product roadmap that’s on our Web site in the Investor Relations site.

So, yes, there is a number of exciting things to come..

Are there questions from the floor or the call, I guess, operator?.

[Operator Instructions]. We have no questions in the queue at this time..

Well, thank you very much. We appreciate everybody’s time and thanks for joining us on this call today. We appreciate your interest in the company and in this discussion and we will look forward to seeing you after our next 10-Q here in mid-May. This concludes the call. Thank you..

Thank you. Ladies and gentlemen, this does conclude today’s conference call. Please note a replay of today’s call will be available on surna.com/investor-relations until May 1, 2019. You may disconnect your phone lines at this time and have a wonderful day. Thank you for your participation..