|Shares Out. (in M):||22||P/E||0.0x||0.0x|
|Market Cap (in $M):||237||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
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September 12th, 2014
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PowerSecure International Inc. (NYSE: POWR)
A cheap collection of recurring cash flow businesses servicing high growth electric utility and electricity infrastructure end markets
PowerSecure in reality is a combination of three cash flow generative businesses under one roof: Distributed Generation Services, Utility Infrastructure Solutions and Energy Efficiency Products.
Distributed Generation (“DG”):
Is a projects based segment that specs, designs, installs and monitors proprietary power management and back-up power solutions for large utility customers/energy consumers such as data centers, hospitals, national retailers, etc. POWR utilizes off-the-shelf equipment to design and install off-grid power solutions that can serve as both primary and back-up generation, and be toggled between at the push of a button. With limited human capital and overhead (NOC requires only 2 employees to operate current fleet of ~1,600 sites), POWR’s DG unit provides 24/7 monitoring of client power usage via internet at their centralized control room, and implements “peak shaving” strategies. Peak shaving is the secret to the DG client value proposition. During peak hours, POWR can take its clients off the grid and switch them seamlessly to their standby system- optimizing their power usage and minimize their utility bill. The utility costs savings are passed largely to the client, resulting in attractive payback periods on instillation cost. Their patented systems, IP and design incorporate their deep knowledge of the utility tariff structures to arbitrage the cost/MW on the grid at peak hours.
As described in U.S. Patent 8,427,005, POWR’s DG system consists of an “improved multiple generator module, typically coordinated together as a unit and paralleled to a utility grid for back-up power generation in case of an electrical utility power failure and for utility peak power needs during grid power shortages, grid low voltage issues and grid reactive power needs.”
DG does not bid on contracts through a competitive RFP process, but instead sells directly to clients. The result is a customized solution that results in high switching costs and limited risk of churn. In 2013, the average project size grew by ~28% on a dollars basis, with gross margins of ~37%. Whereas historical DG contract wins ranged from $5-25MM, POWR has spent the past year “elephant hunting”- competing for mandates in the $50-100MM size range with larger solar, data center and hospital clients. These opportunities have longer sales cycles of 18-24 months but can be transformative to their backlog given their size.
Just this past quarter, POWR landed its first such client. On July 23rd they released notice of a $140MM award comprised of $120MM in utility-scale solar projects from a major (unnamed) utility to provide two large scale solar installations. The contract also includes $20MM of turnkey sales to industrial and retail customers. This contract alone, to be paid equally over ’15 & ’16, added ~48% to 2015’s full year DG backlog. This breakthrough contract win should result in other large conversions from pipeline to backlog.
POWR has sold its DG system as a turnkey solution in about 90% of installations, recognizing revenue under the percentage-of-completion method. In such cases, POWR customers are typically able to achieve 15-35% reductions on their annual utility bill, while benefitting from up to N+4 redundancy for backup power at 98%+ reliability. While POWR receives service fees for ongoing monitoring and control, they do not typically get incentive payments for higher avoided peak usage. In cases where POWR owns the DG system and invests its own capital, POWR targets an IRR in the mid-to-high teens, unlevered after-tax, with 5-15 yr. recurring revenue contracts under a shared savings arrangement. Given the better economics, POWR is moving to a higher mix of owned DG systems.
Utility Infrastructure Solutions (“UI”):
The Utility Infrastructure Solutions segment provides fully integrated servicing to electric utilities nationwide. Much the way BHI, SLB and HAL are one-stop service providers for large E&P companies, POWR’s UI segment services the constant expansion & maintenance needs for their customers’ grid infrastructure. These project contracts are multi-year assignments with normalized gross margins above 20%- or twice the segment’s current margin. These client relationships have historically only grown in size and scope of work, as their electric utility end markets have been growing at 75-100% annually for the past half-decade.
POWR makes itself indispensable by offering a full suite of services to the grid, including; T&D maintenance & construction, substation equipment & servicing, advanced metering & lighting, emergency storm repair, engineering & design consulting and assistance with regulatory compliance.
POWR contracts with IOUs for a mix of mechanical and electrical work as listed above, including the wave of upgrading high voltage transmission lines. Shale oil and gas producers have emerged as a growth area, accounting for ~10-15% of segment revenues, contracting with POWR to build out electric grid infrastructure to production fields. This segment is similar to its UI contracting peers like Mastec &MYR Group, but POWR has been taking share due to strong local relationships and a great reputation for quality service.
Energy Efficiency (“LED”):
POWR manufactures specialty LED lighting for commercial and industrial clients, such as grocery shelf & canopy lights, walk-in cooler/freezer lights, security/street lights, and specialty lamps and fixtures. POWR does this under its energy efficiency segment, which plays in the highly competitive and commoditized LED space. That said, POWR has sold product into ~20% of the top 100 U.S. retailers and has very high market share for certain niche products, 95% of which are into the retrofit market.
