urban-gro, Inc. Q2 FY2022 Earnings Call

Good afternoon, and welcome to the urban-gro, 2022 Second Quarter Earnings Conference Call. At this time, all participants are currently in a listen-only mode. As a reminder, this conference is being recorded. I'd now like to turn the conference over to your host, Dan Droller, EVP Corporate Development and IR. Please go ahead, Sir.

Good afternoon and thank you for joining us. Today's call will be led by Brad Nattrass, Chairman and Chief Executive Officer; and Dick Akright, Chief Financial Officer. I'd like to remind our listeners that remarks made during this call will include discussion of non-GAAP metrics, including adjusted EBITDA and backlog. These items should not be utilized as a substitute for urban-gro's financial results prepared in accordance with GAAP. Reconciliations of our GAAP net loss to adjusted EBITDA are available in our press release and in our Form 10-Q filed with the Securities and Exchange Commission, and can be accessed from the Investor Relations section of our website. On this call, we may state management's intentions, beliefs, expectations or future projections. These are forward-looking statements and involve risks and uncertainties. Forward-looking statements on this call are made pursuant to the Safe Harbor Provisions of the Federal Securities Laws and are based on urban-gro's current expectations; actual results could differ materially. As a result, you should not place undue reliance on any forward-looking statements. Some of the factors that could cause actual results to differ materially from these contemplated by such forward-looking statements are discussed in the periodic reports urban-gro filed with the Securities and Exchange Commission. These documents are available in the Investors section of the company's website and on the Securities and Exchange Commission's website. We encourage you to review these documents carefully. Lastly, a copy of our earnings press release and a webcast replay for today's call may be found on the Investor Relations section of our website at ir.urban-gro.com. With that, I will now turn the call over to Brad.

