urban-gro, Inc. Q2 FY2023 Earnings Call

Hello, and welcome to the urban-gro 2023 Second Quarter Earnings Conference Call. As a brief reminder, all participants are currently in a listen-only mode. Following the presentation, there will be a question-and-answer session for those on the teleconference line. Please note that this conference call is being recorded, and a replay will be made available on the company's website following the end of the call. At this time, I'd like to turn the conference over to Dan Droller, Executive Vice President of Corporate Development and Investor Relations at urban-gro. Sir, please go ahead.

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 at ir.urban-gro.com. On this call, we may state management's intentions, beliefs, expectations or future projections. These are forward-looking statements that 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 do 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, which again, is at ir.urban-gro.com. With that, I'll now turn the call over to Brad.

Thank you, Dan. Good afternoon, everyone, and thank you for joining us. Our evolution into a professional services consulting firm continues to gain momentum, and in addition to our focus on Controlled Environment Agriculture, also known as CEA, we continue to expand growth outside of this market in the industrial, commercial, and healthcare sectors. With the dedication and support of our leaders and their teams, and consistent with the expectations that we communicated in May, we've continued to do what we said we would do. We recorded another sequential improvement in both revenues and adjusted EBITDA. We increased our quarter-end cash position. We continue to have zero bank debt, and we've removed additional costs from the business. With this said, it comes as no surprise that we've been operating in a very challenging environment in the first half of '23. Our reductions in SG&A to offset decreased margin dollars, especially in the equipment category, have yielded positive results. And coupled with our ongoing business development initiative across all segments in which we operate, we are confident that our model will continue to prove its efficiencies in the quarters ahead. Our messaging remains consistent in that our top corporate priority is returning to sustained positive adjusted EBITDA as soon as possible. Based on our third quarter to date trending, along with the cost we've taken out of the business, our increasing revenues and our systems enhanced insight into our project margins, we believe that we are close to reaching that inflection point, and moreover, are not in a position where we would need to raise dilutive capital. In the second quarter, we generated net revenue of $18.8 million, which represents a 12% sequential improvement over the first quarter and a 16% improvement over last year. Adjusted EBITDA for the second quarter was negative $2 million, marking a significant $1.4 million improvement over the first quarter. We remain diligently focused on reallocating resources and optimizing our spending where appropriate to ensure that our infrastructures align with the size of our business. Through these initiatives, year-to-date, we've now reduced our annualized SG&A expense by $2.9 million. While these were difficult decisions, they were necessary ones, and we're now a leaner and more efficient organization than we were at the end of last year. Additionally, we now have improved visibility into our business with all entities operating on the same ERP system, and we'll continue to take action as necessary to position our business for long-term profitable growth. Now turning to current sector trends. Sector diversification continues to help insulate our business from the broader weakness that the cannabis and produce focused vertical farming sectors are working through, although these sectors remain an important component of our future growth. Through our successful diversification strategy initiated a year ago, we've evolved into a professional services consulting company that offers turnkey design-build solutions to multiple markets. In fact, approximately two-thirds of our revenue this quarter were from other targeted markets in which we have diversified. We've established ourselves as a trusted partner for all of our clients' projects, and the quality and level of service we provide lends itself to a high rate of repeat clients and speaks to our ability to attract top-tier companies, including some Fortune 50 as clients to the company. In the CEA sector and as we've detailed on past calls, our equipment revenues have been significantly impacted for over a year now by the weak cannabis market. On a positive note, the second quarter represented the first sequential increase in equipment sales since the second quarter of '22, the primary driver being projects that resumed after an extended pause. This being said, our professional services revenue is also being affected by this downturn and year-to-date more than half of our services revenue is from markets outside of CEA. Overall, we remain well positioned in the sector and will most definitely be ready to handle the surge in demand when the cannabis market rebounds in the future. We also remain confident in the strategic investments that we've made in Europe and believe that we're well positioned for long-term growth. In regards to our backlog, which decreased to $79 million at the end of Q2, the drop is predominantly tied to a design build cannabis cultivation project that was actively in production. Our client is unfortunately facing some funding uncertainty, and so we had to pause the project. While we remain in close contact with the client, the contract does remain open and we felt it prudent to remove it from our reported backlog until their funding source is solidified. As communicated on past calls, urban-gro's backlog is a realistic and trusted indication of our future business. And although there was a quarterly decrease, as of today, we have multiple contracts currently out for signature, which are collectively worth well more than this sequential reduction. Now, turning to our guidance for full year 2023. Due in part to the pause of the project discussed above, as well as some other timing shifts where projects have extended out to additional quarters, we're updating our guidance for consolidated revenues to be within a range of $90 million to $95 million and adjusted EBITDA in the range of negative $6 million to negative $5 million. To put this in perspective, I'd note that our adjusted EBITDA in the first half of '23 is negative $5.5 million, which implies that we expect neutral or breakeven adjusted EBITDA performance in the second half of the year. In terms of cadence, for the balance of the year, we continue to anticipate sequential increases to both revenue and adjusted EBITDA. In summary, we remain closely aligned with the interests of our shareholders, and insider ownership now represents approximately 30% of outstanding shares. This alignment is further supported by: first, the recent open market equity purchases by myself and other directors, totaling about 1.5% of shares outstanding; and second, the commitment of my leadership team near the beginning of the third quarter and led with a 50% commitment for myself. Each executive Vice President and officer of the company voluntarily opted to take a stock grant in lieu of 20% to 50% of their base salary for a three-month period. The key takeaway here, our Board and our leadership team strongly believes in the future of the company. We look forward to continuing to deliver improvements in both the top and bottom line and further unlocking the value for ourselves and for our shareholders that we know our business can provide. Thank you. And with that, I will now turn the call over to Dick.

