Tom Konrad CFA
The high upfront cost of efficient buildings (and efficiency in general) is more than offset by the significant long term rewards, as you can see from the McKinsey chart below.
Despite the long term benefits, the upfront cost is often a barrier, especially to government entities in today’s tight budgetary environment.
Performance contracting offers them a way to square the circle between the long term budget benefits of efficient buildings and the often significant capital cost. This works by funding the capital improvement with debt secured by future energy savings. An Energy Service Company (ESCO) guarantees a certain level of energy savings and performance (hence the term Performance Contracting.)
Yet performance contracting comes at a cost. No ESCO puts its balance sheet behind a promise of energy savings solely out of a desire to green the economy. That ESCO has a cost of funds just like everyone else, and in the case of a performance contract, this cost of funds is built into the contract price. Entities which understand what needs to be done and can borrow at reasonable interest rates or have cash can wring greater savings out of energy efficiency services by avoiding performance contracts.
That’s where Lime Energy Co (NASD:LIME) comes in. Lime (a name derived from “Less Is More Efficient”) has been providing energy efficiency services for 20 years, both directly to clients and also as a subcontractor to ESCOs. Lime does not have the balance sheet to guarantee performance contracts itself, but it does have significant expertise in delivering the energy efficiency services that make performance contracts work.
In a recent interview, Lime CEO John O’Rourke told me that his current ESCO clients include Johnson Controls (NYSE:JCI), Honeywell (NYSE:HON), Constellation Energy(NYSE:CEG), Clark Energy, and PEPCO (NYSE:POM). According to O’Rourke, Ameresco (NYSE: AMRC), the publicly traded pure-play ESCO firm that was profiled in the most recent part of this series, “would probably never use us,” because of overlap in certain in-house capabilities and (I suspect) a bit of inter-company rivalry.
In its 20 years of business, Lime has worked with many ESCOs and directly with public sector or institutional customers which do not need performance contracts. One such example is the United States Postal Service (USPS), which issued competitive solicitations for multiple regions where the USPS financed the work directly instead of a traditional performance contract. Lime was awarded several of these IDIQ contracts with achieved savings in excess of 30 million kWh per year.
While the ESCO business is becoming more competitive, the business of actually delivering energy efficiency has become somewhat less competitive. In Lime’s core Northeastern market, several energy efficiency contractors have recently gone out of business or shrunk their operations significantly. These businesses were unable to weather the trough that the ESPC industry experienced over the last three years. Lime survived by re-directing their focus to other areas, and found growth opportunities in the private sector.
Lime has carved out a niche for itself managing Demand Side Management (DSM) programs for utilities. This is the fastest growing part of Lime’s business, which O’Rourke expects to reach about 40% of revenues in 2011. Part of the reason for the rapid growth is likely Lime’s track record, in which the company has “blown savings goals out of the water” over the last three years.
Utility DSM targets tend to be conservative, since the utility itself usually plays a very large role in setting the regulatory process, and utilities have a vested interest in setting targets low to keep them easily achievable, so Lime’s track record may not be as impressive as O’Rourke makes it sound. On the other hand, targets for delivered savings have increased dramatically over the last few years, and utilities face penalties for failure to meet these goals.
The urgency and market opportunity vary widely between utilities and state regulators, but according to O’Rourke, utility spending on DSM programs is increasing consistently by over 20% per year, and he’s not exaggerating. I checked O’Rourke’s numbers with Howard Geller, the Executive Director of the Southwest Energy Efficiency Project, and he told me that “Based on data collected by the Consortium for Energy Efficiency, utility spending on programs that help their customers save electricity and natural gas has been increasing by more than 25% per year in recent years.”
In addition to this rapid growth, the utility business brings two main benefits to Lime. First, it is a source of earnings stability, since contracts tend to be multi-year and not seasonal like much of Lime’s energy efficiency business. (The energy efficiency business is back-loaded towards the end of the year when many commercial and industrial (C&I) clients decide if they should go forward with energy efficiency projects depending on budget constraints.) The second benefit of the utility business is as a way to reach new C&I clients. Lime may initially contact a C&I client as part of a DSM program, but then go on to provide energy efficiency measures for the client beyond those in the utility program.
Current utility clients include the Long Island Power Authority and National Grid (NYSE:NGG), but O’Rourke hopes to win additional contracts this year.
Finally, Lime has recently introduced a new division (called Lime Energy Asset Development, or LEAD) to develop its own energy projects in-house. These projects involve the development, design and construction of larger alternative energy projects where the clients purchase the energy produced, rather than the asset itself. These larger projects will be limited by Lime’s ability to finance them, but doing project development in-house should allow Lime to maintain strong margins on the projects, and Lime need only undertake them when it will not put undue pressure on Lime’s balance sheet.
Lime is not yet profitable, but O’Rourke says the company has enough capital to grow 30% for the next two years and achieve profitability in 2012 without raising additional capital “anytime soon.” Analyst consensus earnings are for a loss of 8 cents a share this year, and a profit of 21 cents next. The company has $6 million in net cash on the books, no net debt, and a free cash flow of negative $9 million over the last 12 months. Since the third and fourth quarters tend to be the most profitable, cash should increase over the next two quarters, and so O’Rourke is probably right that current assets and credit lines should be sufficient to bring Lime to consistent profitability.
With the stock currently trading at $3, and expected earnings of $0.21 next year, Lime seems quite reasonably valued for a company growing at 30% a year. However, given the current climate of uncertainty, the back-loaded C&I business may turn out to be a little disappointing this year, and possible earnings misses caused by C&I clients deferring energy efficiency projects in order to conserve cash may lead to a somewhat lower stock price in the
next few months. The C&I business has been falling as a percentage of revenue, so any such earnings misses are unlikely to be dramatic, but investors are taking any excuse to sell alternative energy stocks in the current climate.
I like Lime’s business, and think the company is fundamentally strong, and the valuation is quite conservative. However, I expect the current stock market rally to be short-lived. A renewed market decline, along with a possible earnings miss caused by C&I clients hoarding cash in the climate of uncertainty could easily lead to a lower stock price in the coming months. I’ll be watching the stock closely and buying cautiously if either of these comes to pass.
DISCLOSURE: Long AMRC. No position in LIME, but I may initiate one at any time.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.