Good afternoon, ladies and gentlemen. And welcome to the Surna Inc. 2Q 2019 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 Q2 2019 earnings call. My name is Tony McDonald. I'm the company's CEO. And I am joined today by Tim Keating, the company's Chairman. Please refer to our investor presentation, which you can see on this webinar.

This presentation, together with our Investor Fact Sheet, has been filed with the SEC and is also available at the investor relations section of our Web site at www.surna.com. In our first ever letter to stockholders in March of this year, we made a number of promises to our stockholders.

One of which was the implement a full Investor Relations program and establish a robust two way communications program in the form of quarterly earnings calls open to all members of the investment community, and with a short scripted fulsome Q&A. This is now our third consecutive quarterly call, a promise kept. Ask any questions you wish.

As the next supplement to our Investor Relations activities, we will be sending out email notifications regarding Surna news developments and SEC filings directly to interested parties. If you would like to be on our email distribution list, please use the link on the last page of this presentation or send an email directly to me at tony@surna.com.

Before we begin, please be advised that this call may contain statements of a forward looking nature relating to future events. These forward-looking statements are subject to the inherit 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, which we filed with the SEC in March.

Please refer to our SEC filings for more detailed discussion of the risks and uncertainties associated with our business. Please note that we filed our quarterly report on Form 10-Q and issued a press release announcing second quarter 2019 results on August 07, 2019. These documents could 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-Q, the primary purpose of this call is to articulate the progress we are making on our key operating metrics and strategic plans. Please refer to the year-to-date report, Milestones Achieved, slide of our presentation.

We are pleased to report that our second quarter 2019 results were record on many fronts. First, we had $4.2 million in quarterly revenue, surpassing our previous high of $3.6 million. Second, our gross profit margin was 34.4%, our highest level since 2016. Third, we earned net income of $140,000, our first ever positive net income per quarter.

Finally, we had $1.9 million in cash at quarter end, an increase of $1.5 million from our first quarter 2019 and our highest cash position since we completed $1.8 million capital raise in the fourth quarter of 2017. In our March Stockholder Letter, we announced our top two financial goals, increasing revenue and achieving profitability.

Both of which we achieved in the second quarter, while increasing our cash resources by nearly $1.5 million without accessing the capital markets.

Later in this call, we will discuss our expanded focus on multi-facility operators, as well as expansion and retrofit projects as part of our attempt to reduce our reliance on new build facility projects and generate a more predictable and accelerated revenue stream.

We're also pleased to report the first sales of two new products, which we launched earlier this year. First, our SentryIQ sensors, controls and automation platform for our HVAC equipment, now allows us to offer a complete turnkey environmental control solution for both new and existing cultivation facilities.

To-date, we have sold three projects for a total contract value of $225,000. Q2 also marked the first sales of our new custom designed air handling units for ducted HVAC applications. Our Q2 revenue from this new product line alone was $1.1 million or 27% of our total Q2 revenue.

Importantly, our ducted systems as well as our new and improved ductless fan coil units now allow us to serve larger facilities with the technology solutions they prefer or require. In early 2019, we purposely set out to sell new value added technology services and proprietary and customized equipment to meet more of our growers' HVAC preferences.

We have now accomplished this and we continued to pursue other innovative products and services in the climate control segment. Please refer to the operating results slide of our presentation, which shows our income statements for the three and six months ended June 30, 2019 and 2018.

These are the highlights as you compare our results for the six months ended June 30, 2019 to the same period in 2018. First, our year-to-date revenue was $6 million compared to $4.1 million, an increase of 47%. Second, our year-to-date gross profit margin was 32% compared to 22%, an increase of 10 percentage points.

Third, our year-to-date net loss was $761,000 compared to a prior period net loss of $3.3 million, a decrease of 77%. Finally, our year-to-date adjusted net loss was $119,000 compared to a prior period adjusted net loss of $1.8 million, a decrease of 93%.

Our adjusted net income and loss, a key management metric and point of focus is defined as our GAAP operating income or loss after add back for our non-cash equity compensation expenses, depreciation expense and any debt related costs.