Thanks, Brad. In the second quarter of 2023, we generated net revenue of $18.8 million, which represents a 12% sequential improvement over the first quarter of 2023, and a 16% improvement over $16.3 million in the prior year period. This increase was driven by an $8.1 million increase in construction design build revenue associated with the Emerald acquisition in April 2022, while professional services revenue of $3 million remained relatively flat year-over-year. Although equipment revenues decreased $5.5 million versus the prior year, they increased approximately 59% relative to the first quarter and further more than 2 times what we reported in the fourth quarter of 2022. Combined, we believe this is an early indicator that we are seeing more recovery in equipment spending from our cannabis sector clients. Gross profit was $2.9 million or 15% of revenue in the second quarter compared to $3.5 million or 22% of revenue in the prior year period. The decrease in overall gross profit margin was driven by the impact of revenue mix where we experienced a decrease in higher margin equipment systems revenue, offset by an increase in lower margin construction design build revenue. Operating expenses were $6.8 million in the second quarter. On a sequential basis, our operating expenses decreased by $1.1 million. In addition to the annualized savings reductions that we had reported in the first quarter and after aligning all entities into one ERP system, we've taken additional steps to optimize and reallocate our resources, which now total $2.9 million of estimated annualized operating expense savings year-to-date. Non-operating expenses were $1.6 million in the second quarter, which includes a $1.5 million legal settlement. As a result, net loss was $5.4 million or a negative $0.50 per diluted share in the second quarter, of which approximately $0.14 per diluted share is due to the $1.5 million settlement I just mentioned. This compares to a net loss of $1.7 million or negative $0.17 per diluted share in the prior year period. Adjusted EBITDA was negative $2 million in the second quarter compared to negative $0.5 million in the prior year period. In addition to being driven by lower gross profit due to a change in revenue mix, the decrease in adjusted EBITDA year-on-year was due to higher operating expenses, predominantly associated with increased compensation, headcount from both organic growth and our acquisitions, increased professional and insurance-related expenses, and the investment in our European entity, which began in Q3 2022. Turning to our balance sheet, we ended the second quarter with $8.6 million of cash, a $1.3 million or 18% sequential improvement over the first quarter. This cash, combined with no bank debt, provides us the necessary flexibility to manage through the macroeconomic market circumstances until we return the business to positive adjusted EBITDA. And in regards to backlog, our total backlog as of June 30, 2023, was approximately $79 million. This is down from the $105 million that we reported at the end of the first quarter of 2023, primarily due to the removal of a client's project as Brad previously discussed. This backlog is comprised of $70 million in construction design build, $4 million of professional services, and $5 million of equipment systems contracts. That concludes our prepared remarks. Operator, please open the call for questions.

