Description

XWES is a high-growth [52% TTM], high-margin [75% TTM], recurring revenue [~2/3], cash generative business trading at a 14% 2013 FCF yield [24% in 2014*]. It’s the leader in its fragmented $2bn+ industry that is ripe for consolidation; its competitive position is strengthening and defensible. Hyper growth is hurtling XWES toward critical mass and the eventual network effect that results from scale. Backlog represents over 70% of market cap.

We think the stock is cheap primarily because, optically, the last two quarters have looked weak [but weren’t]. Secondarily, there’s a perceived overhang in the stock due to the founder, who owns 1.8m shares, stepping away after 15 years [but can only sell ~2k shares/day]. Finally, the usual micro-cap, sub $5 arguments [these will work themselves out].

We think the stock will experience significant appreciation in the near term. We think XWES' 4Q earnings release will be clean, include nearly a full quarter of the recent NEP acquisition, and demonstrate significant leverage. Also, through cash generation, XWES will be debt free in the next two years which will mechanically accrue 20% to equity. Meanwhile, organic growth will continue with 70% of each incremental core dollar dropping to the bottom line while an average of one highly accretive $8m acquisition per year drives growth above this rate. We think a sell-side small-cap shop or two could initiate during 2013. We also note that if CA governor Jerry Brown brings competition to 100%, it would be a bonanza.

Though XWES’ largest competitor was recently taken out at a value representing >300% upside, ultimately, we think the shares are worth $9.40 (115% upside) based on 8x FY2 EBITDA (FY1 balance sheet) before any further accretive acquisitions.

*In all fairness, 2014’s FCF yield is 18% fully taxed but XWES will not be in a taxable position until 2015.

THE COMPANY
XWES is an energy management company that helps commercial, industrial, institutional, and government customers do three things: 1) Buy energy; 2) Reduce energy usage; 3) Maximize available incentive programs. The Company simplifies the process of managing energy needs through a unique perspective:

E = P * Q – i

--or--

Energy Costs = Price * Quantity – incentives

XWES looks to minimize price and quantity for customers while maximizing incentives through two operating segments: 1) Energy Procurement; 2) Energy Efficiency.

Procurement (80% of revenue, 83% gross margin)
At its core, XWES is an online energy auction platform connecting retail electricity consumers (“listers”) with suppliers (“bidders”) in the 16 U.S. states that have deregulated electricity markets. Commercial and Industrial (“C&I”) retail consumers sign exclusive contracts with XWES to procure their electricity needs over a typically one year period. Federal / State Government and institutional customers typically have a 2-3 year horizon. The Company’s online marketplace is brutally efficient at attaining the best possible price for listers. Using a “broker assisted approach,” XWES provides step-by-step management and detailed documentation throughout the entire procurement process. The typical fee is 1-3% tied to actual consumption over the contract period.

Auctions also extend to the wholesale market where XWES connects electricity generators with utilities and intermediaries that purchase electricity to re-sell on the retail market. Fees for wholesale auctions are fixed and not tied to future energy usage. A similar fixed fee structure is used for retail natgas transactions (~20% of procurement revenue).

A small piece of the procurement business comes from managing demand response and environmental commodity transactions on its platform.

Energy Efficiency (20% of revenue, 25% gross margin)
Through recent investments and acquisitions, XWES is building out its energy efficiency practice. This segment offers technology-enabled solutions such as online audits of facilities to identify retrofit options and project management services for retrofit implementation, believing this practice will also enable more cross-selling opportunities for commodity auctions.

LARGE, FRAGMENTED INDUSTRY
According to KEMA, the United States energy procurement opportunity is roughly $1.5bn. This includes only the U.S. states with competitive deregulation and excludes natural gas. Including natgas, the immediately available opportunity on the procurement side is over $2b before any further deregulation.

Of the $1.5bn electricity opportunity, Large C&I, Government and Utilities represent $850m while Mid-Market retail customers are a $650m opportunity. XWES had historically focused on larger customers but grew its addressable market by 75% by moving into the Mid-Market with the acquisitions of GSE in 2011 and NEP in 2012.

There are between 500 and 1000 small aggregators, brokers, and consultants (“ABCs”) providing procurement services for energy consumers. These operations typically top out at 15-20 heads given the complexity inherent in managing the business. These 500 ABCs are candidates for XWES to roll-up. Today, more than 90% of the brokerage market still uses manual, paper/pen-based systems to transact their business.

COMPETITIVE POSITION IS STRENGTHENING AND DEFENSIBLE
Today, most C&I consumers procure energy through a paper-based RFP sent to a handful of energy suppliers. When the bids are received, consumers choose the lowest price and sign a contract in a one-time sealed-bid auction. Because XWES has virtually every electricity supplier in every deregulated market signed up, they can bring the marketplace to customers and provide significant energy savings. Where a retail consumer may have had 2-3 choices in the past, he now may have a dozen or more bidders.