This significant turnaround means we were almost at operating cash flow breakeven for the first six months of this year. Now, please refer to the key financial metrics slide. These four metrics revenue, gross margin, operating income or loss and cash, are the ones that matter most to us.

We have provided quarter-over-quarter data going back to Q2 to 2017, so you can see the two year trend for each metric. As mentioned, our Q2 2019 revenue of $4.2 million was a quarterly record, our ability to achieve consistency and favorable trends. And revenue quarter-over-quarter remains critical to our financial goals.

Our goal is to generate $3 million to $4 million in quarterly revenue on a consistent basis. To achieve these levels, we must obtain more business and multi-facility operators and on retrofit and expansion projects. Our Q2 2019 gross profit margin of 34.4% is in our targeted range.

We believe this is a positive sign as we try to increase our gross margin with greater revenues from our new value added technology services and proprietary customized equipment, such as our new fan coils, custom designed air handler products and our SentryIQ sensors, controls and automation products.

Please refer to the operating income or loss illustration, which is our most important operating metric as we try to achieve and maintain operating cash flow breakeven and profitability. As mentioned, we had net income of $140,000 in the second quarter of 2019.

But even more importantly, we had Q2 2019 adjusted net income of $390,000 compared to Q1 2019 adjusted net loss of $510,000, a decrease of $900,000 or 177%. This was the result of a combination of factors, increased revenue, increased gross margin and realization of benefits from our Q1 cost reduction program.

Again, if we are successful in maintaining $3 million plus in quarterly revenue on a consistent basis, we expect to continue to be able to operate at cash flow breakeven. We continue to manage our cash resources carefully. We increased our cash position from $500,000 to $1.9 million during Q2 2019.

We continued to work on improving our working capital position. Our business for multi-facility operators and on retrofit and expansion projects has and will improve our operating cash flow. Please refer to the bookings, backlog and revenue conversion slide. These are the highlights.

First, we had $5.7 million in net bookings, which includes signed sales contracts for which we received an initial deposit, adjusted for cancellations and change orders. Our Q2 2019 net bookings represents another quarterly record for us despite $3 million in contract cancellations during the quarter.

Second, we also entered the second half of 2019 with a backlog of $13 million, our highest quarter end backlog ever.

Our revenue conversion, which is important in understanding our business measures our fleet efficiency at converting backlog into recognized revenue using a simple formula, current quarter revenue divided by prior quarter ending backlog. Our conversion rate increased to 36% in Q2 from 21% in Q1, and 25% in Q4 of 2018.

This represents a favorable trend, especially as our backlog has continued to increase over the same period. However, our Q2 revenue conversion was favorably impacted by almost $1.4 million in Q2 revenue from multi-facility operator that was also booked in Q2 and therefore not in our Q1 quarter-end backlog.

Please refer to the expanded market focus slide, a new slide we are introducing, which illustrate how our Q2 year-to-date results were impacted by type of customer and type of projects. Let me explain the table.

First, this financial data is only for commercial scale projects, which we define as those greater than $100,000 in contract value that we signed and booked in the first half of this year. Thus, this information excludes any projects we signed prior to 2019, as well as smaller projects.

Second, we have segmented the market by type of customer, multi-facility operators or MFOs, or owner operators of two or more cannabis cultivation facilities in the U.S. or Canada. Independent and Small Growers or ISGs are all other cannabis cultivators that are not MFOs.

Thus far, based on our initial market research, we have identified approximately 45 MFOs that collectively operate in excess of 250 cultivation facilities. Third, we have further segmented market by type of project, either as; one, a new build; two, an expansion; or three, the retrofit.

We feel this segmentation is appropriate, because these different projects tend to have different risk profiles, which impact project completion and/or revenue recognition. Our commercial-scale projects have increased in both size and complexity.

Our average project size has increased over 2.5 times from about $400,000 in 2018 to over $1 million in Q2 2019.

These larger and more complex projects tend to take longer to complete, especially those new build facility projects, which are subject to financing, licensing and construction delayed risks as well as changing business and market conditions.