We will now begin the question-and-answer session. The first question comes from Eric Beder with SCC Research.

Can you talk a little bit about the G&A? Significantly, obviously, I think we'll see probably a little more of that benefit roll through the rest of the year. Do you have the ability to leverage that? Is this a leverageable number or are you going to have to start ramping it up going forward? And when you look at it, how has it affected your ability do you think to do projects or other pieces here?

Thanks, Eric. We do not anticipate needing to make more cuts in order to get to our targeted positive adjusted EBITDA. That being said, we will experience the benefit from some of the cuts that we made in the second quarter. We'll have a full quarter to take on those cuts we made in Q2. And in addition, those benefits from the leadership team taking stock in lieu of salary, that will be predominantly recognized in the second quarter as well. And as per your second part of your question, it's the most exciting part of our model. We've got a strong team. We do have a large number of Vice President and higher positions. However, we've invested to build out this roster of individuals. Actually, even in Q1, we added our Controller and our Chief Operating Officer. And the good news is, as we build, as revenues double and triple, we don't need to add any more Executive Vice Presidents or hire. We'll need to add architects, engineers, and construction management individuals just to meet the demand and deliver the services. But we will not need to proportionally increase the G&A with the revenue. So it's the exciting future ahead of us that urban-gro brings for sure.

Could you also talk a little bit about the ERP? How many did you have before? And going forward, how can you leverage that and how should we be thinking about that in terms of opportunities?

Dick, will you take that please?

Sure. Hey, Eric, thanks for the question. And just kind of to clarify, you're asking about the ERP system in terms of how we're able to leverage that into our operations and reporting?

I guess the question is, how many did you have before that you collapsed into one, and what does having one ERP as opposed to multiple ERPs mean in terms of your ability to drive more business and drive more profit?

Okay, fair enough. Yes, so, with the acquisitions that we did, everybody had kind of their own ERP. The primary one that urban-gro developed and acquired to really handle the business going forward is the one that we are using on a consolidated basis going forward. But with the three acquisitions that we did, two of them had the same ERP and the other one had a different one. So that was three different ERP systems. Combining those into our existing ERP system going forward, which is conducive to handling the construction design build business that we're doing, it's just been a matter of taking their existing projects, making sure we get them into our new ERP system, but that we get the reporting out to all of the project managers and division managers so that they understand how their business is trending, how profitable it is, and then the things that they have in their pipeline coming into the business so that they can schedule their people and projects accordingly. So it's been not been an easy effort from that standpoint because we had to keep the business running, but now we've finally gotten that to where all the businesses are in the urban-gro existing ERP and making it so that we're just frankly more efficient with regard to doing the work going forward. That did result in some of the headcount savings that we were able to reduce our headcount by, not as much as in some of the areas where we did have some reductions, but there were some savings with regard to those aspects of things.

Our next question comes from Eric Des Lauriers with Craig-Hallam Capital Group.

Thanks for taking my questions and congrats on the cost cuts made on the G&A side of things. It's impressive to see. My first question is just kind of getting a status quo on the cannabis projects. It sounds like there was one that was paused in the quarter and then, in the prepared remarks, I think I may be picked up on some that maybe have resumed. So just wondering if you could kind of give us a status quo of your current cannabis projects? Maybe how many you have active? And then just in terms of the guidance, what's implied in terms of new cannabis projects starting up in the second half? Thank you.