XWES’ seasoned and experienced managers take a “broker assisted” approach to procurement. In other words, supply chain management. Others had raised significant capital to enter the space and had technology that worked. The self-serve model however, was the wrong approach and these players have since vanished or been marginalized. The broker-assisted process includes data collection and usage analysis, establishing a benchmark price, conducting multiple auction events to enable testing of various term and price combinations and assisting in contract completion. XWES creates an audit trail of all the steps taken in a given transaction. Specific web pages track all information provided to energy suppliers including energy supplier calls, supplier invitations, usage profiles and desired contract parameters.

We don’t believe there is a robust, competitive online auction offering on par with XWES. During September 2011, XWES bought their largest auction competitor, Co-Exprise, after having taken its largest customer. Co-Exprise was on a revenue run-rate of $3m and XWES shelved the acquired technology for its inadequacy. Our conviction that XWES is superior is strengthened by the fact that high profile government procurement programs have chosen XWES as the exclusive auction provider:
1. The GSA, the largest landlord in the country, signed a five year exclusive deal with XWES as the electricity and natgas procurement auction provider for the country
2. The Regional Greenhouse Gas Initiative (RGGI or “Reggie”) signed an exclusive agreement for its 10-state cap and trade program.
3. Also state contracts with CT, MA, and others.

XWES has 240 channel partners, 85 wholesale customers, and thousands of retail customers on their platform. The Company is gaining momentum and we believe the network effect is imminent as XWES reaches critical mass. With roughly $0.70 per incremental procurement dollar dropping to the bottom line, we believe this momentum will render significant results.

As the largest player in the auction space with a public currency and past acquisition successes, we think XWES is the natural acquirer in this fragmented industry. XWES’ recent acquisition for NEP valued that business at 5-5.5x earnings and was highly accretive.

HIGH VISIBILITY, SIGNIFICANT BACKLOG
XWES has $38.6m (up 66% y-y) total backlog with $20.7m (up 46% y-y) to be recognized in the next twelve-months. This backlog consists of monthly recurring revenue based on energy usage contracted through auctions. Historically, XWES has realized 101% of backlog as revenue. On a run rate of $34m of revenue, backlog of $20.7m represents 61% recurring revenue, or roughly 2/3.

A FEW REASONS THE STOCK IS CHEAP
Optically, the last two quarters have looked weak. In 2Q12, the founder stepped away from the business after 15 years. Related expenses were $420k in the quarter. Despite growing revenue and backlog 78% and 64% respectively, EPS appeared to have decreased. On an adjusted basis however, EPS grew 160%. Moreover, in 3Q11, one of XWES’ procurement suppliers bought out their own forward backlog and op margins shot up to 15% for the quarter. This one-time event made EBITDA comparisons difficult in 3Q12, despite revenue and backlog growth of 51% and 66%, respectively. The weak appearance in 3Q was exacerbated by two additional items: 1) a $100k non-recurring expense for an office move; 2) $300k of Efficiency revenue under a legacy acquisition’s (GSE) contract at 2% margin caused Efficiency margins to appear extremely weak.

Also, The founder, Richard Domaleski, stepped away and owns 1.8m shares of stock. We don’t view this as an overhang for a few reasons. First, under rule 144, Domaleski can only sell ~120k shares of stock per quarter (~2k shares per day) until he gets below 10%. Assuming maximum sales, it would take Domalseki until 1Q14 to get below 10%. Since he announced his departure two quarters ago, he’s only sold 65k shares. At that rate, it would take him over four years to get below 10%. Second, per management, he has received an offer to take him out at a discount to market that he declined. Third, this is his primary source of wealth and he’s not keen to blow it up.

We’d also mention the usual micro-cap, sub $5 arguments and believe that these will work themselves out.

FINANCIALS AND VALUATION
With 12.5m shares fully diluted, XWES has a $54.7m market cap. Adjusting for the acquisition of NEP subsequent to quarter end and 4Q12 cash flow, we estimate that XWES will report $7.3m net debt at the end of 4Q12 resulting in a $62.0m enterprise value.

Unlike a few (who seem to keep the secret close to the vest :-), we haven’t figured out how to paste nice looking tables into these write-ups so, in the interest of time, we’ve described the inputs driving our projections below. I’ll summarize the relatively verbose description as follows:

2013: $46.7m revenue, 72.8% gross margin, $29.9m opex for a $4.1m operating profit, or 8.9% op margin. Add back $4.7m of D&A and stock comp for $8.9m EBITDA. Interest expense will be $830k, no taxes due to NOL. $0.26 EPS assuming 12.5m shares. OCF of $8.0m, $500k capex results in $7.5m operating free cash flow. Earnouts and debt principal payments will total $7.8m. XWES will exit the year with $3.5m in cash, $7.5m debt.