We are attempting to supplement new build projects, which heretofore had been Surna's exclusive focus by expanding our sales efforts and outreach to well-financed, more sophisticated and knowledgeable MFOs and which, in many cases, have projects ready to go. So let's look at these data.

During the first half of 2019, we entered into three contracts totaling $6.5 million with a single MFO for a project refit or for retrofit project into two-phase facility expansions. We have recognized $2.7 million in revenue on these projects, and we expect to recognize the remaining $3.8 million in Q3.

Clearly, these project contracts have been a significant contributor to our recent financial success. The accelerated cash deposits and revenue conversion for these retrofit and expansion contracts, especially with MFOs, gives us a more consistent and predictable revenue stream and allows us to manage our working capital more effectively.

Our future success will be dependent on our ability to expand our business with other MFOs. Since 2017, we have sold engineering and/or climate control equipment to five MFOs. We are in contact with about 10 MFOs who collectively operate over 100 cultivation facilities.

We define contact as everything from a full-fledged ongoing customer relationship to a past customer with whom we are still in contact to a new contract, to whom we are proposing business.

Based on our initial market research, we believe that many of these MFOs have immediate or near-term, meaning within one year, plans to expand their cultivation facilities, or retrofit their newly acquired facilities as we are attempting to deepen our relationships and business with these firms.

Now, let's look at the data for the Independent and Small Grower or ISG segment. During the first half of 2019, we signed eight new build projects for a total value of $5.4 million. Two of these contracts exceeded $1 million. Our historical market focus has been on these new build projects for ISGs.

We have already discussed the higher risk profile of new build projects in general. Because of the many uncertainties associated with ISG projects, this is an inferior business line compared to the MFO segment.

And while the ISG business remains important to us, in conjunction with our MFO outreach efforts, we are also developing strategies to penetrate retrofit opportunities among the 3,000 to 5,000 indoor grow facilities operated by ISGs, a portion of which will always be considering HVAC improvements.

Please refer to the trusted climate advisor control slide. We have presented this slide in the past and it remains relevant today.

Whether we are pursuing MFOs or ISGs, our go to market strategy is focused on; first, leveraging our strong brand name and Canada specific experience; second, positioning ourselves as the trusted advisor in climate controls management; and third, expanding our products and services to meet a broader range of our customers' needs over the full lifecycle of their facilities.

The key objective of this strategy is to increase revenue by selling more climate control products and services to our customers.

We will continue to identify and assess one-off strategic alliances and possible acquisitions that can enhance our position as a trusted advisor in the climate control space, and expand our climate control offerings to indoor growers. Please refer to the corporate profile slide And I'll now hand the mic to our chairman, Tim Keating..

Thank you, Tony. The corporate profile provides important data on our capitalization and the market for our stock. We continue to believe we are undervalued relative to our comparable peer group, and a derived calculation of intrinsic value. We have zero debt and the cap table is pristine. There are no convertible securities of any kind.

Moreover, we had successfully operated businesses this year with limited cash resources without issuing equity that would be highly dilutive at the current stock price. Most importantly, we have achieved profitability for the first time, which is an especially notable achievement in this industry.

Now that we have our operations on the steady footing, we will be deepening our outreach to the investment community. To kick off these efforts, we expect to be presenting at the LD Micro Conference on December 10 in Los Angeles. This will be followed by a focus and ongoing program of one-on-one meetings with institutional investors.

The old Surna was silent, unengaged and abandoned, justifiably so by Wallstreet. Very simply, our goal by the end of 2020 is to create a widely held actively traded and fully valued company as a stepping stone to an eventual NASDAQ of listing. Please refer to the market comparable slide.

In selecting public company comps, two basic principles guide us; first, the companies must be in the cannabis ancillary products and services sector; and two, the companies must not be principally involved in cultivation, extraction, distribution and consumer branding, which have outsized and therefore distorting multiples.

We arranged our selected comp companies from left to right in ascending order of the price to LTM revenue, in other words, last 12 months revenue multiples based on recent stock prices. As you can see, Surna is close to the bottom of the group, trading at a price to revenue multiple of 1.6 times.

As part of our strategy, we hope to have upward trending and more consistent revenue quarter-over-quarter and to operate profitability.