Thanks, Eric. Regarding the one project, it was a design-build project that started late in Q1. We expected to recognize approximately $15 million this year, but it is currently paused. There's a possibility it might resume, but for now, we decided to take it off the table as a precaution. I have mentioned before that we have over 20 projects in the cannabis sector at the design-build stage. However, progress has been hindered for various reasons, often linked to the expansion of legal states and associated regulatory delays, or new states that have legalized but have not yet issued licenses, or have retracted them, as seen in Alabama. These factors are currently delaying our projects. As these regulatory issues are resolved, we anticipate that projects will advance, and when they do, we are optimistic about moving to the construction phase and subsequently supplying equipment. Furthermore, single-state and multi-state operators in the cannabis field are closely monitoring their capital expenditures. The projects that opened for us were located in Massachusetts and Georgia, which we began working on in mid-2022. Overall, I believe we need some movement in banking and SAFE Banking reform. Unfortunately, I don’t expect that to happen this year, especially concerning 280E, rescheduling, and allowing operators to list on major exchanges and access significant capital. However, some contracts we signed in Q4 and Q1 that are now gaining traction will lead to a strong sequential increase for us as we enter Q3. We have updated our guidance accordingly; it’s not solely dependent on Q4. While we expect some sequential growth in Q3, we'll be prepared to seize opportunities as they arise. Our diversified approach allows us to maintain profits and margins in other areas, so we're managing well, though it has taken about a year to reach this point.

Yes. So, it sounds like with those two projects that resumed, that's going to be driving some of the sequential inquiries from Q2 to Q3. Does the guidance assume that any other cannabis projects release or that there's some regulatory change that's going to cause more revenue to be recognized from new cannabis projects either in Q3 or Q4? Is there anything like that implied in the guidance?

No, there isn't. On our backlog, about 70% of it is in CEA, the majority of that is cannabis, 30% non-CEA. And the projects that have released right now. There's a couple of small $5 million to $8 million ones that we're expecting to release in the next four weeks or so. We proportionately added some of those into the guidance. But guidance is really dependent on continuing with the non-CEA projects and executing, as you saw in Q2 about two-thirds of our revenues were from the non-CEA side of the business.

So, if I heard you correctly, you're indicating that 30% of the backlog is non-CEA. Approximately two-thirds of the recognized revenue in Q2 was from non-CEA. Could you provide some insight into the pipeline of non-CEA projects, considering your strict definition of backlog? How are the new non-CEA projects progressing, and how has the momentum of combining these various businesses into a single solution contributed to these discussions? Additionally, can you give us an overview of the revenue mix for a typical non-CEA project? For example, I understand that cannabis or CEA projects have a high proportion of equipment systems, but I don't think that's the same for non-CEA projects. A rough overview of what a typical non-CEA project looks like would be appreciated. Thank you.

