Description

In the last week, we made OESX US the #2 position in our portfolio.  Only AFH US (detailed in a separate VIC write-up) is currently larger in our book.

We believe that over the next 24 months, this company’s sales and profits will experience a dramatic increase as (i) a new product cycle kicks in and (ii) the company leverages its state-of-the-art manufacturing footprint, which is currently operating at sub-20% capacity utilization as a result of overinvestment by a prior management team.

History

In 2009-10, I led the research effort at the fund I previously worked at on a short of the light-emitting diode (“LED”) industry.  The lighting industry had experienced a major up-cycle just a few years earlier with the conversion from conventional lighting to compact fluorescent and high-intensity fluorescent (“HIF”) lighting solutions.  Expectations were high that the next technology, LED, was just around the corner and would lead to a new up-cycle that would benefit LED manufacturers and their suppliers.

Our variant view was that while it was true that LED prices were rapidly becoming more competitive, we felt HIF prices would also continue to decline as improvements were made to both technologies.  LED stocks were “priced to perfection” with analyst estimates implying that LED would become the dominant lighting technology in short order.  Our short thesis was that LED would eventually become the dominant technology – but that the crossover was five years distant, not around the corner.  In 2010 and 2011, the share prices of many major LED-related companies on which we held bearish views including Cree, Inc. (NASDAQ: CREE), Veeco Instruments Inc. (NASDAQ: VECO), and Aixtron SE (XETRA: AIXA) fell materially and have not recovered since.

Today, however, is “five years later.”  And we believe the inflection point has arrived.

We have maintained strong contacts in the lighting industry, and it is our view that the LED industry is about to experience a major up-cycle as LED becomes the more cost-effective option for most/all lighting solutions.  The “canary in the coal mine,” in our view, is exterior lighting: new technologies have historically penetrated this small niche first as exterior lights (such as parking lots, building exteriors, etc.) tend to remain on through the night and are generally industrial-scale – allowing small changes in energy efficiency to have a magnified impact on the payback period.  Over the last 12-24 months, the “winning” technology for virtually all exterior lighting solutions has flipped from HIF to LED.  Interior lighting, the bulk of the lighting industry, is rapidly inflecting to follow suit into LED.  We don’t believe this is an “if” or even a “when,” we believe it’s actually gaining traction right now.

There are many ways to play this theme, but we think the best is Orion Energy Systems, Inc. (NYSE: OESX) (“Orion” or “OESX”), a lighting company based in Manitowoc, Wisconsin.  Orion has little product risk, an excellent management team, a rock-solid balance sheet with $10M+ of net cash, expectations are low, the company is not widely perceived as a play on LED (so the stock is cheap), and the business has enormous upside operating leverage (as explained in greater detail below).  Just as importantly, we can see a clear event path for the company to be significantly re-rated in tandem with rising revenues and profits.  Our fair value target looking out 2-3 years is between $15 and $20 per share, or 3x to 5x upside from the current price of just above $4 per share.

The Business

Orion is a manufacturing company, but perhaps a better way to view the business is (i) as a designer/assembler of lighting solutions and (ii) as a coordinator of the lighting installation process. 

Orion does not manufacture HIF or LED bulbs itself.  Instead, Orion purchases bulbs from one of the half-dozen major lighting companies engaged in the vigorous, capital-intensive, highly-competitive arms race to manufacture the next generation of cheap bulbs (Cree, GE, Osram, Nichia, Philips, etc.).  As a result, this is explicitly not a call on whose technology will win that arms race.  Orion designs and manufactures the fixtures in which the bulbs are placed, assembles the final product in its manufacturing facility, and then takes that product to market.

OESX’s sales channels are bifurcated into (i) large national accounts (which are handled in-house) and (ii) re-sellers, which are an increasing emphasis for OESX.  A major element to OESX’s current business strategy is to meaningfully grow the number of large external re-sellers (“ESCO’s”) that rely on Orion product by building a strong support platform to assist these re-sellers in their businesses; this approach will allow Orion to leverage sales without significantly increasing boots-on-the-ground.  Product margins are similar between the two channels.

Orion’s historical “sweet spot” has been interior commercial and industrial lighting (“C&I”), a segment that includes warehouses, distribution centers, manufacturing plants, etc.  Winning this business fundamentally comes down to two things: relationships and price.

