Description

Stem Inc (STEM)

Elevator Pitch:

• Bull: STEM operates in a rapidly growing industry with a massive potential TAM.  STEM’s software solutions for the battery storage industry are battle-tested and the company enjoys significant market share.  

• Bear: STEM’s financials include some accounting irregularities that are unexplained, a TAM that is overstated, and operates in a market with lots of competition, several of which that are vertically oriented.  

• My View: STEM is a short.  STEM has a demanding valuation that requires a rapidly accelerating topline which has not yet manifested itself in the high value software line.  There are numerous potential execution missteps that could lead to a much lower valuation.  Conversely, STEM operates in a hot industry with numerous macro tailwinds.  

Business Overview, Segment Discussion and Revenue Recognition: 

Stem Inc. (STEM) is a battery storage integrator.  Their main product is Athena, a cloud- based software suite that monitors and regulates large-scale battery storage deployments at commercial and utility-scale customers.  These battery storage deployments are resold by STEM, which uses their scale to buy third-party battery packs that are installed by sub-contractors on site.  

Historically, STEM was an energy optimization company that was focused on saving commercial customers money by reducing peak energy demand from the grid during expensive peak hours (aka ‘peak demand shaving’).  STEM’s battery packs and Athena software were deployed ‘Behind the Meter’ (BTM), enabling retail, office, and manufacturing customers the ability to shave down their electrical bills by discharging the battery at peak times of the day (usually the hottest times) and charging it via connected solar panels during demand lulls (early morning, late afternoon).  Commercial electricity customers can utilize peak demand shaving because they are charged by electrical utilities in two ways: consumption charges and demand charges.  Consumption charges are like residential bills; you are charged for how much electricity you consume measured in kilowatt-hours (kWh).  Demand charges are unique to commercial customers and represent the highest level of electricity using during a billing period (‘peak demand’) and is measured in kilowatts (kW).  The demand charge often generates 30%-50% of a monthly bill but can be ameliorated by a solar + battery storage solution deployed by a company like STEM.

Today, while STEM is still deploying BTM battery packs, their recent revenue and bookings growth has largely been driven by ‘Front of Meter’ (FTM) deployments at electrical utilities’ solar panel farms.  These FTM battery packs are utilized by solar farm owners to balance electricity loads throughout the day, ‘firm up’ solar generation due to brief disruptions (passing clouds), and provide overall resilience as storage can provide backup power in case of electrical disruption.  Importantly for STEM, these utility-scale deployments need sophisticated software to manage them properly – and that’s where Athena comes in.  Additionally, due to the distinct business models of BTM vs. FTM, the revenue recognition and associated revenue growth are drastically different between the two.

Host Customer Model vs. Partnership Model: STEM’s historical BTM business was based on a Host Customer model where STEM funded the battery deployment on site with their balance sheet and owned the assets over their life.  Customer contracts with STEM always include the use of Athena software, last anywhere from 5-10 years, and charge a fixed recurring monthly fee based upon the energy optimization services used as well as the kWh consumed.  This revenue, ‘Host Customer Services Revenue’, is recognized ratably on a monthly basis, much like a SaaS software business, and zero revenue is recorded upon installation of the battery.  This is very different from the Partnership Model.

In the Partnership Model, arrangements are entered into with FTM energy companies usually as part of a ‘solar + storage’ deployment.  The customer purchases the battery hardware from STEM and this Partnership Hardware revenue is recognized upon delivery.  The customer owns the hardware outright, requiring no funding from STEM, and simultaneously enters into a 10-20 year contract with STEM to provide energy optimization services via its Athena platform.   

This rapid Partnership Hardware growth is a result of changing the business model by focusing on larger FTM deployments.  The first major project that STEM announced was in partnership with Syncarpha Capital, a solar developer, for a solar + storage project in Blandford, Massachusetts announced on 6/23/20.  Importantly for STEM, this began a rapid rise in Partnership Hardware Revenue which really juiced overall growth and set the stage for the SPAC merger.  

Athena Software: Athena is the company’s secret sauce.  This is where their economic value is earned.  Athena is a cloud-enabled software system that increases the value of an energy storage system by optimally charging the batteries during expensive peak times and discharging them during cheaper hours of the day.  While the company likes to market the software as ‘AI’ it’s really just a very sophisticated set of algorithms that takes into account a customer’s energy usage patterns, current grid energy costs, weather, and future energy costs/demands.  The Athena platform is battery-technology agnostic and STEM works with many of the industry’s major players including LG, Samsung and Tesla.  Naturally, management touts themselves as a clean energy SaaS company as they attempt to garner a higher multiple from investors.  It’s not clear to me from my work that Athena is truly a differentiated product although it is worth noting that in 2019 Athena had ~50% market share in California and reportedly has ~30% share across the US.  The software has been battle tested across numerous customers with different state-based regulatory requirements, many types of battery deployments, and has 22m cumulative run-time hours of performance.  