If we can accomplish these objectives, we believe our price to revenue multiple would expand to a level close to 3.0 times with that out of our peer group and based on our LTM revenue of $11.5 million, resulting in internally calculated derived intrinsic value of closer to $35 million. Please refer to the point B business slide.

Last quarter, we presented a high level strategic acquisition plan.

Since then, we have identified several business verticals or silos that we believe could be logical and natural complements to our climate control business, including; lighting, fertigation, which is the automated process of delivering nutrients and water to plants; benches, which are customized systems to optimize use of growing space; software, meaning procurement and supply-chain management platforms; and lastly, consumables, such as packaging, growing facility and lab supplies.

We have identified several companies in these verticals that we believe could be interesting and complementary partners. If we are successful in acquiring leading companies in these verticals, we hope to create a one stop shopping solution for indoor cannabis growers' equipment and supply needs.

We envision a penetrate and radiate strategy where we get into the grower, especially MFOs in any way that we can, o become a trusted vendor, meaning penetrate and then sell as many products as possible to them, meaning radiate.

In this rapidly changing market landscape, we believe a platform tailored to optimize quality, efficiency, cost and delivery times, could be attractive to indoor growers. Our goal is to increase our share of indoor growers' CapEx and operating expense wallet share.

There is of course no assurance that we will be able to consummate any acquisitions and furtherance of the strategy. However, independent this larger strategy, we may still pursue smaller one-off acquisitions to expand our climate control offerings and enhance our position as a trusted climate control advisor.

Please refer to the point B NASDAQ listing slide. Although, we remain positive about our Q2 financial results, to become a financially sustainable public company, we still believe we need to grow our business from its current level to revenues in the range of $20 million to $$40 million by the end of 2020.

Our public company costs alone are over $1 million annually. We believe that even in the best of circumstances, our organic growth plan would take too long and would require additional growth capital, which we are currently not able to raise on favorable terms to attain even the lower end of this revenue range.

As part of our strategic plan, shown in the right corner, we are seeking to acquire companies in one or more of the verticals discussed in the prior slide. Our objective is to add in the range of $10 million to $20 million in annual run rate revenues by the end of 2020 with targeted 2020 adjusted net income of $1 million.

With the combined 2020 revenue of $40 million, we would then have to scale needed to absorb our public company costs and reduce them to a more reasonable 3% of total revenue from the current level of over 10%.

We believe acquisitions, combined with the growth of our current climate control business, would represent an attractive investment opportunity for strategic and/or institutional investors.

If we successfully execute both our organic growth plan and our strategic acquisition associated capital raise initiative, our goal is to become one of the first profitable ancillary businesses serving the cannabis industry to obtain a NASDAQ listing. Tony, I will turn it back to you so you can open the call for questions..

Thanks Tim. In sum, we are pleased with the increased revenue and profitability we achieved in Q2, both records. However, one quarter of strong results does not constitute a trend and we know we must build our business with MFOs and other customers to sustain our revenue growth and cash profitability. This concludes today's prepared remarks.

At this time, I would like to ask our operator to provide instructions for the Q&A sessions and open the floor for questions..

[Operator Instructions].

And operator, we have nine questions that were submitted in advance. So while people are queuing up their questions, I'm going to start with two. And I believe these first two questions are from initials J.T. And they're very lengthy questions and so J. T., I'm going to compress them.

The first question is about patents and as a series of questions, about patents and intellectual property. So the compressed question is. Can you please discuss Surna's intellectual property, including the status of any patent applications and its recent R&D efforts? And again, listeners, there's a multitude of questions that are related to that.

So Tony, fire it away..

Sure. Surna has filed patent applications for several inventions over the years, including liquid cooling systems, reflectors and hybrid grow facilities. As part of the application process, we continue to evaluate the novelty and functional advantage of these inventions.

We eventually determined that the costs to obtain these patents would exceed the value of the patent even if issued and we'd like to advance with these applications.

Our current R&D efforts are focused on working with our manufacturing partners to develop climate controls equipment and technology that meet some of the specific needs of the cannabis industry. Our new ducted air handling systems and our improved ductless fan coils are examples of these efforts.