• We estimate that 30% of “winning the sale” comes down to relationships.  In this respect, Orion has a substantial competitive advantage.  Companies in the C&I niche care deeply about reputation, about having a good business partner, and about getting the job done on time and within budget – no one gets fired for going with the same company that executed well the last time around.  Orion has worked with 150 of the Fortune 500 companies.  Major customers include Coca-Cola (Orion has retrofitted ~400 facilities), Pepsico (~200 facilities), Kraft (~100 facilities), Sysco (~100 facilities), Anheuser Busch (~100 facilities), GE (~50 facilities), Nestle, Toyota, and Caterpillar.  As these and other past customers look to replace their HIF with LED, Orion has a built-in head start on winning the business.

• We estimate that 70% of “winning the sale” comes down to price.  In this respect, Orion’s competitive advantage is even more significant.  For interior C&I applications, Orion’s low-bay and high-bay fixtures offer a structural cost advantage due to the reflector geometry of the fixtures.  In plain English, Orion’s business was initially built on a simple premise: its fixtures are configured in such a way that they reflect light more efficiently than competitors’ fixtures.  Orion’s fixture designs are protected by more than 70 patents; the superior design allows Orion to use (for example) four bulbs in a fixture where a competitor would need six to generate the same amount of light.  Orion can pass along a portion of the savings on bulb costs to its customers, allowing for structurally lower prices for customers with structurally higher margins for Orion.

And that’s the ballgame.  Orion has better relationships in C&I than its peers.  It offers its customers the same amount of light at a lower cost (for a faster payback period).  As Coca-Cola, or Kraft, or Nestle, or Sysco decide to upgrade their facilities from HIF to LED – decisions we believe are increasingly imminent – OESX is well-positioned to capitalize on a substantial increase in demand for its products.

The Turnaround

There’s more to the story, however, than a simple cyclical up-cycle.

In September of 2012, Orion hired John Scribante to be its CEO.  At the time, the company was a mess: the business had generated virtually no profits in the HIF up-cycle because of chronically wasteful spending that included a corporate jet, poor manufacturing practices, over-ordering of inventory, and company Christmas parties that cost well into the six-figures each year (in Manitowoc, Wisconsin!) with blow-out fireworks displays.  John was an extraordinary salesperson with a bullet-proof track record building businesses via top-line growth (he took one business from $4M in revenues to $70M in five years; he took another from $0M to $55M in sales in three years).  But his first task was to get the house in order on the cost side.

In the last 18 months, John and his team rebuilt the foundation of Orion by streamlining its operations: 

• Orion implemented LEAN manufacturing processes;
• Orion implemented a profit-sharing plan for company employees to align all stakeholders with creating value;
• The corporate jet was sold;
• The annual Christmas party no longer costs six-figures;
• The company’s extra facility in Plymouth, WI was shut down, with employees consolidated into the Manitowoc headquarters;
• The Plymouth, WI facility was sold;
• Headcount was reduced by nearly 20% while the sales force was increased by 50%;
• Bloated inventory levels have been worked down, resulting in $25M in cash from operations in the last 18 months relative to a current enterprise value of ~$80M.

An article on the turnaround can be found here: http://bit.ly/1t7TvbU.

In addition, Orion acquired Harris Manufacturing Inc. and Harris LED, complementary businesses that opened up new sales verticals in which Orion had not previously participated, including government, commercial office, and retail.  Harris’s operations have now been integrated into Orion’s Wisconsin facility.

The Harris acquisition, in our view, has the potential to be a game-changer for Orion.  In the previous cycle, Orion’s revenues went north of $100M with the company effectively only competing in the C&I vertical.  The Harris acquisition multiplies the company’s opportunity set.  In particular, we highlight Orion’s LDR product which was launched four months ago and which we are hearing is a home-run.  Links are as follows:

http://bit.ly/1t821rw

http://youtu.be/mLq2CRx9ti8

The payback period on installing the LDR product is often two years or less, and each LDR troffer sells for roughly $150.  Walking around our office space and counting the lights in the ceiling, we estimate our floor alone (in a 70-story mixed-use building with a narrow floor plan) could represent $100-150K of potential LDR sales; multiply that by 17 floors of office space and our building would represent a $2M+ potential order.  OESX could generate $200M in LDR sales from three city blocks in NYC.