Market Participation Revenue: Today, this is zero.  Management acknowledges this stating, “although we do not expect to generate significant market participation revenue in the early years of a project’s life cycle, we believe this revenue stream is an important long-term differentiation relative to our competitors.” In the future, it may be meaningful and should come with ~80% gross margins.  Specifically, market participation revenue is generated by Athena software deployed at a utility customer that likely is operating as a VPP (virtual power plant).  STEM’s hope is that they can utilize Athena’s software to generate arbitrage opportunities for customers and share in the associated revenue (e.g. sell cheaply generated solar energy stored in batteries during peak times when prices are high).  STEM does not have any of these contracts signed today but the company hopes that it can generate 10% of revenue over the life of an average contract: 

Important STEM-Reported KPIs:  While STEM has not been public for very long, management is focused on providing investors with forward-looking metrics that paint the company’s opportunity in the most appealing light.  Given recent trading history and sell side commentary, it seems clear that the main KPIs investors are focused on are: Revenue, Bookings and Backlog.

• 12-Month Pipeline: This represents the total value of uncontracted, potential hardware and software contracts that are currently being pursued by Stem’s salesforce.  This is a non-GAAP, bullsh*t number that will only go up over time.  Do not pay too much attention to it because it is highly manipulate-able.   

• Remaining Performance Obligations (RPO): RPO represent contracted revenue that has not yet been recognized including deferred revenue.  These contracts including a binding purchase order.  Investors should pay close attention to Services Revenue Recognized <1 Year ($$46.5m as of Q222) as this is a proxy for Software Annualized Recurring Revenue (ARR), which Stem does not report.  Finally, note that RPO is effectively the firmest and most conservative version of Bookings.  

• Bookings: These represent the accumulated value of all executed contracts to-date.  Management touts these numbers every quarter as they are bigger than RPO and can grow faster too.  This is due to the fact that Bookings include RPO as well as Partnership sales where the executed contract is not yet paired with a binding purchase order.  This is a non-GAAP metric and should be scrutinized by investors as they can be cancelled at any time prior to receipt of a binding purchase order.   

• Contracted Backlog: This is the total value of Bookings at a specific date – some investors would refer to this as Total Contract Value (TCV).  

• Contracted AUM (GWh): This is the total GWh of systems in operation or under contract.  It’s not clear if ‘under contract’ refers to RPO or Bookings.  

Industry Overview:

The majority of STEM’s revenue growth is largely tied to macro tailwinds as battery storage is booming in the US.  Industry consultant Wood Mackenzie believes that the industry can CAGR at 50%+ for the next few years.  As such, in order to understand and value STEM, investors must have an informed view of the battery storage industry.

Governments and companies across the globe are looking to reduce greenhouse gas emissions in order to limit global warming to well below 2°C above pre-industrial levels.  This was codified by the Paris Climate Agreement in 2015.  Additionally, the economics of renewables are now at a place where it is simply cheaper to deploy renewable sources of energy (wind and solar mostly) than their ‘dirty’ counterparts.  

Policy Considerations: US policy the past 15 years has been very accommodating towards the solar and wind industries.  Expect this backdrop to continue for the foreseeable future which will act as a tailwind to STEM’s bookings and revenue.  Globally, policymakers have pledged to reduce carbon emissions considerably over the coming decades and the only way to hit emissions reduction targets is through renewable energy investment.  

Deployments of solar energy projects have accelerated considerably since the solar Investment Tax Credit (ITC) was implemented in 2006.  Today, the ITC is a 26% tax credit for solar systems installed on residential and commercial properties; the credit is applied against income taxes and is functionally a subsidy on the price of the system.  Also, note that the ITC covers not just solar systems, but associated battery storage systems ($5,000 for residential, $150,000 for commercial deployments).  The ITC was supposed to step down in 2023 and disappear entirely by 2025 but was given another 10 years of life as result of the passage of the Inflation Reduction Act of 2022.  Finally, there is a bipartisan bill called the Energy Storage Tax Incentive and Deployment Act that has been introduced in Congress that would offer a standalone investment tax credit for energy storage.  It currently has just 31 co-sponsors but is worth keeping an eye on as it may be integrated into Biden’s Build Back Better framework and it would turbocharge solar + battery deployments.

