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A reasonably priced growth stock (ENOC)

February 17, 2012 | About:
WGWJ

WGWJ

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The recent sharp rise in the stock market has made value hunting even more difficult. Most prices have moved sharply, particularly companies in cyclical industries, as investors start to position themselves for the next wave of positive news to sweep stock prices to another high.

The smart grid industry has not been given its share of attention compared to other cyclical industries. The enthusiasm for smart grid stocks had hit a peak when crude oil prices were persistently high in the first half of 2008. When crude oil prices subsequently fell the enthusiasm for smart grid stocks also subsided. But with crude oil prices creeping back above US$100 per barrel, smart grid stocks may find themselves in the limelight again as high energy costs would push Utilities to find ways to lower their generation costs. Furthermore, unanticipated spikes in peak power usages due to weather changes, the lag time to build power plants and the need to maintain high utilization rate on base load power plants, would force utilities increasingly, or at least partially, to complement their generation portfolio with smart grid.

EnerNOC (ENOC) is one of the leading developers of smart grids. The company’s key product is the demand response solution which helps utilities reduce aggregate power consumption during peak usage hours. How does it work? ENOC essentially has a network of large electricity consumers who are committed to lowering their consumption during peak demand periods. This reduced consumption effectively serves as a reserve capacity for utilities, thus avoiding potential black-outs and the need for new power plants.

In return for their commitment to reduce consumption, large electricity consumers are paid by the utilities, and ENOC collects a portion of the payment for providing the infrastructure and managing the process. However, this unique business model is not without its own set of challenges; (1) it takes a lot of capital expenditure and research and development to create a smart grid network and (2) the power market has to be well developed and deregulated.

The smart grid industry is generally regarded as a growth industry as it is a relatively new concept and there is a large addressable market. ENOC has demonstrated its ability to capture this growth in its past record.

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There are reasons to believe that its growth would continue in the future. The bulk of ENOC's revenue comes from the U.S. and it is operating in only 22 out of 50 jurisdictions. It has only recently expanded overseas, to Canada in 2008 and the UK in 2010. There are still many potential countries, such as Germany and Australia, where the electricity sector is in the right conditions for smart grids.

Another advantage of the business is the recurring income as contracts are long term, ranging from 3 to 10 years. As ENOC grow the mega watts under management, its revenue would be grow faster due to the recurring nature.

The biggest attraction of ENOC is probably its leading position in the industry. There is barrier to entry as large capex and R&D are required to create a smart grid and it is estimated that ENOC holds 30-35% of the North American market share. In addition, ENOC’s strong financial position – zero debt and high cash (C/E about 136%) – place it in a strong position against competitors as contracts generally require collateral posting or guarantees.

Previously ENOC was priced as a growth stock; At its IPO in 2007, it was priced at 7.7x book value and it had negative earnings. Now it is priced at approximately 1 times book value when it recorded its first positive earnings. With the growth potential described above, earnings are likely to continue the momentum and ENOC looks poised to be re-rated positively in the near future.

Rating: 2.8/5 (12 votes)

Comments

WGWJ
WGWJ - 2 years ago
@SapientInvestor - thanks for highlighting the issue as it brings balance to the article.

As you pointed out ENOC is currently facing regulatory uncertainty. This regulatory uncertainty has been outstanding since early 2011. Below is the chronology of the events:

04/02/2011 PJM issue statement alleging double counting

14/02/2011 ENOC addresses PJM statement

Mar 2011 Federal Energy Regulatory Commission (FERC) rejects PJM double counting statements

Jun 2011 – Demand response leader issue open letter to electricity consumers

15/02/2012 – PJM proposed deadline for phasing the adverse change. However FERC has not taken the proposal to implement the changes.

At the heart of the dispute is how to price Demand Response. PJM says that there is double counting when a customer reduces their peak load more than specified which is then used to offset underperformance by other customers. ENOC, on the other hand, supports the portfolio approach whereby it is not important if individual customers underperform as long as overall portfolio delivers the contracted amount of Demand Response.

There are independent expert opinion suggesting there are inherent agency issue. Generators make their money when demand of electricity is high thus they would be biased against the conservation of electricity, which is the essence of Demand Response. Dr. Alfred E. Kahn, a reowned regulatory economist, said it best in his testimonial in FERC proposed rulemaking:

“That electricity generators have opposed this plan should not be surprising: their primary business is to sell power, not to encourage its conservation, and I have myself publicly cited evidence that they reap the preponderance of their profits on those occasions when demand is at its peak,”

(http://www.nera.com/83_6914.htm)

Notwithstanding the points above, PJM is a significant market for ENOC as it accounts for 60% of ENOC's revenue hence any adverse change would have significant impact.

It is anyone's guess if the final regulation would be closer to PJM's position, or ENOC's position, or a middle ground. But given ENOC valuation is becoming more attractive and its business is in a leading position of a growing industry, I believe that there is sufficient grounds to look closely at ENOC.

I also remind myself that we can either have good news, or cheap stocks, but not both at the same time.

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