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Executives

Jason L. Tienor – Chief Executive Officer

Gene Mushrush – Chief Financial Officer

Analysts

Collin Harding Royster – American Capital Partners, LLC

Arthur E. Byrnes – Deltec Asset Management LLC

Telkonet, Inc. (OTCQB:TKOI) Q2 2013 Earnings Conference Call August 14, 2013 4:30 PM ET

Operator

Good afternoon and welcome to Telkonet’s Second Quarter 2013 Financial Results Conference Call and webcast. As a reminder, today’s conference is being recorded.

Before I turn the call over to Telkonet management, I would like to read the following statements. Certain statements included in this conference call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. such statements involve a number of risks and uncertainties such as competitive factors, technological development, market demand and the company’s ability to obtain new contract and accurately estimate net revenues due to variability in size, scope and duration of projects, and internal issues in the sponsoring client.

Further information on potential factors that could affect the company’s financial results, can be found in the company’s SEC financial filings including today’s 10-Q and on its reports on Form 8-K filed with the Securities and Exchange Commission. Telkonet is under no obligation to update items discussed today to reflect subsequent development.

And now, I would like to turn the conference over to Mr. Jason Tienor, Telkonet’s President and CEO. Mr. Tienor, you may begin.

Jason L. Tienor

Thank you, operator, and thank you all for joining us today for Telkonet’s 2013 second quarter earnings call. I’ll begin today with a brief overview of our results for the quarter and the discussion of our go-forward strategy and commentary on our target markets. After which, I’ll turn the call over to Gene Mushrush, Telkonet’s CFO, to go over our financial results in detail.

While it opines me to report a loss for the quarter, we’ve used the second quarter as a catalyst for the continued growth and expansion of Telkonet’s EcoSmart platform. We again demonstrated year-over-year and quarter-over-quarter growth resulting in a year-to-date offline increase of 25%. By securing our $2 million lineup credit early in the second quarter, we’ve bolstered our balance sheet and provided security for the continued execution of our growth strategy. We made a number of key strategic decisions during the second quarter that while driving our quarter’s operating expenses, support our ongoing platform and growth vision.

These decisions included an increase in our sales and marketing budget to expand our market penetration and market awareness through advertising, outreach and physical market presence. We also funded a substantially increased presence at HITEC 2013, the hospitality industry’s largest technology trade show, where I also appeared on behalf of our EcoSmart platform on the Fox Morning News Show, The Morning Buzz. This appearance has driven a significant amount of sales interest and has credited with increasing the profile of our EcoSmart technology.

In addition, we continued to fuel our EcoSmart development through industry and safety certifications for products including our EcoInsight, EcoGuard and EcoSwitch controls. We recognized a large number of wins throughout the second quarter as well, which includes the award and installation of one of our largest educational institutions to-date through an ESCO partner that totaled more than $700,000 in this credit cost multiple quarters. We were also awarded and completed the largest hospitality project thus far in 2013 during the second quarter in the Galt House Hotel in Kentucky. The Galt House represented more than 1,200 rooms and more than $500,000 in revenue and has been trending at 37% plus in energy savings since its deployment.

One of the most significant relationships executed to-date was also consummated in the second quarter with the signing of an OEM agreement with one of the U.S.’ largest hospitality PTAC manufacturers, Islandaire. Telkonet saw an enormous amount of development in the second quarter contributing to our platform growth, including the introduction of our EcoCentral Virtual Engineering offering, continued developments of our iOS mobile application, and the development of Telkonet’s newest product, the EcoAir touch device.

All of these activities have combined not only to generate an extensive pipeline, growing of our channel and increasing market awareness, but has given Telkonet an increased lead in both technology and savings offered to customers. As a result of this, we’ve been able to show growth in our key indicators of more than 25,000 EcoSmart units sold in the quarter, which represented growth of 150% over Q1, revenue growth for EcoSmart of 17%, and a backlog of EcoSmart revenue of $785,000, excluding recurring revenue carried into the third quarter.

Our EthoStream division has continued its growth at it’s great pace throughout the second quarter. We had numerous significant events, including having been awarded a contract to upgrade 20 corporate-owned Red Lion Hotels, a project worth $460,000. We successfully completed all 20 installations during the quarter as well. Also expansion of our ongoing relationship with Marriott International and it’s franchisees have installed 15 sites with our brand in the second quarter and ending the quarter with another 17 in the backlog.

EthoStream has installed 10% of the completed sites in the last 12 months and there are 2,000 sites still outstanding under the program. EthoStream was also selected as the preferred partner for Twenty Four Seven Hotels, becoming the ninth such designation. EthoStream’s activities in 2013 have exceeded our expectations and have shown that the synergies between EcoSmart and our EthoStream division are valuable and growing. This performance has also resulted in the growth of EthoStream’s key indicators of 15 new hospitality properties added to the EthoStream hospitality network during the quarter.