Thanks, Eric. First, in the non-CEA market, we have a significant potential client base to pursue. Our non-CEA business is currently experiencing a lot of repeat transactions. As I mentioned earlier, we have more contracts in the signing process than what we require to offset our declining backlog. We’ve received many verbal commitments from clients, but we only count them in our backlog once they are signed. We're optimistic about these projects, actively discussing strategic CapEx plans with our clients for the rest of this year and into 2024, which gives us a solid direction. Typically, non-CEA clients do not finalize contracts six months in advance. Instead, we operate on verbal agreements and can move forward quickly once we receive confirmation from them. In terms of equipment, while there is equipment involved in the CEA side, such as mechanical lights and airflow systems, we have successfully entered the equipment market on the non-CEA side following our acquisition of DVO. Their President, Jason Dawson, has established relationships with some of the largest mechanical manufacturers globally. We have successfully completed our first deal, which is part of overall construction costs. We are also starting to explore materials, like insulated metal panels. I expect a significant increase in equipment sales, which will be combined with construction, at least for now. An example project in the non-CEA segment could involve an architect's design worth a few hundred thousand dollars, but we can then incorporate our engineering and construction services. With one of our Fortune 50 clients, we originally just had construction contracts through our acquisition of a construction management firm, and now we are also managing architecture and engineering for these projects. We aim to include equipment resale as part of the value-added services for that client. There is a substantial opportunity within the $10 million to $30 million range, as we've observed that many larger design-build firms operate at much higher project values. The market has a shortage of turnkey design-build firms; it typically consists of separate architecture and construction firms. By offering all services under one umbrella at urban-gro, we are providing a valuable solution. Clients would otherwise need to recruit additional construction management staff themselves, which we can handle for them. In summary, we currently have a robust flow of repeat business in the non-CEA sector, and there are certainly opportunities to integrate equipment into this business moving forward. I look forward to discussing this further in future quarters.

Our next question comes from Brian Wright with ROTH MKM.

Thanks. Good afternoon. I really wish more companies I cover, especially those facing challenges, would follow your lead in stock buying and salary deferral. I want to commend you and the team for that commitment. My question is, when considering the revenue and EBITDA guidance for the year, should I think of it as a slight sequential increase in the third quarter followed by a more substantial increase in the fourth quarter for revenue?

Thanks, Brian. I appreciate your kind words and will share them with the team. We are anticipating a strong sequential increase as we move into Q3, followed by continued growth into Q4, as reflected in both our revenue projections and adjusted EBITDA. I understand your next question might revolve around margins, which is an important topic. I want to emphasize that the bottom line is crucial. We could generate significant revenue, but without positive adjusted EBITDA and cash generation in the upcoming quarters, we may not receive the recognition we deserve. Therefore, we are currently focused on improving our margins. I believe Q2 margins in some areas were anomalies. As our construction segment becomes a larger part of the business, it may negatively impact our overall gross margin percentage. However, as I respond to Eric's question, if we can achieve strong margins on equipment sales within the construction segment or on materials like insulated metal panels, that should help us balance our averages. While we are not pursuing acquisitions at the moment, we do plan to start acquiring profitable service companies in 2024. These could include firms in energy efficiency or other areas with solid contracts that we can integrate our services with. Therefore, improving margins is a key focus for us. Dick, is there anything else you’d like to add regarding this, since you are closely monitoring the team's margin efforts?

Yes, I would echo Brad's comments with regard to margin. And then in addition to that, Brian, I'd just say from the standpoint of our operating expenses. For Q3, we'll see some additional savings reflected that were part of the reductions that occurred part way during the second quarter. So, we're going to see improvement there in the third quarter, then a little bit more of a stabilization going forward. But as Brad commented on the overall call, we have a business that leverages very nicely as we look to grow and have the cannabis customers start purchasing equipment again. We're well staffed on the construction design build side from the standpoint of being able to support growth on that side of the business. So, anyway, we really feel we've got ourselves well positioned so that we'll be able to handle or manage really the growth in the business without having an increase in the operating expenses.

I want to discuss the EBITDA aspect now, considering our year-to-date performance and the guidance. How should we interpret that? Is it likely to be flat in the third quarter, or should we expect a slight decline followed by growth in the fourth quarter? I would appreciate any insights on how to better model that progression. I know the mix is a concern, but any assistance would be helpful.

Yes, I would say it's somewhat dependent on the mix. Currently, we anticipate the adjusted EBITDA to result in a slight negative in Q3, followed by improvement in Q4. However, this will depend on the mix, and that’s how we envision the growth progressing for the remainder of the year.

No, that's very helpful. I have just one more question, more of a theoretical nature. Based on what you've told us, it may not be relevant for this quarter, but does backlog age matter? Is that something you have ever thought about discussing publicly in terms of how the age of the backlog relates to other factors?

