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Stock Picks with a Whole Systems Approach

Tom Konrad CFA

Picking the best energy services stocks.

Fossil fuels are getting more expensive, but so are the industrial metals and other commodities used in the wind and solar farms with which we hope to replace them.   Meanwhile, government and personal budgets everywhere are under strain.  These economic imperatives make energy efficiency the one clean energy sector that may benefit despite rising denial about the existence of climate change among the US political elite and continued economic weakness.

Energy efficiency represents the sort of true win-win-win in that it saves money, reduces the use of scarce commodities and energy, spurs economic activity.  Like any spending, implementing efficiency measures gives the economy a one-off boost, but efficiency is unusual in that it continues to bring economic benefits going forward because it allows money that had formerly been spent on energy to be put to more productive economic use, even after the financing costs of the intial outlay are taken into account.

The Benefits of a Whole System Approach

The problem is that to get the most out of energy efficiency, energy users must go far beyond changing light bulbs.  Only by taking a whole system approach to energy use can all of the benefits of energy efficiency be captured.  For example, a homeowner might be interested in replacing an aging air conditioner or furnace with a more efficient model.  If they do so, they will save on energy bills and probably recoup their initial investment over a handful of years. 

An energy rater using thermal imaging. Photo by Tom Konrad
energy rater.jpg
On the other hand, if the homeowner takes the time to assess the whole home's performance with the help of an energy rater, and improves the home's shell by plugging air leakage and improving insulation, the whole thermal load of the home will be reduced.  The measures to improve the home's shell will typically pay for themselves in a few months to a year or two, and the home will be more comfortable with fewer drafts and cold or warm spots.  More importantly, the reduced heating and cooling load will allow the homeowner to replace the heating and/or cooling system with a smaller and significantly less expensive lower capacity model.

Upgrading the furnace alone might have had a five year payback, while improving the home's shell alone might have had a payback of a year or two, but doing both together allows the furnace to be upgraded at no net cost because of downsizing, making the overall payback of the combined measures quicker than undertaking either measure alone.

Energy Service Providers

Just as the homeowner requires outside expertise to identify the most advantageous combination of energy savings measures, the same is true for larger entities like companies, schools, hospitals and government complexes. 

With this in mind, the companies that help other entities achieve energy savings seem to be well placed for growth even if the economy does not rebound and energy and materials cost stay high.  There are many firms operating in this sector, including energy utilities such as Constellation Energy (NYSE:CEG), equipment providers like Johnson Controls (NYSE:JCI), and Honeywell (NYSE:HON), and IT firms such as IBM (NYSE:IBM).

There are also a number of pure-play energy service providers, both niche players and firms offering comprehensive energy services.  To get a better understanding of the whole sector, I embarked on a series of interviews with the CEOs s of publicly traded, pure-play energy services companies, and published an article after each one.

The companies covered were:
  • World Energy Solutions (NASD:XWES), which helps its clients purchase energy at the best possible price.
  •  EnerNOC (NASD:ENOC) and
  • Comverge (NASD:COMV), two companies which help clients manage energy demand in order to earn incentives from utilities, a service known as Demand Response (DR.)
  • Ameresco (NASD:AMRC) and
  • Lime Energy Co. (NASD:LIME), two companies which help clients improve energy efficiency and make the best use of renewable energy systems.
You can follow the link on each company's name to read the original article.  I learned a lot in the process, and have significantly changed my investments in the sector as a result of my research.  Going in, I owned the two DR companies Comverge and EnerNOC because the stocks looked cheap compared to their prices the previous year, and they seemed to be fairly well capitalized, while DR is one of the most cost effective ways to stabilize the electric grid.

The Commoditization of Demand Response

Unfortunately, the DR industry has become much more competitive in recent years.  Larger players like those mentioned above have been entering the space aggressively.  Electric utilities require significant customer deposits to guarantee the load reductions that DR firms contract with them to deliver.  This can strain the resources of  small firms like EnerNOC and especially Comverge, and so they have to retain a significant portion of the fee the utilities pay for DR in order to cover their costs.  In contrast, larger firms like Johnson Controls can pass on more of the fee because of their lower cost of capital, and firms like World Energy Solutions and Ameresco, which include Demand Response as part of a package of energy services, can also accept lower margins because DR is not their main profit center.