Top line segment growth of more than 28% and carrying a backlog of $230,000 excluding recurring revenue for EthoStream into the third quarter, and finally, growth to more than 8 million monthly users across from EthoStream’s hospitality network. As this performance has shown, Telkonet has continued to execute on strategy for market leadership and top line growth. While the second quarter found a sacrificing profit to invest in our operations and sales, we’ve done so strategically to ensure shareholder value and position the company for continued performance moving forward.

We continue to execute on the plan that we stated for growth in Telkonet’s future. The key performance indicators demonstrate how we manage our resources to generate results. While we have a significant cash position held in ESCO to support our bonding initiatives, we still maintain a solid liquidity position at the end of the quarter with cash and receivables of $3.4 million.

We continued the significant improvement of our balance sheet throughout the quarter through the continued retiring of debt and payables that included such long-term items as the Dynamic Ratings note, their Wisconsin financing, sales and use tax with DDA retirement, professional fee and more.

In addition, as I mentioned earlier, we’re securing the $2 million traditional financing as a revolving line of credit. We’ve been able to do something that the company has not done before and that is to provide beneficial financing, offering stability and security for Telkonet’s future.

We’ve also seen a few additional positive events take place during the second quarter, including the conversion of a large number of our Series B preferred stockholders, demonstrating our investors’ continued support of Telkonet strategy and growth results. We also have strong indication of additional significant conversions forthcoming.

Telkonet’s executive team presented at several investor conferences during the quarter raising the company’s profile and contributing to the 100% plus growth in the stock price since the beginning of the year. As we have stated in the past, growth of our sales and marketing organizations will drive our future success, and with that in mind, we continued our expansion through the addition of two experienced sales and marketing professionals to the team, and Brian Ripp as an Accounts Executive, and Mark Rehwald as Director of Marketing. As a demonstration of the continued expansion of our direct sales efforts and a credit to the expertise of these two individuals, we are happy to welcome both to the Telkonet team and look forward to the positive impact that they bring.

The release of our EcoCentral VE platform has strengthened our competitive position and has helped us with innovative integrations and continued growth of our indirect sales channel and ESCO relationships have assisted in penetrating in markets. At the same time, we continue to focus on operating leverage, asset utilization and margin expansion to increase efficiency and profitability. Overall, we’re more confident of Telkonet’s future than ever before. With the second quarter closed and the third quarter well on the way, we’re excited about the activities of the year thus far, and look forward to posting a solid end to 2013.

If we step back and take a look at Telkonet as a whole, I’m very pleased with where we are in terms of our vision and strategy to lead in innovation and technology, while increasing market penetration and our sales pipeline. That said, we expect to continue the growth of our secondary markets moving forward as well as share exciting news regarding our relationships with the hospitality market.

Now, I’d like to hand the call over to Telkonet’s CFO, Gene Mushrush, to detail the second quarter earnings summary. Gene?

Gene Mushrush

Thank you, Jason. Ladies and gentlemen, good afternoon, and thank you for joining us. Today, I’ll be summarizing our second quarter and year-to-date financial performances. For the quarter ended June 30, 2013, revenues increased 4% to $3.6 million, compared to $3.5 million for the same period prior year, marking the fifth consecutive quarter with revenues greater than $3 million. This described a 12% temporary decline in recurring revenues compared to the same period prior year.

We posted gross margins of $1.5 million, compared to $2 million for the same period prior year. The gross margin percentage of 41% continued to hover below our historical averages due in part to higher than usual installation costs, product mix and the aforementioned decline in recurring revenues, which capture a greater margin percentage versus non-recurring revenues.

Operating expenses for the quarter ended June 30, were $2.2 million, compared to $1.8 million for the quarter ended June 30, 2012. The 19% increase is attributable to sales and marketing costs associated with our revenue initiatives, incentive compensation, professional fees, and bad debt expense. We incurred both operating and net losses of $682,000 and $622,000 for the three months ended June 30, 2013. We reported both operating and net incomes of $175,000 and $157,000 during the same period prior year.

We had a negative adjusted EBITDA, a non-GAAP measure, of $533,000 for the quarter and a positive adjusted EBITDA of $375,000 for the same period prior year.

Current year-to-date revenues were $6.7 million, compared to $5.4 million last year, a 25% increase. The non-recurring revenues for high speed Internet were up 80%, driven largely by new installations with Marriott International and wireless network upgrades at corporately-owned Red Lion Hotels. Year-over-year, energy management revenues increased 17% as well.

