Description

Company Overview

Enernoc Inc operates in a niche segment within the Electrical Industry.  The company does not generate, transmit or distribute electrical power.  Instead, Enernoc works closely with its more than 6500 Commercial and Industrial (C&I) clients to help them actively manage their energy expenses through two business segments:  Demand Response and EIS (Energy Intelligent Software).  Since its inception in 2001, ENOC has built a lucrative business around demand response, increasing revenues from $10 million in 2005 to $470 million by 2014. Today, the company is in the process of diversifying its demand response portfolio while at the same time aggressively growing its EIS business.

Industry Overview

Demand Response

Except for the increase in power generation from natural gas and renewable sources like wind, there has been very little change to the electrical grid over the past 100 plus years.  The biggest change to impact the electrical industry happened over 20 years ago with deregulation.  Today, approximately 60% of all power transmitted throughout the United States is managed by an RTO (regional Transmission Operator) or an ISO (Independent System Operator).  These grid operators have three main responsibilities:  1) To make sure that electrical demand and supply are kept in balance, especially during the summer months;  2) Supervise the wholesale pricing of electricity, making sure the process is run efficiently and is competitively priced, and 3) To oversee the electrical grid to make sure it is being maintained properly, not just for today and tomorrow, but well into the future.

For 8 months out of the year, an electrical grid will operate around 60% of its peak load.  However, from June through September (correlated to heat waves that impact the need for additional electricity), that number will spike to as high as 100%, making the grid unstable.  To plan for higher electricity demand during the summer months, grid operators will conduct a yearly forward capacity auction.  A capacity auction brings together suppliers of electricity and companies like Enernoc, who are willing to reduce the consumption of energy, to the table.  Suppliers indicate how many megawatts of electricity they are willing to add to the grid and at what price, while Enernoc will offer to reduce megawatt capacity at a specific price. When the grid operator achieves the number of megawatts needed (both from supply and reduction), a clearing price is set.

After the capacity auction, Enernoc knows exactly the number of megawatts it will be required to reduce in the future if called upon and works directly with its C&I clients to establish electrical curtailing protocols (example: turn down lighting, shutting down elevator banks, reducing air conditioning usage to 70% to achieve the required reduction).  During a Demand Response event, Enernoc will be contacted directly by a utility company and told the start time and number of megawatts of reduction needed.  Enernoc, in turn, will contact its C&I clients, execute the pre-established megawatt reduction protocols, and monitor the companies in real time to make sure they are achieving the megawatt reduction agreed upon.  Enernoc receives a payment for both its willingness to reduce capacity consumption (the lion's share of the payment) and for the actual megawatts it reduces.  That revenue is then shared with its C&I clients.  In total, demand response events take place between 5-6 times a year and last, on average, for less than three hours.  Besides knowing the exact amount of megawatts it needs to reduce, Enernoc also has good optics into how much revenue it is going to receive from acting as a provider of demand response.

The Demand Response market in the United States has grown significantly and quickly over the past 10 years, maturing into a $1.4 billion market.  Demand response is expected to continue to grow, but at a reduced rate of 6% per year over the next 10 years.  Enernoc accounts for nearly 35% of the demand response market, which translates to nearly 80% of the company's total revenue.  One grid operator, PJM (largest grid operator in US), accounts for 55% of ENOC’s total yearly revenue and 77% of revenue from its demand response segment.  Even though demand response continues to be a profitable business for ENOC, slower US growth, combined with volatile pricing, high dependence on one grid operator and government infighting on who should oversee the pricing of the wholesale market, has motivated the company to diversify into international demand response markets (growing megawatts 25% per year) and EIS.

EIS (Energy Intelligent Software)

There is no doubt that technology, like LED lighting and Energy Star products, have had a positive impact in reducing energy consumption.  But for C&I companies, the real time cost of electricity still remains a mystery.  Unlike filling a car with gasoline, where a driver knows in advance the exact cost per gallon to power the car’s engine, the cost of electricity is paid for after it has been used.  Trying to calculate the cost of electricity in real-time is a very complex equation to solve because the spot price of electricity changes not only day to day, but hour to hour based on the time of day it is used, the weather, what is being used within your region and a company’s demand charge.  However, this complexity creates an opportunity for Enernoc.  In 2014, ENOC reconstituted its software business from a variety of point solutions programs into a software platform that focuses on three main areas:  How a company procures electricity, how much the company uses, and when the company uses its electricity.  The software platform is a “good,” “better,” “best” SaaS (software as a service) subscription model that starts at $250/site/month and increases to $1,000/site/month.  The average recurring revenue (ARR) for the EIS platform is $4,000/site/year or about $333 per month. Over the last year, ENOC has spent $115 million acquiring EnTech, Pulse Energy and World Energy Solutions.  Each acquisition adds to or expands a component of the EIS software platform, with World Energy Solutions also bringing in 3,000 new clients (not all are candidates for EIS).  These recent acquisitions will help both expand ENOC’s subscription offerings as well as provide a new group of potential clients to expand its customer base.

Enernoc has estimated that the Energy Intelligent Software to be a $5 billion market in the United States and $20 billion globally.  The company generates over $120 million in ARR from its “Utility” and “Enterprise” segments, up from $82 million in the previous year.  The expectation is that the “Utility” and “Enterprise” businesses will continue to grow at 25% & 40% per year respectively and within four years will account for approximately $500 million in revenue or nearly 60% of total revenue.  Unlike revenue from demand response, EIS revenue is a contract subscription lasting, on average, for a period of 3-7 years.

