SRNA : Surna Stock Analysis and Research Report

2017-11-13 - by Asif, Contributing Analyst

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Surna develop, design, and distribute cultivation technologies for controlled environment agriculture (“CEA”). The company's customers include state-regulated cannabis cultivation facilities as well as traditional indoor agricultural facilities, including organic herb and vegetable producers. The company's technologies include a comprehensive line of application-specific lighting, environmental control, air sanitation, and cultivation facilities. These technologies are designed to meet the specific environmental conditions required for CEA and reduce energy and water consumption. In addition, Surna offers mechanical design services specific to hydronic cooling, including mechanical equipment and piping design.

The company's standard CEA project consists of small chillers, fan-coils, and dehumidifiers, the major equipment items which the company manufacture. Other required equipment items typically consist of large chillers, pumps, air separators and expansion tanks which the company purchase from outside vendors. The company believe its core competency is to provide integration services for these equipment items delivering a fully engineered, turn-key, single-source solution to its customers.

This integrated, single-sourced solution can create gross profit margin fluctuations depending on project design and the mix between its proprietary equipment, which typically generates a higher gross profit margin, and the equipment manufactured by outside vendors. Further, quarterly fluctuations in gross profit margins can occur based on the timing of a project’s needs for its manufactured equipment versus third party manufactured equipment.

The demand for its integrated solution, including engineering design, proprietary equipment and third party manufactured equipment, is primarily based on the new construction of cannabis cultivation facilities in the U.S. and Canada.

Recent and anticipated regulatory changes involving medicinal and/or recreational cannabis use in various jurisdictions, such as California, tend to be a leading indicator for the granting of licenses for new facility construction. As more new cultivation facilities become licensed, the company in turn have more opportunities to sell its systems.

For 2017, Surna is focused on new facility construction in California where recreational cannabis use was approved in November 2016 and in Canada where federal legalization legislation has been introduced and recreational cannabis use appears to be gaining support.

The company's marketing efforts are generally targeted to those persons who are actively seeking licenses to produce cannabis and, in many cases, its engineering services are needed for the completion of license applications. As such, the projects the company quote may not advance to the contract stage due to either a failure of its prospect to receive licensure or to obtain project financing. In other cases, the successful licensee was either unknown to it at the time of application or elected to use a competing technology – rooftop duct system or traditional split air conditioning system – as opposed to its ductless hydronic system.

While its typical project sales contract is non-cancellable, there are risks that the company may not realize the full contract value in a timely manner or at all. Completion of a sales contract is dependent upon its customers’ ability to secure, license and build their growing facility and take possession of the equipment. In order to address these risks, Surna has three key milestones built into its contracts.

  • First, the company provide its customer with engineering plans for which the company require an upfront deposit before the company begin its services. In many cases, the engineering phase is done as part of the license application or building permit process, represents on average approximately 10% of the total contract value, and takes approximately four to six weeks to complete. The company previously required a larger initial deposit that covered engineering and initial equipment items; however, beginning in early 2017, the company began offering its customers a lower initial deposit for engineering only. The company's strategy is to lock in the sales contract and commence the engineering portion of the project earlier, which is important for a number of reasons: (i) the company can assist its customers with their engineering and design plans as part of their licensing application process, (ii) Surna is better positioned to lock in its technology for the project at an earlier stage, and (iii) Surna is able to help reduce the customer’s time to market.
  • Second, upon completion of the engineering phase, it may take its customer on average five months to complete the facility build-out, with possible delays due to financing or other aspects which are beyond its control. Customer delays in obtaining financing and completing facility build-out make the timing of completion of its sales contract unpredictable. For its protection, before the company begin manufacturing its proprietary equipment items, the company require an upfront deposit that brings the total to approximately 50% of the contract value.
  • And third, the last phase of its contract involves procurement and drop-ship delivery of third party manufactured equipment items and commissioning of the system after installation, performed by third parties, is completed. The company undertake this step only upon payment of the third and final deposit of the remaining 50% of the contract value.

As of June 30, 2017, Surna has executed sales contracts with a total unearned contract value of approximately $3,933,000 (“Q2 2017 backlog”), an increase of approximately $143,000 over its Q1 2017 backlog. Of the total Q2 2017 backlog, approximately $2,012,000 was attributed to sales contracts executed during the three months ended June 30, 2017 and the remaining $1,921,000 is attributed to prior quarters. About 30% (down from 78% in Q1 2017) of its Q2 2017 backlog is attributed to projects for which Surna has not received a further deposit on its proprietary equipment and, as a result, there are potential risks of project cancellation or delays. In April of 2017, the company entered into a sales contract with a value of $1,300,000. This project is currently in the engineering phase. Further, a substantial portion of its Q2 2017 backlog is not expected to be recognized as revenue until the fourth quarter of 2017 or the first half of 2018.

In an effort to increase its bookings, we: (i) are in the process of implementing a new customer relationship management (“CRM”) system to better manage an increasing number of inbound requests for project quotes, (ii) continue to build its sales team with more experienced personnel, including the recent addition of a director of sales and business development, a director of technical sales and a sales coordinator who assists its outside sales team, and (iii) have assigned sales territories to allow the sales personnel to focus on individual regional needs and to become more personally involved in their markets. The company also recently developed a sales quotation tool reducing the time it takes to prepare detailed system proposals from an average of four hours to less than an hour. The company anticipate this tool will also shorten the learning curve of its new sales personnel. The company also hope to realize the benefits of a preferred pricing program recently received from one of its major equipment suppliers, who awarded it national account status. As new jurisdictions continue to ease regulation of cannabis and larger scale projects become more prevalent as the market matures and investment capital becomes more readily available, the company believe Surna is well positioned to address the new challenges and opportunities the market presents.

Nonetheless, the ever-changing nature of its sales and the needs of its customers make it difficult for it to predict when the company will recognize revenue. The company continue to remain focused on increasing its sales contract backlog and quoting larger projects in an effort to increase revenue.

Starting in the second quarter of 2017, Surna has allocated more resources to improving its internal project management process in an effort to shorten the time period from the execution of a sales contract to commissioning of the customer’s system. Commissioning is the last step of the installation process of its system, where the company require its customers to pay to have its representatives and representatives from its suppliers on site to initially start the system, balance the equipment, achieve the designed temperature and identify any installation issues. Surna has worked to improve its internal and external kick-off meetings for smoother transition from sales contact execution to project management and from project management to commissioning. Processes and documentation have been established and integrated with its CRM system to allow it to more efficiently identify and manage project execution.

For example, the company created customer project launch documentation to ensure all necessary information is timely conveyed and received, project scheduling and timing is adhered to, invoice and billing systems are accurate, equipment delivery and installation are completed on time, and project commissioning meets its desires and those of its customer. Surna has also initiated a weekly project tracking update document depicting a visual representation of the current progress and milestones of each customer’s project, which is delivered to its sales and project management teams as well as the customer’s project and management teams. This tracking communicates current status, pending activities and next steps, supplier involvement and key issues needing attention. While the company believe its efforts in improving project management can lead to earlier completion its customers’ projects, external factors outside of its control, such as the customers’ ability to secure, license, finance and build their growing facility, can significantly impact the delivery and installation of its equipment.

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