Energy tech companies have a business model that's closer to Apple Inc. than Apache Corp. In other words, it's all about the new product. The products Dominick & Dominick Analyst James McIlree is excited about offer major benefits like improved geological mapping for oil and gas explorers, or electric grid safety for energy utilities. In an interview with The Energy Report, McIlree talks about his favorite companies in the energy tech space and how understanding product cycles can help investors time their buys.
The Energy Report: Your investment firm, Dominick & Dominick, keeps a sharp eye out for companies that back up electrical grid operations. Are the ongoing battles over President Obama's proposed budget likely to impact small companies in this space?
James McIlree: We focus on companies with new products that have the ability to grow even in a sluggish economic environment. Companies that are looking for federal subsidies, or that rely upon the U.S. government as a customer, should re-think those business plans. Although the overall shape of economy is important, the product cycles of the companies we invest in are much more important to determining their success than the macro-economic scene.
TER: What are product cycles and why do you focus on them?
JM: In the technology markets, product cycles are the most important determinant of success. Companies with strong, new product cycles are successful; those without it are not. Look at a company like Apple Inc. (AAPL:NASDAQ). When Apple introduced the iPhone, then the iPad, then the iPad Mini and then the next version of the iPhone, those product cycles drove extremely rapid revenue and earnings growth. Without a new product, Apple's stock falls.
Here are concrete examples of product cycles with three energy technology companies that I follow: Acorn Energy Inc. (ACFN:NASDAQ) is the majority owner of US Seismic Systems Inc. It manufactures a device called a fiber optic geophone, which maps geological formations using seismic waves. US Seismic's new geophone delivers a much greater sensitivity for detecting seismic activity, and at a much lower price than the existing technology. For this reason, this new product is expected to replace the geophone products oil and gas companies currently use. The product is still in the development stage, but assuming that it gets successful results from a series of upcoming tests, the company will increase its revenue via the successful launching of a new product cycle.
Active Power (ACPW:NASDAQ) has just introduced a new flywheel that is used for backing up power, primarily in data centers. It is bigger than the firm's previous flywheel, and it's cheaper on a per-unit of power backed up than the previous device. Because of its greater size, it can target a bigger market with a new product cycle.
Hydrogenics Corp. (HYG:TSX; HYGS:NASDAQ) makes utility-scale electrolysers that convert excess electricity into hydrogen. The gas can be stored and used to recreate electricity in place, or transported as a gas to a different part of the grid and re-electrified.
In each case, the new products address an existing need, have a clear return on investment for customers and can have a significant impact on the company's revenue, earnings and cash flow growth.
TER: A product cycle has a downturn built into it by definition. In July 2011, Acorn's stock was $4, rising to $12 last May, and now it is around $7. Why the volatility?
JM: Acorn's stock was affected because it took longer than expected for its new fiber optic geophone to be accepted by customers. Instead of starting six months ago, the product cycle has been pushed into the future. That drove the stock price down. But what drove the stock price up last year was the expectation that the new product cycle would start relatively soon. The market expected the product cycle to begin earlier and is now pricing a new expectation of when that cycle will begin into the stock.
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TER: When will Acorn deploy the new geophone?
JM: Acorn delivered the geophone to an unnamed super major for testing. This is a global oil and gas company with assets in exploration, production, refining, marketing and chemicals. The super major will be testing the geophone side by side with other products. That test should begin in May. At that point, there are several future paths for the company. The most bullish path is that the super major says, "We love this geophone, and we are going to buy a whole bunch of them!" And then US Seismic obtains significant revenues in H2/13. Or, the customer says, "I like it, but I'm not going to start buying it until next year." Revenues will appear then. Or, the customer says, "We don't like this, and we are never buying it." Revenues will disappoint in that scenario. But that is not the scenario I am betting on!
TER: Does US Seismic have sufficient cash reserves to survive until the geophone takes off?
JM: At the end of 2012, the company was sitting on about $27 million ($27M) in cash and burning upwards of $5M/quarter. The cash burn can be reduced relatively quickly if necessary. Acorn has six quarters of cash at current burn levels, assuming no change in its product cycle prospects.
TER: Is this cash from investors, debt or a combination thereof?
JM: The most proximate source of the cash came from the sale of an Acorn subsidiary called CoaLogix in 2011. CoaLogix makes selective catalytic reduction systems for the coal-fired electric utility industry. The business sold for about $101M. Acorn collected about $60M cash, and that funded the reserve; debt is only about $150 thousand ($150K).
TER: What about Acorn's other properties, GridSense Inc. and OMNIMETRIX LLC?
JM: GridSense makes a device that monitors the performance of the electrical transformers that are ubiquitous throughout the electric utility network. It can predict breakdowns. That allows a utility to do preventative maintenance, rather than waiting for an outage and deploying a truck to fix a broken part of the grid. Unfortunately, it is difficult to sell this type of product directly to an electric utility. The firm needs to target system integrators, such as Silver Spring Networks (SSNI:NYSE), or Landis+Gyr (owned by Toshiba Corp. [6502:TSE]). The product is very relevant, but its sale cycle is quite long.