This competitive landscape along with lower-than-anticipated electricity demand because of the economic downturn, has led to rapidly falling prices for DR, and has undermined the profitability of EnerNOC and Comverge, as can be seen in the chart below.
Energy services earnings and CF.png
While it is possible that EnerNOC and Comverge might be attractive acquisitions for a better capitalized company looking to move into Demand Response, such companies seem to prefer to build up their own DR business.  While both Ameresco and World Energy have been making significant acquisitions in the energy services space, both are focused on companies which they consider strategic fits, and neither is interested in pure-play DR.

Addressing Energy Systems

Because DR is a standarized service, the industry has been fairly open to new entrants, and this has contributed to its commoditization.  In contrast, Ameresco and Lime Energy take a systems approach to managing energy for their clients, much like what I outlined in the homeowner example above, except that they serve customers with demand in the megawatts, not the single digit kilowatt demand of a typical homeowner. 

Although it produces the greatest benefits, the systems approach is very knowledge and skill intensive, making it very difficult to commoditize.  These companies' businesses are very much about the skills of their people and the customer service they deliver. 

That does not mean there is no competition, especially among Energy Service Companies (ESCOs) such as Ameresco, where equipment providers like Honeywell (NYSE:HON) and Trane, as well as utilities are active.  While these are heavy weight competitors, Ameresco has a long track record of winning and delivering on large projects, and its independence from equipment manufacturers gives clients confidence that it will use the best equipment available for the job at hand.

The competitive picture is even better for Lime Energy, whose CEO John O'Rourke told me in our interview that competition has actually decreased in the insulation business in the Northeast.

Energy Sourcing

Lastly, World Energy Solutions helps customers find the lowest possible price on energy services using a unique electronic auction platform.  They may also include some green energy, energy efficiency services, and demand response.  World Energy has recently acquired several small companies in the energy efficiency space, but their core business is getting customers the cheapest possible power, something I do not see as particularly green, so I have not been following the company since I profiled it for this series.

Energy services
Balance Sheet.png

Financial Strength

Because of their poor earnings prospect, the two Demand Response firms EnerNOC and Comverge are trading only slightly above book value, and I expect the stocks to continue to decline unless they are acquired by larger firms that can finance their operations at a lower cost of capital. 

Of the three others, the least risky is Ameresco.  The company is already profitable, and its apparently large debt load is in large part project debt which will be removed from Ameresco's balance sheet when the projects are completed and turned over to it.

World Energy would look like a safe bet because of its lack of debt and strong balance sheet, but the low earnings yield implies investors are betting on continued extremely rapid growth.  They may be right, but that's not the sort of bet I'd like to take in the current financial climate.

Lime's business is similar to Ameresco's, but since Lime does not take project debt onto its balance sheet, it's easy to see from the above chart that Lime can easily cover all its liabilities with current assets.  With Lime likely to become profitable in 2012 without the need to raise any additional outside funding, this company has the most potential upside, but only if management is able to deliver.

Conclusion

Of the five, I like both Ameresco (currently trading around $11) and Lime ($3.)  I acquired a significant stake in Ameresco when the stock was in the $9.50-$10.50 range, and I don't have plans to buy more unless the stock falls to $9.  I've been buying Lime near current prices, but given the unsettled state of the current market, I'm not in a rush to build up a large position.

While I currently don't like the prospects of EnerNOC and Comverge, the reason I'm staying away from World Energy is different: the company is not a green enough investment for my taste.  The company might be a great buy at current prices or it might not: I simply have not looked into it.

This article was first published on Forbes.com.

DISCLOSURE: Long AMRC LIME.

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.



was posted on AltEnergyStocks.com.


       

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