Description

Polar Power (POLA – USA) is a rapidly growing producer of DC power systems for the telecom industry. The shares trade at a valuation just slightly over working capital—which seems wrong as the company is growing so rapidly (52% YoY in first 9 months) and is profitable.

The stock is down for a variety of reasons, some of which are self-inflicted as Polar Power missed initial guidance following the IPO. However, the business continues to grow and I believe the shares in the mid $2s offer a unique opportunity to invest in a rapidly growing company with high insider ownership (61%) at a very undemanding valuation.

What does Polar Power do?

Polar Power provides DC power solutions to various markets. I’m going to ignore a lot of their smaller initiatives (military, residential generators, EV chargers, etc.) and focus on the only one moving the needle—DC power solutions to telecoms. If one of these other verticals works, that’s just upside.

There are approximately 6 million cell towers across the globe. They run the gamut from needing backup power for minor interruptions to being completely off the electrical grid. In the US, most systems have electrical power and electricity is reliable. In many other countries the power is frequently out or not available at all at cell sites. Even in the US, following a number of high-profile natural disasters (Hurricane Harvey in Houston, Hurricane Maria in Puerto Rico and Hurricane Sandy in New York) where the power failed for days or weeks at a time, first responders did not have cell service to coordinate rescues—hence the FCC is leaning on telecoms to “harden” their systems.

Polar Power provides solutions to power reliability by offering customized DC generator systems integrating 3rd party DC generators with automated controls and remote monitoring. These systems work on natural gas, diesel and propane often with a solar solution as well. The systems are designed to instantly start-up when power fails, even for a few seconds or run continuously in the case of off-grid systems.

There are a number of competing backup generator systems for telecoms, but they are all AC power solutions, while Polar Power offers DC solutions. This is important as telecom infrastructure runs on DC power, meaning that AC generators need to convert from AC to DC which adds dramatically to the cost of a generator system. Additionally, DC systems are substantially cheaper to operate in terms of fuel usage and maintenance cost. While fuel usage is less important if the system is only meant for occasional interruptions, the operating costs of an AC system are quite substantial for a system that is off-grid (think many EM or FM countries).

Finally, and most importantly, DC systems are dramatically lighter than AC systems. If the system is on the ground, this doesn’t matter, but much of the system “hardening” is going to be happening in urban areas where cell towers are on roof-tops. In order to meet FCC guidelines, for an AC system with a week of backup fuel, you’d need hundreds of gallons of fuel in addition to the much heavier unit, making installation impossible without structurally supporting the building’s roof itself—which is clearly cost prohibitive, beyond the fact that no one wants a fuel bomb on their roof. All of the above has led to a steady increase in orders and will likely lead to a rather dramatic increase in future orders.

The telecom purchasing cycle

Polar Power undertook an IPO in December, 2016 at $7 a share in order to rapidly grow its sales force so that it could broaden its customer base while providing the working capital to scale up production for a substantial order from Verizon. As you can imagine, when you hire salespeople and send them around the world to sell systems, there is an increase in costs up-front and no associated revenue. The company was rather clear about this during the IPO, but investors seemed shocked at the increase in SG&A and margin compression. Additionally, I don’t think anyone (including management) fully appreciated how the telecom purchasing cycle works. If you are Generac, telecoms simply buy from you as they expect the product to work and know there is customer service if issues arise. If you’re Polar Power, when you tell customers that your system is cheaper to purchase, maintain and fuel, telecoms are skeptical. Therefore, after many months, you start with a trial order of a handful of systems and then after they are proven to be reliable with good customer service, you get follow-on orders. Often the lag from the initial contact until you get repeat orders is two to three years as they monitor reliability. Meanwhile, sending service technicians to a country to maintain 2 units is a money loser. As a result, margins compressed and the promised orders never seemed to show up or if they did, they were in the tens of thousands instead of the promised millions of dollars.

In any case, since its IPO, Polar Power has gone from being almost exclusively a vendor to Verizon to becoming an approved vendor to all 4 US telecoms, multiple last mile US telecoms and at least 35 international telecoms. The company is in various stages of ramping orders at these telecoms, ranging from a handful of trial units to dozens of units a quarter every quarter depending on the telecom. As more of these customers convert from small batches of orders to steady flow, quarterly revenue trends should become less choppy while also accelerating. Complicating issues was the fact that the company hit peak production capacity at their initial production facility and had to find a second production facility to continue the expansion of production. This has now all been solved; hiring is completed and the 2nd facility is becoming increasingly productive after having bottlenecks earlier in the year that hit margins. All of this should lead to increased orders, revenue, throughput and gross margins in 2020—though Q4/2019 may be a bit soft due to timing issues on system deliveries.