POWR targets specialty applications and leverages existing client relationships. For example, POWR developed its cooler/freezer product in cooperation with grocery stores that were existing DG clients. POWR recently vertically integrated it’s LED business by acquiring Solais. The acquisition has brought with it strategically valuable IP and high-quality product development. Solais has a number of approved and pending patents on technologies.
Most importantly, Solais provided a margin improvement opportunity. POWR sources most of its LED chips from CREE and has outsourced manufacturing to Asia. Following the acquisition in April 2013, POWR has consolidated all LED-related manufacturing activities into the Solais supply chain. As a result, margin improvements should become evident in the second half of 2014.
In general, we view POWR’s LED segment as cash flow generative but non-core to the company as a whole. We believe also there would be numerous buyers for it.
In Q1 of this year POWR reported a steep gross margin decrease in its core UI business- down 13.6 percentage points to 5.9% for utility services, and down to 9.9% for the overall UI segment. That compares to a 25.6% gross margin across the UI segment in the same quarter of ‘13. That decline was the result of a single mispriced contract that underestimated service crew travel time and utilization rates in a new geography. What quickly became evident from our meetings with the Company’s CEO, following his own investigation into their pricing process, was that this was in fact an isolated incident. Never before had POWR priced negative margin business within the UI segment, and given the controls now in place, it’s unlikely they will again.
In a statement on the Q1 call, CEO Sidney Hinton made the following comments on the Q:
“We feel good about the future, but we've been working relentlessly over the past few weeks to understand how the
business dynamics that impacted our first quarter results and 2014 expectations could jump up and bite us so hard and so quickly following the record fourth quarter and record full year 2013 results that we were just describing back in March, a couple of months ago.”
POWR had two options at their disposal- to walk from the negative margin piece of business or renegotiate the contract with improved pricing. In either case, management had the ability to turn off the cash burn.
In addition to the disappointing Q1 results, management announced they were halting new growth and incremental bids on new UI contracts until their “swat team” reported their findings and ensured this was a one-time incident. In addition, management released heavily discounted guidance, kitchen-sinking estimates and assuming decelerating growth across the company. POWR had been caught off guard in two of its core segments, resulting in a meaningful miss in spite of operating businesses characterized by recurring contract revenues and a sticky client base. The price move that followed was severe, as the stock traded from ~$21/sh to ~$7/sh over the course of a few days. By all accounts, it was a spectacular blow-up for a quality business.
In a statement on the Q1 call, CEO Sidney Hinton made the following comments on the UI segment:
“We have one division that has had difficult gross margins, and we'll talk about that, utility services. But don't look at roughly 21% gross margins and think it's systemic across company. It's one area, and we're focused like crazy on getting it tuned up.”
“What are we doing about it? Well, we've basically deployed a SWAT team of finance and operations leaders into the utility services business whose specific assignment is to partner with our strong UI team to correct these inefficiencies as we move our people and equipment from lower margin to higher margin opportunities.”
To make matters worse, POWR simultaneously reported a year-over-year decrease in its DG project backlog. That decrease was the result of the company’s strategic shift in focus towards larger more transformative contract wins. Those sales take longer and require greater resources, which added lumpiness and extended the timing of announcements.
In a statement on the Q1 call, CEO Sidney Hinton made the following comments on the DG backlog:
“When we look at our DG business while we're anticipating slightly less sales this year, we've never had a higher quality of pipeline. The opportunities that we are chasing are bigger. They're game-changing opportunities. In the forecast that we've included in the press release today, we have not assumed that we win those and recognize revenue this year.
“We definitely are finding as we pursue these larger projects, the timeline for conversion is longer than what we'd experienced on the smaller projects. We were more accustomed to chasing, winning and forecasting.”
POWR updates its backlog estimates quarterly, breaking out “near-term” backlog for projects expected to have revenue recognition within 9 months; “longterm” backlog for projects expected to have revenue recognition 9-24 months; and (3) recurring, long-term revenue. However, backlog does not provide a complete proxy for forward cash flow. LED lighting represents the largest portion of the additional revenue not captured in backlog.
Since Q1, POWR has addressed both the troubled UI contract and DG backlog delay and demonstrated healthy additional growth. On June 25th, just six weeks after their Q1 report, the company announced that it had successfully amended the troubled UI contract to include vastly improved pricing and commitments for additional high margin business from the same utility. What was a cash-losing contract was immediately renegotiated into a profitable one. As a result, margins in the UI segment have already increased ~75% from the lows, and continue to ramp back towards a normalized 20%+.
Despite 20-25% topline growth, increasing margins and a net cash balance sheet, the company was trading ~7.9x full year 2015 EV/EBITDA. On a sum of the parts basis, the company’s highly saleable segments could collectively be monetized at a ~50% premium to POWR’s trading price following the release, and more importantly, just under a 30% premium to today’s price.
We have valued the company along two separate methodologies; a sum of the parts sale of the business either in its entirety or by segment, and on an earnings basis.
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