Investment Thesis

When industries transition to a new technology, there is usually an “air pocket” associated with the transition – a moment when orders for the old technology fall away in anticipation of the new technology, but when orders for the new technology have not yet ramped.

In Q1 2014, Orion experienced that air pocket moment.  Revenues were awful, gross margins collapsed, the numbers were simply terrible.  In the last six weeks, the stock price has nearly been cut in half.

We, on the other hand, view this as the inflection point.  HIF orders have fallen off in anticipation of the arrival of LED.  Now it’s only a matter of time before LED orders begin to arrive in size.  Importantly, management noted in its earnings release that the company’s “pipeline of opportunities has been growing at unprecedented levels,” the first time an otherwise non-promotional management team has made this statement.  We are hearing similar things in our channel checks.

The company’s current market cap is roughly $90M with $11.5M in net cash for an enterprise value of just shy of $80M.  Guidance this fiscal year is for revenues of $80M to $105M – a wide range given the variability in the potential revenue ramp of LED.  We believe that over the next 2-3 years, revenues will grow substantially to the $200-300M range, and that a solid portion of the sales increase will be reflected in earnings.  We note that peers to OESX generate double-digit operating margins, with some in the high-teens; OESX has never generated these margins due to (i) the chronically wasteful spending of previous management and (ii) the $16M build-out of the company’s state-of-the-art headquarters under previous management that left the manufacturing facility running at less than 20% capacity utilization.

The positive spin from prior management’s overspending is that inventory levels remain too high and the company’s operating facilities are in pristine condition.  Orion has little in the way of cap-ex needs going forward to meet incremental demand, and there is further cash that can be pulled out of working capital.  In addition, Orion has approximately $20M in NOL’s that can be utilized should the company achieve meaningful profitability.

Should sales reach $200-300M and operating margins mirror that of the company’s direct peers, the business would generate tens of millions in EBIT and $1.00+ per share in EPS.  In such a scenario, we believe OESX would command at least a market multiple and trade for $15-20+ per share.  There is further optionality should investor infatuation with LED rise and OESX become a “story stock.”

Finally, it is worth highlighting the event path.  With calendar Q1 2014 behind the company, we believe the news flow should improve materially.  Orion recently hired a new investor relations firm to assist the company in being noticed by the Street and in communicating an effective story.  Orion also has publicly stated it intends to re-brand as an LED company in the near future; LED companies generally command higher multiples (see RVLT US), and if Orion is grouped into this peer group the shares could re-rate. 

Most importantly, however, is sales growth, which we believe will begin to accelerate in the back-half of the year or sooner.  Orion management earned credibility over the last 18 months by successfully executing its cost-cutting initiatives; now CEO Scribante has the opportunity to do what he does best – drive the top-line.  Orion management commented on the most recent earnings call that several large potential orders are nearing the finish line.  As these orders are announced, we believe investor confidence can return to the stock as the business gains momentum into the LED up-cycle.

Risks

We note the following risks to our investment thesis:

• Orion has not previously earned double-digit operating margins, or much in the way of operating profits at all.  If the company’s upside operating leverage is not as great as we expect, our thesis could prove incorrect.
• If the LED cycle does not play out as we anticipate, or if LED adoption takes longer than we expect, our thesis could prove incorrect.
• Orion operates in a competitive industry with many larger competitors including Cree, Cooper, Hubbell, and Acuity.  Orion is the dominant player in C&I interior retrofitting, but this position could be vulnerable if a competitor finds a product solution that can effectively compete against Orion’s superior fixture technology.  Orion also may be unsuccessful competing against these larger peers as it enters new verticals such as commercial office, retail, and government.
• Orion’s previous CEO recently filed a lawsuit against the company for wrongful termination.  It appears to us that the lawsuit is without merit, but if the lawsuit proves time-intensive or costly to Orion it could affect the likelihood our thesis plays out as expected.

Disclaimer

The author of this posting and related persons or entities (“Author”) currently holds a long position in this security.  Author may buy additional shares, or sell some or all of Author’s shares, at any time.  Author has no obligation to inform anyone of any changes to Author’s view of OESX US.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in OESX US.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.

Catalyst