Thank you, Dan. Good afternoon, everyone and welcome. I'll begin today's call by providing an overview of the state of our business, including an update on our execution results and vision. This will be followed by Dick reviewing our financial results in more detail. And then we'll open the call for your questions. I want to preface my remarks by stating that I'm very proud of our team for their resilience this quarter amid the well-documented headwinds that are impacting the cannabis industry. I'm not only the CEO of the company, but I'm also urban-gro's largest shareholder. And despite our performance being below our internal expectations due to a variety of macro-economic and industry forces, I remain incredibly confident and excited about the success that lies ahead. We've been laser-focused on perfecting our go-to-market strategy through integrating strategic acquisitions and continuing to build out our internal capability, which has resulted in a pipeline that is qualified and growing. Before diving into my comments around our quarterly performance, I want to make sure that you have three key takeaways from today's call. First, and as seen in our backlog, our professional services business remains strong and meaningful contracts are being signed in all three sectors in which we operate. In fact, the team is currently working on more than 150 open service contracts as of today. Although we're actively diversifying our business in all trends, we've been most negatively impacted by the overall turbulence in the cannabis sector and the associated downturn in cultivation equipment sales. While we're not recognizing the cultivation equipment sales as quickly as we had previously anticipated, no contracts have been canceled. Opportunities have been pushed back, but the business is still there, and we believe this path will prove to be temporary. Second, we're confident that we built the right model as a professional services and design build firm and continue to invest in our strategy of diversification, which includes both sector diversification and the development of our European business. And third, we're confident we can navigate through this dynamic environment with our committed team of talented experts in their respective areas. Coupled with our strong balance sheet, with a cash position of $23 million and zero debt, we have the flexibility we need to continue pursuing growth and enhancing shareholder value. Now to the results. We achieved second quarter revenue of $16.3 million, which represents growth of 27% versus $12.8 million in the second quarter of 2021. Adjusted EBITDA for the second quarter was negative $500,000, which reflects both the impact of lower fixed cost absorption as our sales came in below plan, and also our continued investment into our European expansion. Our backlog at the end of the quarter was $22 million, consistent with the backlog at the end of Q1. While Dick will go into more detail on the numbers later in the call, I'll now turn the focus to providing an update on each of the three business sectors in which we operate: Cannabis, food-focused vertical farming, and non-CEA focused commercial. Starting with cannabis, as that has been most impactful to our performance as of late. To summarize, in addition to an uncertain federal regulatory outlook, the cultivation focus of the sector has been negatively impacted by not only delays in new state rollouts, but also weakness in other legalized states related to a well-documented oversupply situation. Multiple states that were scheduled to start awarding licenses earlier this year have further delayed the rollout. One notable example is New York, one of the most population-dense prospective legal cannabis markets in the country. Thus far, they have only granted conditional cultivation licenses to existing hemp farmers with severe limits to the size of operations and equipment that can be used. Further in the South, licensing delays for both medicinal and recreational markets have also slowed progress. Coupled with these delays are shifting macro-economic forces, resulting in reduced access to capital, combined with higher rates for that capital, forcing industry operators to rethink, for the time being, and delay their capital deployment plans as they focus on creating efficiencies and preserving liquidity. We believe this has affected our results in the form of temporarily delayed cultivation equipment spending. As noted on the Q1 earnings call, we were beginning to see some softness in cultivation equipment sales, but we didn't foresee the pronounced pullback that we're experiencing, and others have now reported. During the second quarter, we saw historical sales volumes from some of our largest clients, but materially compared to our forecasted sales, and that air pocket has persisted in the third quarter to date as well. However, based on the strength of our pipeline, increasing number of contracts being signed, and the Company entering into full end-to-end design build contracts that include full equipment integration, we currently expect equipment sales to resume their upward trend in the fourth quarter. Although we believe this air pocket to be temporary, we are seeing progress in states that have experienced delays now resuming their pace. These delays are a prime example of why diversification remains a foundational component of our strategy in urban-gro. Our team has been working hard to enhance all facets of diversification over the past year, through building out our turnkey design build platform, advancing our M&A strategy of acquiring synergistic, accretive and cash-flow positive service companies, and making efficient and targeted entries into new global markets. Expanding further on our international strategy, and as the Netherlands has been the epicenter of horticulture growing innovation for nearly a century, we felt it critical to build a formal presence in this region. Further to our commitment at the start of the year, we continue to make investments here both in terms of infrastructure and reach in the overall CEA market. In addition to hiring a Netherlands-based Managing Director this quarter, we've begun building his team, and based on the signing of cannabis-focused design contracts in approximately eight countries, we continue to expand our visibility by attending, presenting and exhibiting at key industry trade shows and conferences in the Netherlands, Germany, Spain, Dubai, the UK, Israel, and early next month in Switzerland. This leads me to our next business sector, food, and more specifically, food-focused controlled environment agriculture, which includes vertical farming. Brands within the CEA sector continue to be a strategic area of focus and a healthy source of future growth for the Company. Our service capability and the equipment we help to procure are plant agnostic. Working with one of the most valuable crops in the world has given us a great entry point into produce. We have immense capabilities to serve in the indoor food-focus sector, and we continue to see strong momentum in the North American market. In the international markets, with food security being top of mind, and due to new environmental and geopolitical events, interest and demand for our services continue to increase as well. The third and final sector that we operate in is the commercial sector, which primarily represents diversification of revenue outside of the CEA sectors into the industrial and healthcare segments. Diversification of our offerings beyond CEA is not only a key area of organic growth for us, but also fosters a more durable operating model. We have the flexibility to position our design assets or architects and engineers based on the demand variances in each market segment to maximize billable hours that cover our fixed overhead. The synergy that we create with our balance sheet has allowed us to bond larger construction management projects, thus providing us access to previously unavailable projects and revenue opportunities. Since the closing of our acquisition of Emerald Construction Management last quarter, we have found many new design build and related contracts to design and build facilities located across the U.S. We're also making strides in other growth sectors, such as healthcare, where we've also signed many new contracts with both ongoing and new clients. Our prospects and pipeline are strengthened there as well. With the integration of our recent acquisitions, we're now able to address a larger market and capitalize on opportunities in adjacent markets, where our growing team has built decade-long relationships based on expertise and trust. My vision for urban-gro is now a reality. We strive to deliver a world-class level of service as a single point of responsibility across all aspects of our client’s operations. This is not only urban-gro's value proposition, but it has been the foundation of our success to date. Before I turn the call over to Dick, I'm going to spend a few moments on our outlook for the second half of 2022 and share with you how we're navigating through this dynamic environment. As a result of the cannabis industry headwinds, especially regarding the timing around cultivation equipment sales, we're withdrawing our full year 2022 guidance. Until we have improved visibility and can provide greater certainty in our projected results, we're shifting our outlook to guide on a quarterly basis. For the third quarter, based on an anticipated minimum amount of cultivation equipment sales being recognized, we anticipate revenues to be in the range of $10 to $11 million and an adjusted EBITDA loss to be in the range of $2.6 million to $2.4 million. This should not be inferred as a slowing of our long-term opportunity pipeline; it's quite the opposite. However, our ability to effectively predict the timing of these opportunities turning into revenue is a moving target. Based on the strength of our pipeline and the increasing number of contracts being signed, especially with design build clients, we currently expect cultivation equipment sales to begin to show recovery in the fourth quarter. Again, while we believe this air pocket we're experiencing is temporary, we have taken steps to prepare our business for any further changes in the environment. Over the last couple of months, we have looked closely at every division of the company to ensure that we're operating as efficiently as possible. Our evolution to a turnkey professional services and design build firm has decreased our reliance on field business development representatives to drive cultivation equipment sales. As our design build business increases, the integration of equipment is more of a natural integration process versus a discrete sales process. By increasing the number of manufacturers we work with, we now holistically design and equipment packages that meet our clients' budgets, ensuring that we have three to five alternatives for our clients to consider in each equipment category, for example, mechanical cooling or environmental control. We have increased our vendor partner network considerably, adding nearly 20 new manufacturing partners. In our model, we now use sales engineers or more broadly referred to as recruitment specialists to educate clients on a variety of solutions from which to choose for each equipment category. As a result, many new clients are now being handled by a professional relationship project management structure that lasts for the life of the project, which can range from anywhere from 12 to 18 months. These adjustments, while tied to increasing the efficiencies of our model, allowed us to reallocate and optimize resources, in turn creating approximately $1.25 million of annualized savings to help us remain nimble and protect adjusted EBITDA while still being positioned for the growth that we see ahead in our pipeline. In closing, I want to be very clear that I'm confident that the investments we've been and are making in the business today will result in strong future financial performance. Yes, there's uncertainty in one area of our business today that is affecting our actual performance versus forecast. But our pipeline of projects is strong, qualified, and growing, and our model is locked in and beginning to prove itself. We remain committed to advancing our diversification strategy, which is reducing our exposure to any one sector. We not only expect this to help insulate us in the short run, but we're positioning our company for new and larger avenues of growth in the quarters and years to come. Thank you. And with that, I'll now turn the call over to Dick.