We also have several employees actively pursuing new product development initiatives, including our new SentryIQ sensors and control systems, which we can now test in our Boulder offices, and which has resulted in three project sales to-date..

Great. And operator, I'm just going to slip one final question from J. T., and then we'll go, open live questions. And J. T. had a series of questions that we've consolidated and as follows.

Can you, Tony, please comment on the company's -- or actually, I guess I'm going to handle this one, recent offerings to mitigate dilutive stock offerings? And can we explain any potentially dilutive securities currently outstanding? Since this is in the capital markets domain, I'll take that one. So, J. T.

in our March 2018 Shareholder Letter, we noted the large increase in the number of our common shares outstanding from $161 million at the end of 2016 to $224 million at the end of September due to equity capital raises to fund our operating losses, and equity compensation programs.

Disciplined cash management and achieving cash probability have been and will continue to be top priorities for us as we try to grow the business without accessing the equity markets or current stock price.

As we noted in our presentation, we've increased our cash position and we've achieved cash operating profitability, all without substantial increases in our outstanding common shares, which today, currently stand at approximately $228 million.

If we are able to continue to properly manage our working capital and can maintain cash operating profitability, we hope that we will not have to access the capital markets in the near future. To be crystal clear, we do not have any convertible debt securities of any kind outstanding.

We do have about $40 million warrants outstanding from past equity offerings but the average exercised price is about $0.24 per share. We also have about 13 million shares and employee stock options outstanding, but these are at an exercise price of $0.10 per share.

It is important to note that none of these warrants are -- or options have so called cashless exercise features. Meaning these investors employ month pay cash flows to exercise these securities. So J. T., we hope that is responsive to a bunch to your questions, and we'll circle back to you after we go to the live questions from the operator..

Your first question is coming from [Jay Taylor]. Sir, your line is live..

Actually, Jay, can I do this. Operator -- hey Jay, just because -- I just want to see if we have any other questions. I know you have other ones. But Jay, can we come back to you just to get some other people a chance first, and then we'll circle back to you..

Sure..

Thank you for your consideration. And operator -- and Jay, we definitely will come back to you that's a promise.

But operator, do we have questions other than from Jay?.

[Operator Instructions].

And I think we have some online questions coming in. So let me just rip this one off. So what is the status of any reverse split being considered? And that's from Gary. Gary, the short answer is we're not thinking about a reverse stock split at all right now. So it's not being discussed in the board, not on the table. And the next online question is.

Can you highlight which Canadian LPs are using your equipment, as well as any domestic grower operations, maybe an update on the reflectors too, sales figures? Thanks. This is from Greg..

Yes, and I'll address that, Greg. This is Tony. Historically, about a quarter of our business comes from Canada. And while I can't speak to any Canadian LPs by name, I'll just say that, yes, we have relationships from sales to some of them. With respect to the reflectors, we're not presently selling those and don't have any attention to in the future.

Operator?.

There are no questions in the line at this time..

So let's go back to Jay. And then we do have a few more -- we have a number of other written questions. But just let's go to Jay and then we'll circle back to these other written questions that came-in in advance..

[Operator instructions] Jay, your line is live..

First of all, congratulations on a great quarter. And I promise this question will be more brief than my written one. When you were discussing the revenue from the single mult-facility operator that was responsible for a decent chunk of the revenue.

In this quarter, you mentioned the numbers that you expect to recognize in Q3, I believe it was $3.2 million. But I'm wondering if you could just confirm that number? And also any other insights that you can provide into what Q3 is looking like? Thank you..

Well, I couldn't speak further than the published number, which we believe is correct and that is our current forecast..

But it's for your reaffirming….

Yes, we're reaffirmed that as published, okay. And it'sSlide 7 on the presentation….

So let me just get into another question that was provided in advance. So the question is in [mid]. Can we provide any details on the recently announced acquisition strategy, specifically how do you intend to finance them? And again, for those of you who sent questions in, some of them were quite lengthy and we're just trying to cut them down a bit.

