Description

Can I interest you in a $10 stock trading for $5, at a critical inflection point, with limited downside? A company that has grown sales organically 46% in the trailing 12 months, has an all-time record forward backlog, and whose entire enterprise value can be justified by its smallest of three operating segments? Meet PowerSecure.

SUMMARY
POWR is cheap likely because it’s small, misunderstood, and does not screen well. We think however, that POWR has an inimitable competitive position within its base of more than 200 power utilities; each with its own customer base, geographic region, interconnect agreement, and tariff structure. A thorough investigation of the last several years reveals well-telegraphed strategic decisions to invest in product and customer diversification initiatives while divesting non-core businesses. The result is a company growing organically at a healthy 23% CAGR with three interrelated operating segments and an all-time record backlog. Importantly, management has now telegraphed its focus on leveraging operations to drive margin expansion and EPS growth. Based on recent conference presentations and conference calls, we think POWR has made meaningful adjustments to stabilize and leverage their opex during this quarter (3Q12). This leverage, coupled with continued revenue growth and recent upwardly revised gross margin guidance, causes us to believe the business is at an inflection point. We think the stock is worth $10 in the near-term, and $20+ longer term.

We model downside protection from a couple of angles:

1. POWR has $53m in net cash and net receivables (56% of market value) and its Distributed Generation segment generates more than $6m of recurring pre-tax cash flow on 10-year contracts. This compares favorably to a $77.3m enterprise value. 
2. A comparable recent transaction values POWR’s smallest segment, Energy Efficiency, at a value representing 107% of POWR’s overall enterprise value.

We believe EPS growth will be nearly 230% in 2013 as revenue growth results in opex leverage. At 20x our $0.46 estimate, POWR is worth $9.29 (PEG = 0.1). We think that the annual earnings power of this business is nearly $1.50 EPS in the next few years. At 15x, POWR would be worth $22.50. We discount this back to today at 20% resulting in $10.85 per share. Our conservative $10.50 DCF-based price target assumes the business achieves our targets by 2015 before growth slows and margins compress. A sum of the parts analysis on 2013 revenue results in a $9.96 target. Averaging these together, we value POWR’s shares at $10 over a 12 month timeframe with potential to reach $20+ in the next 18-24 months as management progresses toward long-term operational targets.

POWR has three segments: 1) Distributed Generation or “DG”; 2) Utility Infrastructure; 3) Energy Efficiency. The unifying element tying these businesses together is POWR’s base of roughly 200 utility partners throughout the United States. POWR focuses on bringing a proprietary element to each business.

Distributed Generation (45% of revenue, ~40% gross margins) designs and manufactures on-site interactive power generators and aligns with utilities to co-market to customers. POWR interconnects with the utility grid, installs the generators, and uses software to monitor utility load. POWR’s distributed generation (“DG”) systems are engineered to carry the full load required to operate the businesses they support. POWR’s proprietary NexGear parallel switchgear enables power to be transferred from grid to generator without any interruption. During times of peak demand, POWR switches the utility’s customers seamlessly and transparently to onsite generator power in a process known as “Peak Shaving.” Customers get value in two ways: 1) backup power with obvious benefits; 2) Peak Shaving, which reduces the amount of energy purchased from a utility during peak hours when charges are the highest. Because utilities realize operational and financial benefits when customers reduce the amount of power they draw from the electric grid during peak power periods, utilities provide incentivizes through reduced pricing, or tariff structures. Typical customer savings is 15-35% off their annual power bill.

The Distributed Generation has two primary business models: 1) Turnkey System Sales which recognizes system revenue up front and a small recurring maintenance fee; 2) Company-Owned Projects whereby POWR owns the equipment installed at the customer site, takes 90+% of the energy incentives, and recognizes revenue pursuant to multi-year contracts resulting in a mid-teens ROI. For Company-Owned, annual revenue is roughly equal to 30% of total capital costs. The incremental cost of sales on these projects is primarily limited to fuel resulting in very high recurring margins. 

POWR’s DG business has virtually no competition. ENOC for instance, provides demand response by notifying customers to turn down / off their air conditioners (obviously it’s slightly more sophisticated but this is the gist). ENOC serves primarily unregulated markets, is seeing its margins squeezed, and has one large customer (“PJM”) representing over half its business. They don’t have significant proprietary distributed generation capabilities, and, we believe, they provide substantially less value to utilities than POWR.