I am very optimistic about the prospects for OMNIMETRIX. It produces a monitoring service for backup power. It has just transitioned to a new business model, and did about $1M in revenues in 2012. It can do $2M this year, and maybe $7M in 2014. The nice part about this business is that most of its infrastructure has been built, so the extra dollar of sales has a high incremental margin attached to it. OMNIMETRIX should see subscribers, revenue and cash flow all grow rapidly over the next few years. It's in a hot space called M2M, or machine-to-machine communications. Other firms in the M2M space include Orbcomm Inc. (ORBC:NASDAQ), Numerex (NMRX:NASDAQ) and Fleetmatics (FLTX:NYSE), which has a very high multiple. In short, OMNIMETRIX is poised to create a lot of value. It's still a bit early for it, though.
TER: Do the three companies that Acorn holds all have separate management teams?
JM: Yes, each unit has its own management team. The corporate level of Acorn is very close to the teams at each of its subsidiaries. It does exert some authority and control over what the subsidiaries do, but it is not micromanaging them. Acorn strikes a very reasonable balance with its portfolio companies.
TER: Do you have a target price for Acorn?
JM: It's $14.
TER: You expect it to double?
JM: Right. We expect the company to grow its subsidiaries and sell one or two of them at valuations around $75–100M. That will get us to the $14 target.
TER: How does Active Power's product work?
JM: If, for some reason, there is a power outage, Active Power's interruptible power system kicks on and provides electricity until either power returns, or a diesel generator plugs the energy hole. Active Power's UPS (uninterruptible power system) is based on flywheel technology. The UPS is green because it stores energy snatched from the grid itself. And when the grid goes down, it does not fire up a gas or oil-powered generator. Instead, it delivers previously stored energy to the data center until, again, a more permanent fix appears. It's a short-term solution, but it's not a fossil fuel-based solution. This is important, because a smart phone stores applications that seek data in the internet cloud. The telecom companies want the data centers to be physically close to where you are, because that reduces the amount of time it takes to transmit data to your phone. The data centers are very valuable assets that must be powered 24 hours a day.
TER: How does the flywheel work?
JM: Electricity generated by the grid spins the flywheel. When the electricity stops, the flywheel keeps spinning. The spinning motion creates electricity. It will stay on for nine to 10 seconds, which is generally the amount of time needed to fire up a backup generator. Most of grid outages are of very short duration. The flywheel itself is actually relatively small, but it is housed in a cabinet that is 6 feet tall, 3 feet wide and 3 feet deep.
TER: And this is deployed at the site of a factory that is connected to the grid? It is not designed to be inserted into a major node of the grid?
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JM: Correct, it would be on an end-user's site, rather than at the electric utility's site.
TER: Let's take a deeper look at Hydrogenics, which is based in Toronto. What makes it attractive?
JM: It sells a device that makes hydrogen gas from water using electricity. Hydrogen is used in a variety of industrial applications. In North America, it's usually provided by Air Products and Chemicals Inc., or Linde Industrial Gases, or Air Liquide. In international markets where there is not a robust distribution network for industrial gases, Hydrogenics markets a fuel cell that produces hydrogen onsite for use in industrial processes. Simply put: the device splits a water molecule (H2O) into its component atoms: hydrogen and oxygen.
TER: By heating?
JM: No, it's an electrolysis-based solution. The electricity separates the hydrogen and the oxygen molecules. This is not about boiling the water, because all that does is create steam, where the H2O is still combined, but in a different form. In the electrolysis process, the oxygen and the hydrogen atoms are split apart from each other. It's very old technology. It's been around for 100 years. Hydrogenics has worked very hard to commercialize it. In large-scale applications, the hydrogen gas can be inserted into a natural gas pipeline and transformed back into electricity many miles away.
This utility-scale electrolyser for the "power-to-gas" application is the real key for the company's success. A utility that generates a lot of electricity from wind, solar or hydro-electricity often has a timing problem. What happens when the wind is blowing, the sun is shining, and the hydro is going, but there is not enough consumer demand to use the electricity at the time of generation? This is a problem in many countries that have mandated renewable sources of energy, such as Germany. It's a problem in Canada. It's a problem in California. It's going to be a problem in a lot of states across the U.S. where renewable fuel standards have mandated that between 20–30% of electricity be generated from wind, solar or hydro. What do you do with the excess electricity? Hydrogenics has a solution.
TER: That's quite interesting. Thanks.
JM: Thank you.
James McIlree has 25 years of experience in the investment business as a sell-side research analyst and buy-side analyst and portfolio manager. He focuses on emerging growth companies in the technology, telecom, energy and defense electronics markets. Prior to joining Dominick & Dominick in October of 2011, Mr. McIlree was a Managing Director and research analyst at Merriman Capital covering firms at the intersection of satellite communications and defense electronics. Prior to Merriman Capital, McIlree was with Collins Stewart and its predecessor firm, C. E. Unterberg, Towbin, where he covered the defense electronics/communications sector and was Director of Research. McIlree holds a Bachelor of Arts in economics from the University of Chicago and a Master of Business Administration from the University of Colorado. He is a CFA charterholder.
By. Peter Byrne of The Energy Report