Thanks, Brad. Revenue was $16.3 million in the second quarter of 2022, compared to $12.8 million in the prior year period, representing an increase of $3.5 million, or 27%. This increase was driven by a $2.9 million increase in construction design build revenue, as well as incremental services revenue of $2.7 million. These increases were offset by a decrease in equipment systems revenue of $2.1 million, primarily reflecting soft equipment demand in the U.S. cannabis market. Gross profit was $3.5 million, or 22% of revenue in the second quarter of 2022, compared to $2.9 million, or 23% of revenue in the prior year period. This represents an increase of $0.6 million. The decrease in gross profit margin was driven by a mix with an increase in the lower margin construction design build revenue, offset by increases in higher margin services revenue. Operating expenses were $5.4 million in the second quarter of 2022, compared to $2.7 million in the prior year period, representing an increase of $2.7 million. Of this total increase, $0.9 million is attributable to non-cash expenses associated with stock compensation and amortization expenses of intangibles from our acquisitions. The remaining increase in operating expenses was driven by increased headcount to support both current and future demand for the Company's solutions, continued investment in European growth, as well as incremental costs associated with acquisitions. This resulted in a loss from operations of $1.9 million in the second quarter of 2022, as compared to income from operations of $0.2 million in the second quarter of 2021. Net loss was $1.7 million, or negative $0.17 per share in the second quarter of 2022, as compared to net income of $1.3 million, or $0.11 per share in the prior year period. The prior year period did include $1 million in other income associated with PPP loan forgiveness. Adjusted EBITDA was a negative $0.5 million in the second quarter of 2022, which compares to $0.6 million of adjusted EBITDA in the prior year period. The decrease was driven by strategic investments and operating expenses to drive growth, particularly in the European market, which was partially offset by growth in revenue and gross profit. For the first six months of 2022, we reported total revenue of $37.3 million, compared to $24.9 million in the first six months of 2021, representing an increase of 50%. Net loss was $2.4 million, compared to a net loss of $0.3 million, and adjusted EBITDA was a negative $0.1 million compared to positive $1.1 million in the prior year comparable periods. Now turning to our balance sheet, our capital structure is in excellent condition, and we enter Q3 with $22.8 million of cash on our balance sheet and no debt, which provides us the necessary flexibility to manage the macro-economic market circumstances while we fuel our growth strategy, including potential additional M&A targets. Moving to reported backlog, our total backlog as of June 30, 2022, was $22 million and is unchanged from the end of the first quarter of 2022. Backlog is comprised of $10 million of construction design build contracts, $5 million of professional services, and $7 million of equipment systems contracts. While there are several variables that influence the change in backlog, the two primary factors are signed orders and revenue recognized from signed orders during a stipulated period. Because our backlog generally relates to capital expenditure commitments made by our customers, the dollar amount of signed customer orders in any individual period can fluctuate materially. Revenue recognition is then dependent on delivery of these orders. That concludes our prepared remarks. Operator, please open the call for questions.