Why the opportunity exists?

Polar Power likely promised too much when the IPO happened. They missed guidance repeatedly as they misunderstood how long it takes to convert an initial order into repeated orders from a telecom. Along the way, margins compressed due to increased SG&A, tariffs and ramping-up staffing to increase production. I would like to think this is mostly behind us as their SG&A is now at scale and production rates have increased to the point where gross margins have improved. Additionally, orders are once again increasing though backlog remains a bit opaque still.  

In any case, Polar Power seems to have slipped through the cracks amongst investors—particularly as the float is roughly 3.8 million shares or $10 million dollars. This is all made worse as the company has fumbled their IR function and has minimal public visibility—which is odd for a company that is growing so rapidly while remaining profitable.

Valuation

I hate building models for companies like this one, as they always look like hockey sticks as revenue ramps. Therefore, I’m not going to bother. Put it this way, at $25 million of revenue, they roughly break even today. Every incremental dollar of revenue has an EBIT margin of about 25 cents. They’ll likely do a bit under $30 million of revenue in 2019, which leads to $1-1.25 million of EBIT. During the first 9 months, they produced $685,000 of EBIT so clearly, I’m a bit optimistic her; but R&D also picked up a bit and they had some teething issues earlier in the year as they ramped up production. In any case, if I’m off by a few hundred thousand in my model, it is still close enough. Let’s say they can grow at a similar 52% rate as 2019 and they hit $45 million in revenue in 2020 and should have about $5 million in EBIT ($20 million over the $25 million break-even level at a 25% EBIT margin). On 10.1 million shares, we’re talking about 49.5 cents of EBIT per share. As I said above, mid-$2’s seems wrong if they get to anywhere near my estimate as telecom equipment providers shouldn’t be at 5 times forward EBIT when they’re growing this fast.

The question then is; will they keep growing? I visited their facilities in early December 2019, I can attest that they were humming with activity and that there were completed orders waiting to be delivered. Additionally, it sounded like a number of substantial orders were near the signing phase—these were step-ups from a few systems at a time to dozens of systems at a time. I genuinely think that they have figured out the bottle-necks with various customers and there will be additional substantial orders this year—particularly from international telecoms. US telecoms are harder to predict but the FCC is leaning on US telecoms to “harden” their systems.

That said, I don’t have great visibility into how things will look in 2020, but the transition from batches of orders from single customers to a steady flow from multiple customers should allow Polar Power to better align staffing and production flow to improve margins and right-size inventory which grew a bit bloated as they had to pull forward ordering due to tariffs. 

I can get deeper in the weeds here and try to refine my model but I think I’ll just end up with imprecise precision. I do know that there are a few things worth noting.

1-     It’s absolutely insane to manufacture anything in Los Angeles, the capital of the People’s Republic of California. Management recognizes this and their next expansion facility will be in a lower cost location. Management realizes that they’re a research, design and sales business and they may even choose to outsource additional production. I could see substantial margin increases here if they go this route.

2-     Some of their new technologies, particularly related to residential generation are quite attractive—remember that the People’s Republic has rolling blackouts when it’s hot or dry or windy. Additionally, as more EVs roll out, people will need additional power to charge their cars as the grid gets strained in individual neighborhoods (local grids weren’t designed for the demands of 2 EVs per household) and residential generators are cost competitive with utility scale power costs.

3-     While choppy, orders genuinely do seem to be ramping up

I can answer questions in the Q&A but I don’t feel this is a particularly contentious investment pitch. You’re buying a rapidly growing profitable business with a unique niche that is in high demand as 5G gets rolled out globally (can’t have driverless cars if the cell network goes dark for even a split second) at a few dollars more than working capital (working capital is mostly inventory and tier 1 telecom receivables). I have no idea what the right multiple is here, but I could easily see the shares trading at a low double-digit share price (~20x EBIT) if they come anywhere close to my estimate of $45 million in revenue and $5 million in EBIT—particularly if there is visibility that the growth rate will continue. From a current price at $2.70, that seems awfully attractive.

https://d1io3yog0oux5.cloudfront.net/_c2a5ab852d8dcb84aaec6ff9147f1821/polarpower/db/253/1206/pdf/Polar+Power+Investor+Presentation_September+2019.pdf This corporate presentation is a bit dated but gives a solid overview of the business, the business history and the sorts of systems that Polar Power sells.

Catalyst

Revenue growth in 2020

5G roll-out

More customers get past trial periods and begin to steady-state order systems