FERC, the federal interstate electricity regulator, issued Order 841 in February 2018 which states that barriers to distributed and behind-the-meter (BTM) storage participating in wholesale electricity markets should be removed.  Functionally, the Order removes numerous barriers to BTM storage systems operated by commercial and industrial companies to selling excess power back into the grid, thereby increasing the ROI for most projects.  Historically, these BTM projects have been in STEM’s sweet spot.  Similarly, FERC’s Order 2222, issued September 2020, sought to enable distributed energy resources (DERs…sometimes referred to as virtual power plants or VPPs) to compete directly in wholesale energy markets along traditional power providers.  DERs/VPPs require battery storage to compete effectively as they aim to recharge batteries when energy is cheap in the wholesale market and discharge them when it is expensive.  Taken together, these two orders continue to chip away at the old paradigm of unidirectional power markets and are opening up new use cases for solar/wind + battery deployments which are at the core of STEM’s business model.

Economic Drivers: As US Policy drives investments in renewables, a resultant driver of the industry is that the Levelized Cost of Electricity (LCOE) from Wind and Solar has been declining rapidly the past decade and in many parts of the US is now cheaper than fossil fuel alternatives.  

Similarly, the cost of battery storage has come down considerably in the past decade, declining at about a -20% CAGR.  This decline in price has led to exponential growth in battery installed capacity.  Expect these declines to continue albeit at a decelerating pace (second bar chart).  

But, there is an obvious problem with wind and solar power; the wind does not always blow nor the sun always shine.  Peak energy demand is typically in the morning and early evening which does not align well with the peak of solar energy hitting the Earth (mid-day).  Battery storage can solve this problem by shifting solar power generation from mid-day to the evening peak, which reduces overall peak demand softens ramping of natural gas peaker demand.  

Ultimately, the largest opportunity for global battery storage, according to Bloomberg’s BNEF, is in the Utility Scale market (see estimates below).  In fact, BNEF expects Utility Scale deployments to be 80%+ of the market over the next 30 years.  Utility Scale batteries serve several roles in a renewables-based power generation mix: 1) System Operations – batteries can respond in milliseconds, providing frequency regulation (regulating imbalances in supply and demand), 2) Investment Deferral in Gas Peaker Plants – large-scale batteries can serve as capacity reserves that discharge power during peak hours that have historically been served by Gas Peakers, 3) Complement Solar and Wind – batteries firm up renewable output and can shift capacity from mid-day to peak demand in the evening.  

Wood Mackenzie has a similar outlook on the battery storage market – that ultimately it will be dominated by FTM Utility Scale projects.  This much larger TAM for Utility Scale batteries is the exact reason why STEM has refocused their energies on the FTM market over the past 18 months.

Bull Case:

• Like all SPACs, Stem laid out the Bull Case in its merger document with the projections detailed below.   STEM expects massive Bookings and Revenue growth for the next several years which in turn should drive Gross Margins into the low-40s and EBITDA Margins into the mid-30s.  If they hit these numbers then FCF will explode (today the stock is trading at ~6x 2026E FCF) which is way too cheap.  Needless to say, the stock will be a LOT higher if they hit these projections.  

• Rapidly Growing TAM: As noted above, the US market for battery deployments is expected to be ~$8B within the next few years according to Wood Mackenzie.  The US Energy Storage Market saw a 162% increase in megawatts deployed in Q221 which was the second fastest quarter of growth on record (according to Wood Mackenzie 9/9/21 press release).  There is little doubt we are in a steep part of the adoption S-curve for battery storage in the US right now.  Expect the global market TAM to be multiples the size of the US over time as well.

• SaaS is a Solid Business Model: Selling Athena software yields a predictable, high margin revenue stream that should be capitalized at a high multiple.  STEM enjoys a 100% attach rate on Athena with its hardware deployments and combines that with 10-20 year contracts in order to generate a highly predictable ratable revenue stream at 80%+ gross margins.  

• Athena makes ‘dumb’ batteries smart and increases the ROI for solar project developers considerably.  Storage (and software like Athena) will likely become a necessary component of any major solar farm over time.

• Optionality: STEM’s stock is going to move on big customer/project wins, strategic M&A and international expansion.  This is going to be a headline and revenue-driven stock.  Given the major tailwinds in the industry it would not surprise me if investors get really excited if STEM announces a deal with a household name like Tesla or NextEra.  

• Today, STEM has operations in the US, Canada, Chile, Japan with a goal to expand into Mexico, Australia, Colombia and Europe.  Again, lots of possibilities for splashy headlines.

• STEM does not participate in the residential market today but I could see a scenario where they partner with a solar + battery installer to deploy Athena at people’s homes.  