So I'll take that one. So we launched our strategic acquisition plan last quarter to complement the organic growth plans. As we noted in the prepared remarks, our objective is to make one or more acquisitions that would add $10 million to $20 billion in annual run rate revenue by the end of 2020.

So if we're successful in growing organically and through acquisitions, we hope to achieve $20 million to $40 million in annual run rate revenue on a combined basis by the end of next year. We believe this level scale is needed to better cover the cost of maintaining the public company status.

As we mentioned in prepared remarks the current public company costs represent about 10% of revenue, we need to drive those down to 3% just to get them in the realm of reasonableness. Overtime, we do intend to use the public company status and our stock as partial acquisition consideration.

In addition, if we can execute our strategy, we believe in invest for our company will be attractive to investors as roll-up and potential listing to NASDAQ. So the bottom line is, in conjunction with an acquisition, that's the time when we might consider doing a capital acquisition.

And we'll see if that's also the right time to consider doing an uplifting to NASDAQ, so all of those things are interrelated. And then let's go to the next question. Okay. So we had a question from Ryan about the reverse stock split. I think we've covered that. Next question is about cancellations, and this question is from Mark.

And let me just, again, just slim down the question.

So Tony, how does the $3 million in contract cancellations in Q2 2019 impact the second quarter results? And will they impact the second half of 2019 results? And related, did these cancellations result in any write-off of inventory?.

Good questions. The answer -- these cancellations included $1.8 million that we booked in early 2018 with a multi facility operator that put two projects on hold in states based on current market conditions. These cancellations had no direct impact on Q2 2019 revenue, but they did reduce our Q2 quarter end backlog.

It is important to highlight that we had $8.5 million in new bookings in Q2 2019. And we are going into the second half of 2019 with $13 million in backlog, highest level in our history. These contract cancellations did not result in any inventory write downs since we typically do not order inventory unless we've received an advance payment..

I'll throw one other in operator then we'll go back to you.

So, Tony, the question is, what is Surna's relationship with Sterling Farms?.

Sterling Farms is a licensed cannabis cultivation facility located in Boulder. It's partially owned by one of our co-founders. We currently have a lease arrangement where we provide environmental control equipment to Sterling, but our lease is not material to our financials..

Operator, any live questions?.

Yes. We have one question coming from [David Pleasant]. Sir, your line is live..

Good afternoon.

I was wondering if you have explored developing business in other non-cannabis botanical markets at least during the period that the cannabis market matures in order to accelerate the growth?.

I guess the short answer to that is no. And the reason is that we still see a tremendous amount of opportunity for us just in the cannabis market. So while we see that, there's really no point in diverting our focus..

Written question, do we anticipate having a shareholder meeting in the fall? In the fall, the answer is no. However, we're going to continue to evaluate whether or not to hold an annual meeting this year.

We do strongly reconfirm our commitment to implement a full Investor Relations program and to fully engage with the investment community on an ongoing basis. I think it's just a matter of time when it will be natural to have a shareholders' meeting. But no, there won't be one in the fall.

Operator, any other live questions? If not, I've got one, about retrofits for Tony..

There are no further questions from the lines..

Tony, question I'm not sure who posed this one.

How many retrofits can be performed at one time? And related question is, is there scalability in that portion of business model?.

Retrofits are really no different than other projects except the facility is already licensed and operational. So retrofits are more immediate project for us, because the operator wants to redesign, replace existing climate control equipment to achieve better operating results. And this business can be scaled based on demand.

So we definitely -- we have scalability in that space..

Okay, I think I'm just -- we're scanning on screen looking at the online questions. We think we've covered them all. We also think and we believe we covered all -- and substantially all the questions that were submitted in advance.

So operator, we'll do one final sweep of calls and this is the, speak now or forever hold your peace moment, for anyone listening in. And if not, then we'll wrap it up..

[Operator Instructions] There are no further questions from the lines..

Well, very good. This conclude today's conference call. We look forward to presenting our third quarter results in mid-November, and we thank you for your continued interest in Surna. Have a good day..

An audio replay of this call will be available tomorrow on surna.com/investors-relations until November 1, 2019. You may disconnect your phone lines at this time and have a wonderful day. Thank you for your participation..