One moment please while we poll for questions. We have a first question from the line of Eric Des Lauries with Craig Hallum. Please go ahead.

Thank you for taking my questions. First one, so appreciate your comments on the capital environment within cannabis right now. And obviously, that's had the majority of the impact here. As you guys do look to diversify into other industries, including CEA, I was wondering if you could just give us a sort of your assessment on the current capital environment in the CEA industry, if it was any notable difference in the capital environment there versus in cannabis. Thank you.

Thanks, Eric. The CEA space, with what's happening in Eastern Europe right now, is starting to change quite a bit in terms of funds coming in. There have been some large operators in the food space in the U.S. that have been raising up to hundreds of millions in the last couple of months. In Europe, we still see a little weakness in the primary European market in terms of funds coming in, but expect that to increase as we go into the fall. We also expect a focus on indoor food vertical farms as well.

All right, and then on the design build side of things. Could you talk about the overall sales cycle there? I appreciate your comments on sort of expectations for a pickup in or maybe a resumption in growth on equipment sales in Q4; could you just kind of help us flush that out in terms of the usual sales cycle that you see from design build to maybe getting to a point to be able to book some of those equipment system sales and, I suppose, comments as well as any of that has lengthened in these past months? Thanks.

Thanks, Eric. Well first, we do go-to-market outlook cards. So whether it's engineering design or architecture, or a combination or the full design build, which is a market in many different ways. The acquisition of Emerald Construction a few months ago changed everything, and the response and why I'm saying our model is strong and working is because we've got tremendous support and interest, and I look forward to announcing those contracts. The end-to-end design build is about 18 months. The difference between urban-gro and others is we engage one or two months before the architecture starts, and we stay engaged after on the back end in terms of training and remote monitoring, just helping people ensure that the soft start. The architecture really lasts for the entire length for urban-gro. But the architecture up front is about three to four months; it is way into engineering. During the engineering stage, is when the equipment is starting to be purchased. We can mitigate a lot of those supply chain issues because we just talk to the client a little bit earlier. If mechanical is seven months now instead of three months in the past, it's okay, we just talk a little bit earlier. So starting with architecture, and certainly thereafter engineering and then finding the construction management side of the deal; you're looking at 18 months total. That gives us the confidence that business is there in the pipeline; it just hasn't been signed yet. So I look for a stronger equipment backlog as the year progresses into Q4. The reason I can confidently say that we believe that there will be a bounce back in equipment sales near the tail end of the year is because we are in early design on quite a few projects right now. So it'll naturally move into the equipment selection side.