Utility Infrastructure (35% of revenue, ~25% gross margins) provides utilities with transmission and distribution construction and maintenance as well as substation construction and maintenance, metering and lighting installations, and storm restoration. Whereas before they were doing lower value distribution work, POWR’s mix is now skewed toward higher value transmission work which is less volatile/sensitive to inclement weather, etc. The Utility Infrastructure business grew organically from $0 mid-decade to $54m in the trailing twelve months. The impetus for getting into this business was simple: POWR was working with outsourced E&C companies when interconnecting with utility grids. In the process, management worried that their proprietary business methods were too apparent to these partners. In response to the potential competitive threat, management hired a manager from Georgia Power to build this business. The service segment also serves to validate POWR’s position under the “umbrella,” which is accretive to the development of their other businesses. Today, Utility Infrastructure is a significant contributor to revenue and has been nearly doubling top-line consistently. Interestingly, size begets size in this business as they earn the trust of utilities. 

Energy Efficiency (20% of revenue, ~30% gross margins) is focused on LED lighting. Management saw the growth opportunity and figured they could bring an engineering-centric vs. a science-centric approach to delivering products. They began in freezer cases and have continued to bring additional LED products as they identify niches where they can add proprietary value.

INVESTMENT BACKGROUND
PowerSecure began in 1991 as Marcum Natural Gas Services, after founder Philip Marcum. During the mid to late-‘90s the strategy was to buy data-centric companies primarily in the energy space. In 1999, the company renamed itself Metretek. The early management team acquired several small businesses which have since been divested.

In 2000, the current CEO, Sydney Hinton, pitched the distributed generation business to Metretek’s management team. The PowerSecure business unit was formed with $250k and landed its first distributed generation contract with Tyson Foods in 2001. Metretek’s varied underlying businesses met with mixed success over the next several years however, PowerSecure landed what would become a $200m order from Publix Super Markets in November of 2005. By 2006, PowerSecure represented more than 80% of Metretek’s revenue and the majority of its profitability.

As the value of Metretek was increasingly represented by the PowerSecure business, Sydney was promoted to CEO in May of 2007. A few months later, Metretek assumed the name of its largest subsidiary, “PowerSecure.”

In 2007 however, PowerSecure could have been characterized as a one-product, one-customer company (Distributed Generation, Publix Supermarkets). On the back of the watershed Publix deal, the board made the decision to diversify products/services and customers within their core focus (serving utilities), and divest non-core businesses.

POWR intended to sell non-core segments in the ‘07/’08 time period. They sold one small subsidiary in 2008 however, the remaining divestitures were put on hold with the capital markets crisis. POWR subsequently sold the other two non-core businesses in 2011 completing their progression toward focusing on the core utility space.

Meanwhile, POWR planted two seeds: LED and Utility Infrastructure. Both were started internally and have become substantial contributors to the overall business in a few short years. With these three legs of the stool, POWR is in what we believe to be a good position. Each business reinforces the other: serving utilities with Infrastructure services puts POWR under the utility’s “tent.” LED lighting adds a green element to the offering and sells to utilities and their major commercial and industrial customers. Their base DG business continues to grow and we think they’ve only scratched the proverbial iceberg tip.

Cut scene to the equity markets - the Publix deal was largely complete by 3Q08 and with the economic situation being what it was, the stock got crushed and forgotten. Management stuck to their guns and continued to invest in LED and building out the utility infrastructure capability. They brought DG manufacturing in-house, built and acquired proprietary technologies, and introduced the recurring revenue DG platform. Along the way, management continued to telegraph their investment intentions. 

POWR did 73¢ EPS in ’08 before the crisis hit but consciously took EPS out as they invested SG&A in new businesses. At this point management has built the business. They made the step-function investments necessary to drive the business long term and are now beginning to harvest those investments and leverage the platforms to drive margin and EPS expansion. As management marches toward their mid-term goal of $300m by 2015 (26% 2010-2015 CAGR, same as 2005-2010) while at the same time leveraging operating expenses, we believe they can deliver roughly four points of margin expansion per year (bringing them to 15% EBIT margins by 2015).