I understand your question. Brad usually handles theoretical questions, but I'm happy to answer this. If we ever feel that something in backlog suddenly looks like it was just signed by the customer with no intent to move forward, we would consider removing it from backlog. Most of what we have in our backlog consists of projects that were signed recently. For the construction build side, we have remaining amounts under contracts that haven't been recognized yet. From our perspective, all ongoing projects related to construction design build are good since they are actively being worked on. We don't have any concerns in backlog about customers signing contracts without an intent to proceed.

I'll elaborate on this further. We have an internal backlog review team consisting of our COO, Dick, JT Archer, and two of our EVPs, Sam and Dan Droller. They meet every two weeks to review the backlog from both sides, ensuring regular communication with all clients, that they are progressing, and that they are being invoiced. This team helped us make the decision to pull out one project in Q2. I want the backlog to remain a strong indicator of future business for urban-gro. People should take note of the backlog, and investors should recognize that we have $79 million in revenue expected with over 80% confidence for the future. We need to keep its integrity as well.

Our next question comes from Thomas McGovern with Maxim Group.

So firstly, I just want to see if you guys can provide an update on your planned expansion in Europe. Last time we spoke, you discussed that you were monitoring, but there was not quite as much visibility as we were hoping for at that time. Just wondering if you guys have a little bit more visibility going into the third quarter on that front?

Thomas, in Europe, the market on the horticulture side, it's very tight, very tough right now, still since one year later after the war broke out in Eastern Europe. On the cannabis side, it's a little bit looser. But it's similar to the issues we have at the state level here in the U.S. Germany, for example, they had regulations that went against the EU. And so they're trying to figure out their path. And until those regulations are defined, we won't invest aggressively in Germany, but we'll make sure we're in regular contact with the existing growers and the potential operators in the country. So we are operating right now in the Netherlands from a business standpoint. The other two that are active and increasing in terms of momentum for us, Portugal and even South Africa. So there's, there's progress there. If there is any progress on the vertical farming side, it's still quarters away, there are discussions, ongoing discussions in the industry in the Middle East. And Sonia Lo, our Board member, who has been the CEO of other vertical farming companies in the past, she's involved in playing a nice role for us there. But that's more biz dev, early stage, but definitely an opportunity in the future. So, hey, look, overall Thomas, I would've hoped, we would've hoped that we would be breakeven in Europe by now, we would've been stronger. As far as top line Q2 of this year was the best quarter that Europe's experienced thus far. But it's still in the hundreds of thousands of dollars of revenue and hasn't pierced $1 million. Mostly all design, no build at all at this point. But as it becomes material, we will absolutely talk more about it and we review it. Every Board meeting and every month as a leadership team internally, great opportunity cheering them on and hoping they can sign contracts and we can get those released.

Awesome. I appreciate that insight. And then finally, just on the backlog, you mentioned in your prepared remarks that there were a number of contracts were up for signing. Just wondering if you could provide any additional color on when we might start to see some of those deals signed? Is that something we could expect to kind of pick up in the third quarter, or is it something that maybe will have more impact in the fourth and maybe early 2024? Thanks.

I expect the contracts that are currently out for signing will be finalized this quarter. A considerable amount of work is involved in these contracts. Some have memorandums of understanding associated with them, but we only count them as part of our backlog once we have a signed contract or purchase order from the client. On the CEA side, we are confident in our funding. As we make progress in the third quarter and finalize these contracts, we will announce them. In the past, we have selectively announced updates, but in this quarter, we plan to communicate more proactively with our investors about the developments, including details on the region, market, whether it is CEA or non-CEA, the contract's dollar value, and the timeframe for revenue recognition.

That is all the questions we have for today. Please reach out to investors at urban-gro.com with any additional questions. Thank you and have a nice evening.