That's very helpful. I appreciate that. And then last question for me here. As you look at the volume of projects that Emerald is doing, could you just give us a sense of maybe volumes of projects to quantify the number of projects that you expect to do with Emerald under your umbrella as opposed to maybe what you guys were doing in 2020, or 2021? Just sort of help give us a sense of how impactful Emerald could be from a number of projects that you're working on going forward. Thanks.

Yes, in 2021, Emerald's revenues were just over $26 million. I think they had about 22 employees at the time. Ever since we finished the acquisition, our CEO has been working very closely with their CEO to scale the business as rapidly and efficiently as possible. Our design build contracts for Emerald outside of CEA typically would range from $1 million to $5 million, and in the CEA segment, it could be anywhere from $20 to $60 million, depending on the equipment solution or holistic solution that the client decides on in terms of equipment selection. We are laser-focused on helping them scale. That includes putting a plant or project superintendent on site and also increasing the number of relationship project managers that we have. They are a 31-year-old business; they have a lot of experience. Their CEO is laser-focused on ensuring that we keep delivering that high level of service to maintain those long-term partnerships with leading companies like the CPG company, and we bring those service levels into cannabis.

I appreciate the color. Thank you.

Thank you. You have the next question from the line of Eric Beder with SCC Research SSC Capital. Please go ahead.

Good afternoon. Could you just talk a little bit about…

Eric, I'm sorry to interrupt. This is the operator; I would request if you can please use the handset. Your audio is not coming in very clearly, sir. Thank you.

Okay, I'll try again. Can you hear me now?

Yes, I can hear you fine now. Better.

Okay, so let's talk a little bit about the opportunity in Europe. When do you think that will start to generate material revenue and actually thinking about the margins for the European business versus the U.S. business?

So first of all on the cannabis side. As I've said before, I kind of look at the European market being where the U.S. market was five or six years ago. There's a demand for our expertise and also our solutions as far as it relates to equipment. Now answering the pandemic, the European market in cannabis didn't have the momentum that we did in the U.S., so it sort of paused for about 1.5 years. For us, it gave us time to hire the right Managing Director; we identified that we needed that expertise on the ground, we needed that credibility in the European market. So we hired an individual with over two decades of horticulture experience in working in greenhouse and indoor facilities and in cannabis and food. Over the last four months, we have started to build the team around Eric. We have relocated some key employees and we continue to aggressively get into the market by presenting at conferences where we can. The first tie-off is going to be services contracts. That's what we have been signing. They will lead to equipment sales, but in terms of regulatory approvals, that's what the clients are waiting on right now. For the meantime, it's our 50% margin services business utilizing assets that are now relocated to Europe, as well as utilizing our assets back here in the U.S. On the food side, we signed our deal with Urban Health Farms a little over nine months ago. For us, it depends on Urban Health Farms signing their deals with the end users for us to step down and design build the 20 indoor vertical farms. We’ve been working with them in Europe with our team on site selection analysis in a couple of different countries. But until they find that deal with their clients, we can't officially announce our deal here to the market. On the design-build side in Europe, those are probably 10% plus margin projects, but they'll also include a lot of the architect and engineering services, which are high-margin services ahead of time. I have a lot of confidence in the team; we're making great progress. Our goal is to get involved as early as possible with the client. Many new countries right now are opening up their licensing process, making it clear to the market what's needed to successfully obtain a license. When they award the licenses, urban-gro aims to be already working with those clients ahead of time. That'll probably save us three to six months. If we can get a client to market one or two harvests earlier than everyone else, that's worth a lot of money to them because that's when the price of cannabis is the highest.