DOWNSIDE PROTECTION
CREE, a leading provider of LED Lighting components, recently bought Ruud Lighting for $526m (8/17/11). CREE bought the company for its LED lighting which represented 60% of Ruud’s overall revenue. We assume that Ruud’s traditional lighting business would have garnered a multiple close to other traditional lighting peers. Acuity for example, trades/traded for 1.7x EV/sales. This implies a valuation on Ruud’s traditional lighting business of $143m. The remaining value of $383m ($526-$143) we ascribe to Ruud’s LED business. As this segment did $126m in revenue, we estimate that CREE paid roughly 3.0x sales for Ruud’s LED business. If we apply this multiple to our estimate of POWR’s LED revenue this year ($28m), we arrive at a value of $84m. That’s larger than POWR’s entire enterprise value.

In addition, POWR has $17.4m net cash and $35.9m net receivables together representing 62.4% of POWR’s market value. Coupled with $6m of recurring pre-tax cash flow on company-owned DG systems under 10-year contracts, we believe there is solid downside protection.

CAPITALIZATION AND TARGET PRICE
POWR has an $94.7m market cap and a $77.3m enterprise value. We estimate that power will do $159.1m in 2012 sales, growing 23.1% to $195.8m in 2013. We model 2012 gross margins of 31.7% expanding to 33.0% in 2013. Though management suggested opex would be leveraged, we still model a $4m increase. Taken together, we think POWR’s op margin will expand to 7.4% in 2013. Fully taxed, we think EPS will come in at 46¢.

At 20x our 2013 EPS estimate, POWR’s shares would trade for $9.29. We think a 20x multiple is reasonable given the astronomical earnings growth we expect. If management hits their 2015 target, POWR will generate $1.50 EPS. At a 15x multiple, the shares would trade for $22.50.

From a sum-of-the-parts perspective, POWR has superior margins and growth profile relative to all public peers for the various business units. Assigning a 1.0x multiple to DG revenue of $73.3m, a 0.5x multiple to utility infrastructure revenue of $58.2m, and a 2.5x multiple to Energy Efficiency’s $27.6m revenue, we arrive at a $171.4m enterprise value. Add back $17.4m of net cash to get a $188.7m market value, or $9.96 per share.

Our DCF shows POWR hitting management’s targets by 2015 before growth declines to a 3% run rate and margins decline to 10%. Discounting back at a 14% WACC with 3% perpetual growth gives us a $10.50 target. We note that a CAPM analysis of WACC is 10.0% which would put POWR’s value at $16.13 per share in our DCF model. [We use 14% to remain conservative]

RISKS
We view de-regulation of the grid as a negative. POWR’s competitive advantage lies in understanding complicated individual tariff structures on a large scale. If large portions of the grid were de-regulated, pricing would be more transparent and other competitors would potentially come in. Management has relayed however, that some of their best opportunities in the DG pipeline are on deregulated grids. What’s more, we don’t believe there will be a large scale change in tariff structures in the foreseeable future if for no other reason than cities not wanting businesses to face uncertainty potentially resulting in relocation.

We view an overall increase in the US base-load supply of energy as a theoretic negative for POWR’s DG business. When we apply a high-level analysis to the current environment however, we do not believe this will impact POWR in the foreseeable future. It’s difficult to impossible to get a permit for a new nuclear or coal plant which is why utilities are pushing natgas plants through. Natgas however, diminishes the heat rate and input cost advantages that utilities have vs. localized generators. We’d feel less comfortable if there were a bunch of new coal plants going up.

Though the DG and Utility Infrastructure segments are posting significant growth, management has indicated that the Energy Efficiency segment would face some headwinds in the second half of 2012. To the extent that analysts haven’t built this into their models, it could be a negative surprise.

In the report, we discuss a valuation of the LED segment relative to a recent comparable transaction. While we believe there is significant value, we use this purely as an illustration and do not rely heavily on this analysis to arrive at our ultimate valuation.  

Note: We completed this report toward the end of last week when the stock was in sub-$5 range. We elected to keep the $5 price in the report to save on labor. As our expected upside is significant, we didn’t figure the first ~10% would be of significant consequence to the write-up.

DISCLAIMER
This report is neither a recommendation to purchase or sell any securities mentioned. The authors may or may not have a position in any security discussed in this report. Further, the authors may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be correct as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report. The authors undertake no obligation to update this report based on any future events or information.

Catalyst

• 3Q earnings announcement showing continued growth and tangible evidence/comments around operating leverage. This includes what we expect will be a one-time charge for business rationalization which we believe will be applauded by the market.
• Margin expansion in 2013 and beyond as operating expenses are leveraged on continued top-line growth. 
• Large potential greenfield substation buildout contracts using PowerSecure’s proprietary SmartStation product. These deals, if successful, represent double-digit $millions for POWR’s top line.