Our operating expenses increased 12% to $4 million for the first six months of 2013, compared to $3.5 million for the same period prior year. The increase is attributable to once again, sales and marketing costs associated with our revenue initiatives, incentive compensation, fees related to the revolving line of credit and bad debt expense.

We incurred both operating and net losses of $1.1 million and $1 million for the six months ended June 30, 2013. Operating and net losses of $522,000 and $572,000 were incurred during the same period prior year. We had year-to-date negative adjusted EBITDA of $862,000 and $213,000 for the six months ended June 30, 2013 and 2012 respectively.

We’ve reported $715,000 in cash and equivalents at June 30, compared to $745,000 at this time last year. In January 2013, $382,000 of operating cash was used as collateral to meet the performance bound requirement, related to a federally funded contract. These monies will remain as restricted cash until project completion estimated to be in October 2013.

Cash provided by operations during the first six months was $10,000, compared to cash used in operations of $144,000 during the same period prior year.

Our current ratio of liquidity measurement of our ability to pay short-term obligation has remained at 0.9 for the fourth consecutive quarter. During the past 12 months, working capital deficit improved 32% to $710,000. Our debt-to-equity ratio, a measurement of our financial leverage, increased slightly from 0.6 to 0.7 during the last three months.

Our progress on reducing the sales tax liability continues albeit, at a pace lower than anticipated. During the year, we have successfully executed and paid in voluntary disclosure agreements in four states. We have currently short-term payment plans in three additional states. Voluntary disclosure agreements have been submitted, but we still await acceptance notification in an additional 21 states.

As we enter the third quarter, the backlog for high speed Internet and energy management projects was $230,000 and $785,000 respectively. Last week, we were awarded the small energy management project through Johnson Controls, the second such award in the last four months. We’re viewing this as another testament from the global energy service leader and our ability to optimize energy and operational efficiencies.

During the quarter, we executed $2 million revolving credit facility with California based Bridge Bank. We are often faced with contractual bonding requirements for energy management projects. Historically, a condition of the bond underwriting was for us to contribute cash as collateral. This facility allows us to satisfy those requirements at a reasonable cost and have multiple projects outstanding concurrently, all without comprising operating cash. Our borrowing base at June 30 was $530,000 with no outstanding balance.

Once again, thank you for your interest, and to our shareholders specifically, thank you for your continued support. I’ll now turn the call back to Telkonet’s President and Chief Executive Officer, Jason Tienor.

Jason L. Tienor

Thank you, Jim. With that, I will hand the call over to our conference operator to answer any questions you may have. Operator?

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer session. (Operator Instructions) Our first question comes from the line of Collin Royster with American Capital Partners. Please proceed with your question.

Collin Harding Royster – American Capital Partners, LLC

Good afternoon, Jason. Good quarter. Not to beat a dead horse, but could you give me a simple breakdown on the loss from where we did have a profit and then we can, I know sales and marketing costs, but can you break it down for me a little bit better.

Gene Mushrush

Collin, I’ll address this. This is Gene Mushrush.

Collin Harding Royster – American Capital Partners, LLC

Okay fantastic.

Gene Mushrush

It’s comprised of both headcount additions.

Collin Harding Royster – American Capital Partners, LLC

Okay.

Gene Mushrush

Tradeshow attendants as Jason had mentioned it’s kind of the, who is who, with the HITEC as well as some consulting work that we’re doing for product development or I guess you would say product development, which all of those towards the end of the revenue initiatives that we have in the future years.

Jason L. Tienor

From a lot of the basically all of the expense, and the loss that you’ve seen, the conscious decisions that we’ve made in order to both develop our platform as well as our sales and our marketing activities and expand into the secondary markets, including education, healthcare, military, government. Obviously, as you know, mortgage will expand in retail to a wider audience, and we have to spend money in order to do so. Since we put ourselves in a position, where we are not so leveraged from an operation standpoint, we made conscious decisions during this quarter in order to see those results moving into the next couple of quarters and into the years forthcoming.

Collin Harding Royster – American Capital Partners, LLC

Do you see this trend changing quickly or continuing?

Gene Mushrush

Which trend are you referring to?

Collin Harding Royster – American Capital Partners, LLC

The last trend.

Gene Mushrush

No absolutely not, obviously the intention is also increase top line revenues as well as to end the year profitably and that is where our interest lies in. But obviously, beginning this year, starting this quarter specifically with having put the line of credit in place, we chose to make conscious decisions to follow our strategic plans, develop our platform as well as investing in sales and marketing.

Collin Harding Royster – American Capital Partners, LLC

I did read it. It’s a delivering and continuing expansion.