2014: $56.0m of revenue, 70.2% gross margin and $29.4m opex for a 17.7% op margin. Add back $4.5m of D&A and stock comp for $14.5m EBITDA. Interest expense of $655k, still no taxes due to NOL. $0.73 assuming 12.7m shares. OCF of $13.8m, $500k of capex results in $13.3m operating FCF. Earnouts and debt principal payments will total $3.5m and XWES will exit the year with $13.3m cash, $5.0m debt.

Valuation: Using 2013E balance sheet of $4.0m net debt and assuming 12.7m shares outstanding, we use a forward enterprise value of $59.3m. Using 2014’s $14.5m EBITDA, XWES is trading at 4.1x. We think a highly predictable, recurring revenue business growing EBITDA at a 50% two-year CAGR deserves a multiple of 8.0x. At 8.0x EBITDA, XWES is worth $9.42 per share representing 2.1x sales and 12.9x earnings. We focus on EBITDA because XWES has a $15m NOL and will not pay taxes until 2015. Although not direct competitors, ENOC trades at 21.4x EBITDA and Usource’s parent company, UTL trades for 8.1x. Further, Schneider Electric bought Summit Energy, World Energy’s chief retail competitor (operating a pen / paper approach) for 4.1x sales in 1Q11. Applying that same multiple to XWES’ procurement revenue would result in a $15.70 stock price. All in, we think 8.0x is fair.

Projections Discussion
We conservatively estimate 30.4% revenue growth in 2013 to $46.7m. This consists of 15% growth in the procurement business + $6m contribution from NEP. Although much smaller, energy efficiency is a high growth segment and, with cross selling to NEP’s 2k customer base, we think this segment will grow 25% in 2013.

Although the Efficiency segment has been gaining as a percentage of revenue at a lower margin, the NEP acquisition will reduce the Efficiency mix in 2013 bringing the corporate average gross margin up 500bps to 72.8%, in our view.

XWES drives significant revenue from their base of 240 channel partners. Therefore, sales and marketing expense has a 30% variable component (roughly 12% inside sales, 18% channel partners). We think that the fixed S&M will run $5.2m in 2013 while the variable component is 14.0m. Net G&A is running roughly $7m and, per management, XWES can double revenue without adding G&A heads. We estimate $7.3m in 2013. We add NEP opex of $2.2m (calculated based on revenue and EBITDA earnout targets) and assume an additional $300k per quarter of amortization to get $29.9m of opex in 2013. We note that XWES strives to be the low cost provider and thus management is laser focused on frugality; they’re extremely proud of flying coach on connecting flights, staying in low-priced hotels, and paying $20/sqft for their headquarters in Worcester, MA. We don’t believe opex is going to run away as revenue grows.

XWES issued a $2m seller note for NEP at 4.0%, took a $4m 8-year term loan from Mass Capital at 10.5%, and increased their line with SVB to $6.5m paying 6%. Given the principal paydown schedules on each of the loans, interest expense will be $830k in 2013, $655k in 2014. There are no penalties for paydown into 2014 and management has stressed their plan to pay debt down as quickly as possible through cash flow.

In 2014, through cross sell opportunities and acquisition integration, we believe sales will grow 20% to $56.0m. As Efficiency creeps up in the revenue mix, we model margins giving up 260bps to 70.2%. Adding $200k to fixed expenses and a 30% variable expense, we project $22.2m for S&M expense. We think G&A will actually decrease as $300k of amortization rolls off.

Outside of some inventory for the Efficiency, there is very little working capital requirement. XWES also has very little fixed assets and minimal capex needs.

RISKS

• Procurement revenue is paid by bidders and is based on listers’ actual monthly energy usage. To the extent that customers use less energy than expected, XWES’ backlog could overstate future procurement revenue. We note that historically XWES has realized 101% of backlog as energy usage outpaced expectations.
• Energy Efficiency segment generates substantially lower margins than the Procurement segment. To the extent that Efficiency grows faster, or Procurement grows slower, than expectations, margins could be meaningfully impacted.
• When energy prices spike, retail consumers are less likely to lock-in to higher fixed price contracts resulting in lowered bookings in a given quarter. In 3Q12 for example, a large procurement was postponed because a generator went offline on auction day causing a spike in pricing.
• XWES is highly dependent on their channel partners to bring listers to the marketplace. Two channel partners are greater than 10% customers (23% together).

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

• 4Q earnings release in February will be clean and include nearly a full quarter of the NEP acquisition
• XWES will be debt free in the next two years accruing 20% to equity
• Continued highly accretive acquisitions at ~5x earnings
• Imminent network effect inflection point with $0.70 of each incremental dollar dropping to the bottom line
• Sell-side coverage initiation(s)