The enterprise growth that ENOC is forecasting will come from three areas:  1) Overall growth in the number of clients subscribed to the EIS platform.  Of the 1300 active EIS subscribers (not including new clients acquired from World Energy Solutions) it is estimated that less than 700 also participate in demand response, providing an ongoing source of new EIS clients.  2) Migrating current EIS clients onto the newly launched EIS platform and to higher subscription packages.  Of Enernoc’s top 10 EIS revenue generating clients, 6 have ARR that are below $3,000/site/year or the lowest subscription rate of $250/site/month.  This is because many of ENOC’s existing EIS clients are still using legacy point solution software that is in the process of being twilighted.  Migrating existing clients onto the EIS platform as well as elevating current EIS subscription rates will continue to increase revenue. 3) Enernoc estimates that it has a less than 5% penetration rate into all of its current EIS clients sites.  Since the EIS platform was launched approximately 1 year ago, many of its current clients are still “test piloting” the platform, providing another area of revenue growth as client site penetration rates increase.

Competitive Edge

Enernoc operates in a niche segment of the electrical industry through its two operating segments:  Demand Response and EIS.  Over the last 10 years, Enernoc significant revenue growth has been highly correlated to quick and substantial growth in the US demand response market.  Demand response in the US has slowed, but the international market continues to grow its megawatts by 25%, allowing ENOC to grow globally and provide 1 uniform platform to its multinational clients.  The first mover advantage in demand response has not only provided ENOC with an approximate 35% market share, but an established brand and trusted name within the space.  Enernoc is now leveraging its brand and its established demand response clients to cross sell its reconstituted EIS platform.

Additionally, having operated in the demand response market for the past 10 plus years has afforded Enernoc with an extensive database of megawatt usage.  Every Demand Response and EIS client provides ENOC with real time data of their energy usage, which in turn helps the company improve its algorithms for accurately anticipating future demand spikes, real time megawatt charges, utility bill management, as well as cater its platform to its clients needs.

Valuation

Enernoc guided EPS to be -$3.05/share and flat to slightly positive FCF in 2015.  The lower guidance stems from an $80 million decline in revenue from PJM.  Fifty of the $80 million decline is due to participation in an extended PJM demand response program.  The program runs beyond September of 2015 and its revenue will be accounted for in 2016, even though cost and expenses associated will be accounted for in 2015.  ENOC has already indicated that its Sales, Marketing, and G&A expenses will continue to grow as it works to quickly expand its EIS business.  It is expected that over the next couple of years, even though revenues will increase and EIS margins will improve, overall expenses will continue to rise as well, leading to negative EPS and flat to positive FCF in aggregate.

Ultimately, the true value of Enernoc will be determined by its SaaS revenue.  Currently, the company is not breaking out its customer acquisition costs and its current EIS churn rate reflects the twilighting of legacy software, which makes valuing its SaaS business challenging.  SaaS companies commonly trade at 3-8x their ARR based on the size of the addressable market, margins, churn, acquisition costs, ARR and growth.  Currently, at $120 million in ARR from the company's Utility and Enterprise segment (ignoring revenue from demand response), Enernoc stock price ($10/share) is trading at 2.5x its ARR.  Conservative growth assumptions will bring ENOC’s EIS ARR to $160 million by 2016 or a 33% annual growth. Without a clean churn rate or the company’s customer acquisition costs, it is a waste of energy to try and pinpoint the company’s exact valuation.  Instead, if one feels comfortable that the downside valuation of the company is limited, then the upside opportunities should take care of themselves.

Summary

Why is ENOC Cheap?

The main reason why Enernoc is cheaply priced when compared to its future intrinsic value is because the market continues to focus primarily on ENOC’s demand response segment. Representing 80% of Enernoc’s total revenue, the market sees demand response for what it has become:  A market that matured from a quick growing high margin business over the past 10 years, into a business that has seen gross margins decline to around 40% and whose overall market growth is expected to slow to 6% annually.  Even though the markets perception of demand response is accurate, demand response remains a lucrative business for ENOC.  The company continues to diversify its demand response operation through international expansion, which is growing megawatts at 25% per year, while de-emphasizing its exposure to PJM, the United States largest grid operator and representing 55% of ENOC revenue.  Additionally, demand response provides ENOC with a client base of 6500 C&I businesses that it can continue to monetize by cross-selling its EIS platform.

The real growth and future opportunity for ENOC is its growing EIS SaaS business, which remains hidden in plain sight.  Masked by the revenues and pricing volatility in demand response, EIS remains a nascent segment with a 40% growth rate that does not appear to be slowing anytime soon.  Over the next four years, ENOC expects that EIS will represent 60% of its total revenues and will continue to maintain gross margins in excess of 60%.  Unlike demand response, EIS has a recurring revenue stream that lasts between 3 & 7 years.  The current churn rate reported by management is tied to legacy point solution software that is no longer being supported.

Historically, management has done a poor job communicating the transition the company is currently undertaking.  In the past, partly because the majority of their revenue is coming from demand response and because there was not any EIS revenue to speak of, management continued to focus on demand response during their quarterly calls.  More recently, the company has released SaaS metrics for its Enterprise and Utility segments and spent a good deal of time during its analyst day presentation to walk through its EIS segment including: Customer ARR, customer growth and revenue divided between organic and acquisition.  The company has promised to continue to release more specific information about its EIS business, including more defined SaaS metrics.

Catalyst

Catalyst

• Continued expansion and growth in the EIS market through increase in clients, subscription pricing and increasing site penetration in active accounts