Sure. Could you talk a little about this very precious amount of capital here? How can you leverage that to the best use and the best returns when you look at it here in terms of moving projects along, or in terms of just how you plan on using this capital to maximize return?

Well, first and foremost, we aim to get back to a positive adjusted EBITDA position as quickly as possible. Instead of giving full year guidance and then stepping out with a weak Q3, we thought it best to put the cards on the table. We don't have limited visibility right now. We have confidence in the pipeline, but want to provide full transparency to the market. We do have a tremendous amount of momentum that we would look to capitalize on in Q4, but conserving the cash is crucial to be ready to make strong acquisitions and take advantage of good opportunities if they present themselves.

Okay, and for my final question, you mentioned when you expect some of these states to open up. Is your optimism about the future pipeline connected to that, or is it unrelated? Yes, let's leave it there. Thank you.

Yes, I know, they're absolutely linked, Eric. For example, New York and New Jersey; we announced a few months ago, a design build contract with a group in New York E29. We started on the architecture and engineering stages, and as that client moves through the process and secures a license, we then move to that next stage. What’s happened in the states have slowed down, they typically move forward on the design side and then push pause. When the states begin to open up, they begin to open up with us as well, and it will start with the equipment. Another example is Missouri. It's a perfect example; they just decided last week to add recreational to their ballot. It was anticipated that they would, but it was added last week. Once it was added, then people feel comfortable; the class feels comfortable, and their finance partners feel comfortable moving forward. So it's definitely correlated.

Thank you. We'll take a final question from the line of Aaron Grey with Alliance Global Partners. Please go ahead.

Hi, this is Remy Smith on for Aaron Grey. Thank you for the question. So while you've been able to avoid some of the pain the hydroponics market has faced, we're now starting to see more of the larger operators and MSOs scale. How long do you believe that might persist? And how do you believe safe could play a factor in that?

We'll say so, or any other regulatory change, will play a huge factor, not only for urban-gro, but for the entire industry. Since the Q1 calls, a lot's changed in terms of really nothing has been happening. In the last couple of weeks, there's been a little bit more movement around safe or perhaps letting some of the operator’s trade on the big boards. Once that happens, once institutions can invest in the larger operators, they'll have funds to grow a lot quicker. As they continue to scale, it's not only just scaling their cultivation, but they're also right now in the process; large operators have been building out a lot of dispensaries. That's one of the things that I'm really excited about as we go into the end of the year and enter '23, is that we now have a turnkey dispensary offering as well. We have all the tools; we have the architecture, the engineering, we have the interior designers, and of course, now we also have the construction management arm. We've signed good contracts with existing clients on dispensaries that we didn't have before. I'm very positive and excited about that development as well. I believe as we get closer to the mid-term, there are going to be some regulatory changes in the industry as an overall entity that will benefit.

Thank you. Sir, do you have any further questions? Thank you, ladies and gentlemen; we have reached the end of the question and answer session. Now I would like to turn the call back over to Mr. Bradley Nattrass for closing remarks. Over to you, sir.

Thank you. I'm confident that the investments we've made and the investment that we continue to make in the business today, are going to result in a very strong future financial performance. The model that I told you about when we were listing on the NASDAQ and we've been building for the last 18 months; it's locked in and proving itself. Every division of our company is performing with the exception of one, and that's the equipment sales division. That's an issue that's affecting all ancillary companies in the sector. Our cannabis-focused architecture and engineering design business remains strong. As a result, we see equipment sales beginning to rebound for us by the end of the year. Yes, the uncertainty in this single area has impacted our actual performance versus our forecast, but I assure you our pipeline of projects is strong, qualified, and it's growing. Again, thank you for joining us today, and I'm grateful for your ongoing interest and support. Have a nice evening.

Thank you very much, sir. Ladies and gentlemen, that concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.