• Investor Buzzwords: Similar to embedded optionality, STEM’s investor communications reveal that they understand how investors think today in terms of buzzwords: ESG! ESaaS! (Energy Storage as a Service) AI! Asset Light! While these are not fundamental reasons to own the stock, they do make growth investors warm and fuzzy and the more they are touted by management the more investors can get excited about the stock.  Finally, it’s worth noting that STEM offers investors one of the very few ways to ‘play’ battery storage as there are really only two US-based pure play companies public today: STEM and Fluence (FLNC).  STEM thus offers investors scarcity value.  

• Risks to the Bull Case:

• Supply Chain Issues and Inflationary Headwinds: Both are well understood by investors now but should be continually monitored.

• Seasonality: STEM has historically experienced a lot of seasonality in its Hardware revenues with as much as 80% of annual bookings generating in the 2H of the year.  This year, STEM expects ~50% of bookings and revenue to be generated in Q4 alone.  As such, any hiccup in Q4’s performance and color the stock’s performance for the forward year.  

• Customer Concentration: STEM has had six customers in the past year that have accounted for >10% of Revenue and/or Accounts Receivable.  If any major customer moves away from STEM or if a future deal of size gets pushed out for any number of reasons then STEM can miss revenue/bookings estimates quite easily.

Bear Case 

• Accounting Red Flags: My sense is investors do not really understand why revenues are ramping so quickly nor do they realize that software revenue growth is not keeping pace.

• STEM’s rapid revenue growth the past several quarters is due to a shift in business model and revenue recognition.  These hardware-related revenues are low margin (10%-30% gross) and undifferentiated as STEM acts largely as a broker.  

• STEM’s software revenues, the company’s crown jewel, have not kept pace with hardware revenues. Not even close.  Additionally, Partnership Software Revenue is anemic – why haven’t these multi-million dollar hardware deployments generated commensurate software revenues?  This issue is by far my biggest concern for the company and I do not think investors understand the implications at all.

• Management wants investors to focus on Bookings growth but as I detailed above, Bookings are an aggressive version of RPO as they are cancelable at any time prior to a binding purchase order.  I can foresee a scenario where there is an air pocket of growth as management effectively pulled forward Bookings from future periods by aggressively labeling them as such.

• Projections are Fanciful: Perhaps STEM can hit the Revenue/Bookings estimates they gave to investors but their estimates for Gross and EBITDA margins are fanciful.  Today, the company is generating  ~100% of incremental revenue from low margin FTM Hardware Revenue.  In order to hit 2024 Gross Margin targets they need Software sales to reach 30% of total revenue – and it’s not yet clear that software sales can be anywhere near that proportion of hardware sales.  Additionally, the company’s expectation that they will grow Operating Expenses just $6m from 2022 to 2024 despite Revenue nearly tripling is extremely aggressive.  This is a rapidly growing and diverse market with lots of competition; they will need to invest a lot in R&D and Sales to compete effectively.  It’s extremely aggressive to think that the company can get to 40% incremental EBITDA margins as soon as 2023.  Nothing in the energy space has margins like that; incremental margins on that level are only available to pure play SaaS software companies of notable scale that do not have a low margin hardware business attached to them.

• FTM is Low Margin: While it’s clear that STEM has moved aggressively towards utility-scale FTM projects, it also seems clear that the FTM market will be lower margin than the BTM market given enhanced customer negotiating leverage and increased competition.  As such, STEM’s management team has guided investors to hardware revenue in the wide range of 10%-30%; expect FTM deployments to be towards the lower end of that range.  

• TAM Misestimated by Investors: The bar graph above from Wood Mackenzie estimates that the US energy storage market will be $7.6B in 2023.  Sure, there is a rapid amount of growth from 2019-2023 (the market will increase nearly 11x), but if the market is ‘only’ $7.6B in size and at that point is only growing at a single digit rate, does it make sense that STEM is currently trading at a market cap 30% the size of its largest market’s TAM?  We are at the steepest point of the S-curve for energy storage adoption; one could argue that STEM is trading at a massive multiple on a market that will rapidly decelerate in growth beginning next year.  

• Competition:  While STEM would try and lead you to believe that they are the only major energy storage software company out there, the reality is that several vertically-integrated power providers have software suites for both BMS (Battery Management) and EMS (Energy Management).  Some of these include STEM’s own ‘partners’ including Tesla and BYD.  In particular, Tesla offers a comparable product called Autobidder and Fluence offers IQ; Athena is no longer as unique of a product as it once was.  See two slides below from BNEF.