Gene Mushrush

And one thing that we want to get across is that a lot of what we did this quarter is through constant conversations at the board level as well as at the executive management level was due. Understand that we want to close out the year profitably, but in doing so we also want to grow as a company, not just throughout this year, but in years forthcoming. So in doing so, we need to work with partners, we need to reach out to the additional markets that we want to pursue and really penetrate those markets getting people to know who Telkonet is and getting them to know what EcoSmart is.

Collin Harding Royster – American Capital Partners, LLC

Right. One last quick question, how many of the Marriott, you said you’ve done 15 and there are 17 to go or I may have gotten that wrong?

Jason L. Tienor

No, we actually installed on the EthoStream hospitality side, we installed 15 Marriott properties during the second quarter. We had another 17 contracted that was carried over for backlog into the third quarter. There’s more than 2,000 properties in the Marriott portfolio that still have to upgrade their services to reach compliance with standard.

Collin Harding Royster – American Capital Partners, LLC

Great. Thank you all very much.

Jason L. Tienor

You’re welcome.

Collin Harding Royster – American Capital Partners, LLC

It’s a good work. Thanks.

Operator

Thank you. Our next question comes from the line of [Ed Stein], Private Investor. Please proceed with your question.

Unidentified Analyst

Hi, Jason, sounds like you’ve got a lot done this quarter.

Jason L. Tienor

(Inaudible)

Unidentified Analyst

It sounds like we were getting pretty low loan in a bunch of different sectors in military and hospitality and schools et cetera that we may have a – nice probably to have, which is more demand than we have the ability to fill and I was wondering how is that going. Do we have the ability to install if we get loads and loads of offers for multiple projects? Have we subcontracted with folks or do our partners like Honeywell and Johnson Controls do some of that for us. What’s the plan for meeting the demand that already started to materialize?

Jason L. Tienor

Absolutely, and its’ a great question, the demand for both sales as well as for integration on what we call field services, the installation activities differs among the markets that we participate in. Largely within the hospitality space, we try to do a majority of the installation ourselves, utilizing subcontracting when necessary. The one thing that we found through growth in our education and military/government markets is that more and more of those projects, especially when driven by escrows, have requirements that actually obligate us to utilize our own internal resources, comprise the certification our staff requires, comprise the terms that they require, not really serviced by a lot of the subcontractors that we work with.

So you kind of walk a balance between who owns the job, where the job is and what market you’re dealing with, but we absolutely do have a large funnel of subcontractors that we work with nationally as well as partners that we work with internationally that perform those field services themselves and those installation services themselves. The same thing goes on the sales side, while we don’t perform in the majority of our international sales directly, we do that through partners by building up indirect channels, what allows us to break through and not see those types of cash like you were referring to.

Unidentified Analyst

Thanks.

Jason L. Tienor

Absolutely, thank you, Ed.

Operator

Thank you. (Operator Instructions) Our next question is from the line of Arthur Byrnes with Deltec Asset Management. Please proceed with your question.

Arthur E. Byrnes – Deltec Asset Management LLC

Well, my question is when you were unable to get a quorum at the last Annual Meeting, why did that happen? And please assure us that it won’t happen again.

Jason L. Tienor

Absolutely, Arthur, I’d be happy to answer that question. The traditional proxy statement involves a number of standardized questions and one of those questions is the approval of auditors for the company for the forthcoming year. In this last proxy, you’ll find that we actually switched auditing from Baker Tilly LLP, here at Milwaukee to BDO out in Chicago, and it happened right at the time after the proxy has been sent out prior to the shareholder meeting.

Thus without having that question on the proxy of the approval of the audit group, we didn’t have a broker vote question on the proxy statements itself, which meant that all of the individuals who don’t vote their proxies themselves that were typically voted in past years by their brokers, they no longer have the benefit of that convenience. Thus in order to have the proxy closed out and the shareholder meeting completed, they needed to achieve quorum and in order to do, so we had to reach out to individuals to vote their proxies appropriately.

Moving forward, we don’t have plans to change auditors at all, much less change auditors during the proxy process. So we’ll have the benefits of those brokers voting those shares while individuals who don’t actively do it themselves.

Arthur E. Byrnes – Deltec Asset Management LLC

Thank you very much.

Jason L. Tienor

Absolutely.

Operator

Thank you. (Operator Instructions) It seems there are no further questions at this time. I would now like to turn it back to Mr. Tienor for any closing comments.

Jason L. Tienor

Well, thank you, operator. And again, I’d like to thank you for everybody joining us on today’s call. We look forward to speaking with you again during the interim during the third quarter as well as on the third quarter earnings call. If there are any other questions for Gene or myself, please don’t hesitate to reach out to us here at ir@telkonet.com or directly at our office telephone lines. I’d like to wish everybody a great afternoon and thank you for joining.

Operator

Thank you. This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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