• Valuation: Honestly, valuation is not a great reason to short STEM although as I detail below, the stock is expensive using a variety of methods and any hiccup in the bull case will result in shareholders assigning the company much lower multiples.

• Risks to the Short:

• Smart M&A: STEM has some room to raise capital for accretive M&A although the market was not what it was six months ago.

• Passage of the Inflation Reduction Act spurs solar and battery storage growth.

Valuation:

STEM is an expensive stock, especially given the fact that it is rapidly growing, not yet profitable and future growth estimates are high.  To wit, STEM is currently trading at the following consensus estimate multiples on FY24E: 2.5x EV/S, and 27x EV/EBITDA (with crazy incremental margin assumptions).  

Ultimately, I’m not sure how much STEM’s valuation ‘matters’ to the stock because the valuation is so high.  Rather, what is going to drive the stock are simply headlines and revenue growth.  If STEM can continue to announce new deal wins and revenue that is consistently above their own guidance/consensus then the stock can power higher.  This is a concept-driven, TAM-focused stock and investors today do not care much about profitability.

My Investment Recommendation:

• I believe STEM is a short.  While the company’s revenue growth is high and the TAM is expanding rapidly, there are numerous red flags that make me think the sales and profit opportunity are overstated by the market: please see my Bear Case bullet points above.

• In particular, the fact that Services (Software) Revenue have not ramped despite the company’s Hardware Revenue ramping is deeply concerning.  Is the company drop shipping batteries to customers who are not attaching them to the grid?  Or is the company signing really small associated software deals that have been turned on but barely move the needle?  Perhaps my view on this risk changes in Q4 when they are supposed to print a massive revenue number but for now it’s such a notable red flag that I currently lean short on my investment recommendation.

APPENDIX:

SPAC Background:

• Overall, this was a solid SPAC merger: the stock jumped upon announcement, the sponsors are ‘real’ investors/managers, prior shareholders of Stem rolled their equity over, there was a sizeable PIPE backstopping the deal and near zero redemptions.  

• STEM’s SPAC sponsor was Star Peak Energy Transition Corp. (STPK).  STPK was functionally an arm of Magnetar Capital (multi-billion dollar hedge fund).  The deal to bring STEM public was announced on 12/3/20, approximately 3.5 months after STPK went public.  The deal was well received by the investing public with the stock jumping 70% the next day. 

• STEM’s prior shareholders, including all the majors, rolled their equity into the public vehicle and STPK engaged with PIPE investors to invest $225m.  

• Star Peak Sponsor LLC (the ‘sponsor’) held 12.4m shares as of August 2021 but has since sold nearly 3m shares outright in a secondary and then distributed the rest of the shares to over 30 entities in an October deal.  While the original Stem shareholders still own their shares, it is worth pointing out that the SPAC sponsor has divested a considerable portion of its stake so shortly after the merger.   

• It’s notable that Magnetar currently owns zero shares of STEM and has only disclosed a stake once at the end of Q221 (43,500 shares).

• STPK Management:

• Michael Morgan (Chairman): Appears to be a quality manager/investor, having founded Kinder Morgan (KMI - $38B market cap), as well as serving on the Board of Sunnova Energy (NOVA).  His private investment firm, Portcullis Partners, owns 50,000 STEM shares.  

• Eric Scheyer (CEO): A partner and member of the managing and investing committees at Magnetar Capital.  

• The rest of STPK’s Board is largely comprised of Magnetar executives.  

• The Sponsor shares were locked up for 1 year post business combination UNLESS the stock exceeded $12.00 per share for any 20 trading days within a 30 day period commencing 150 days after the initial business combination.  Thus, the lock up functionally expired 20 days after the merger was completed.

• The same SPAC sponsor had a second vehicle, Star Peak Corp II, which also deSPAC’d into Benson Hill (BHIL), announcing the deal on May 9, 2021 and consummating it on September 30.  This deal was not as well liked as STEM as 76.5% of the shareholders redeemed upon deal closure which led to 28% drop in the share price.  The stock today is at ~$7.60.

• Overall, give the managers at Star Peak credit for raising two vehicles and consummating the mergers.  But given the current share prices of their two public companies their current ‘success record’ is just 1-2.  

DISCLAIMER:  This is not a recommendation to buy or sell any investment.  Additionally, this document should not be relied upon to make an investment decision as the numbers and figures presented are solely the author’s estimates.  Investors should contact the company directly and read GE public filings to form their own opinions and make their own investment decisions.  The author may transact in the securities of GE without notice.  

Catalyst

2023/2024 Incremental EBITDA margins fail to materialize as most of the revenue growth is hardware (low margin)