From James LoGerfo, Michael Riedinger and Joe Berwind (Alternative Energy Investing); Please click on images to enlarge:
> Distributed Energy Systems canceled its share distribution agreement with UBS May 17, removing the overhang on the stock at a time when the short-interest ratio jumped from four days to eight (an all time record).
> Catalysts for DESC shares include a potential partnership with a large utility for critical power infrastructure marketing, power purchase agreements, and service; new project announcements; and leasing partnerships for hydrogenation generation units.
> DESC shares are trading within 13% of its five-year low price-to-sales ratio creating an excellent investment opportunity as the company puts the wheels back on the cart, resuming its fast growth in the second half of this year. In a recent visit to the company's offices, AEI uncovered a host of new initiatives previously unknown to us that we think will reignite the next leg up in the company's hyper-growth story.
> Distributed Energy Systems intellectual property [IP] spans product, service and contract sales and remains little understood by analysts and investors alike. The company is advancing into near-term growth opportunities in WIND POWER and CRITICAL POWER INFRASTRUCTURE (read power back-up and power quality) making the company “the quintessential” power-grid play.
> Moderating natural gas prices are positively impacting Distributed Energy Systems quote activity and project starts, delayed in the first half of the year are poised to begin. Further moderation of natural gas prices below is likely to mean upside to 2006 due to accelerated project starts beyond what’s in the guidance.
In Detail: Distributed Energy Systems: The Stock Looks Right
Distributed Energy Systems (NASDAQ: DESC) is perhaps one of the best companies in our sector. The company encompasses excellent management, solid accounting and excellent technology far beyond the degree to which the company has communicated with investors.
Distributed Energy Systems stock looks right for a turn in every respect. We think the DESC story has multiple ways to win while the downside risk (5-year low price-to-sales multiple of 3.71x ttm) to $4.40 per share or 13% downside seems unlikely to us.
Upon visiting the company Thursday, May 18th to see top management, we picked up a great deal of confidence in the company's ability to return to growth, and that management has been very busy with new business initiatives to accelerate growth.
New partnerships and expanded existing ones combined with new project announcements for the basis for upside to consensus estimates for growth. Catalysts include 1. a potential partnership with a large NE utility for critical power infrastructure marketing, and service; 2. new project announcements; and 3. leasing partnerships for hydrogenation generation units.
Lastly, DESC shares short-interest in DESC stock is at an all-time high and recently doubled in the last four weeks. We think these conditions make it right for traders and long-term investors to consider DESC ahead of evidence the "wheels are back on the cart".
How Did We Get Here in the First Place?
On March 8th, 2006 in a surprise to investors, the company said 1Q06 revenues will be down 25% compared with last year's first quarter, and second-quarter revenues are also expected to be lower, although to a lesser extent, than the second quarter of 2005. After what was eight consecutive quarters of hyper-growth, DESC shares fell +30% on the news. Despite the shortfall and marginal full-year growth we said that the story behind the stock remains intact and those investors who watched in amazement as the stock went from 3.5x estimated sales to 8.8x will have an excellent opportunity to buy DESC on the cheap again. At $5 DESC’s shares are trading at 4.24x TTM sales. DESC’s 5-year low price-to-sales ration is 3.71x suggesting the downside risk is 13% from here.
On April 10, 2006, Distributed Energy Systems entered into an equity distribution agreement with UBS Securities LLC. The equity distribution agreement provided that the Company could offer and sell up to 3,000,000 shares of the Company’s common stock from time to time through UBS Securities LLC, as sales agent or principal. From April 12, 2006 to May 5, 2006, the company sold an aggregate of 1,171,297 shares under the equity distribution agreement, at daily average prices ranging from $6.43 to $6.81 per share, resulting in net proceeds to the Company of $ 7,485,648. On May 18th the company cancelled the equity distribution as it was sensitive to a reduction in its share price. We visited the offices of the company on May 18th and learned that management beset with investor calls questioning the share sales to which management felt compelled to cancel the plan and eliminate the overhang.
For those asking where could DESC shares trade to we offer the following back of the envelope look at if the stock bottomed at the low of 3.71x. We think traders will look to snap-up DESC shares under $5 or $4.85 (500MDA) as they bet pressure on the sector will get the stock to that level. Long-term investors have already begun to accumulate positions with a strategy to complete the position if management’s outlook remains unchanged on the June quarter’s conference call expected in late July or early August.
The Distributed Energy Systems Story:
Distributed Energy Systems is a product, service and contract company with opportunities throughout the value chain to accelerate its growth rate with leasing programs for its products and build, own and operate opportunities to develop commercial and industrial electric power projects. The company’s products include hydrogen generation electrolizers and megawatt-class critical electric power infrastructure. Services include integration and engineering project development, construction and facilities maintenance. The company has opportunities to use its services to build, own and operate distributed commercial and industrial electric power projects selling power under purchase power agreements for highly reliable high quality power. It also has leasing opportunities for its products that are likely to facilitate faster growth in electrolizer shipments while improving return on investment while smoothing sales growth in key product categories.
Distributed Energy Systems’ sales growth is largely a function of the distributed energy market for combined heat and power which in itself is a function of natural gas prices. As subscribers well know, natural gas markets impact so many alternative energy stories with distributed energy and solar being impacted the most. A simple rule of thumb, however shortsighted is this; when natural gas is high solar stocks are long and distributed energy stocks are short. When natural gas is low distributed energy stocks go up and solar stocks go down. We do not advocate this rule of thumb as an axiom (things are not so simple), but in general is does reflect important considerations which can impact the stocks. > In this case, with natural gas down from $12-$14mmbtu after Katrina and Rita to $6mmbtu today distributed energy stocks are in a position to outperform.
Distributed Energy Systems’ first half slowing was due to the post-hurricane spike in natural gas prices and as a result, the timing of revenues and orders and the lagging effects of an unpredictable rise in natural gas prices meant first half sales would fall significantly year over year. “The decrease in contract revenues was a result of lower revenue associated with Northern’s industrial infrastructure business of approximately $1.2 million and its on-site business of approximately $1.3 million. These decreases were due to record high natural gas prices which impeded Northern’s ability to close new orders in its on-site business, as well as the timing and size of the contracts in the first quarter of 2006 compared to the comparable period in 2005.”
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Distributed Energy Systems’ contract business competes mainly on price per delivered kilowatt-hour of electricity to the end user. In the domestic market, Distributed Energy Systems competes against the cost of electricity delivered by the local utilities through the electric grid. Since the cost of electricity varies widely from utility to utility and from state to state and is subject to change, contract revenue is negatively impacted when the underlying fuel (natural gas) unexpectedly spikes (see chart above) as it did in the second-half of 2005. Essentially, when natural gas prices “spike” (sudden changes exceeding 100%) potential customers for Distributed Energy Systems’ combined heat and power projects freeze development. and wait for a return to trend-line changes in feed-stock prices before proceeding in project development. For those subscribers who are not clear why this is true we remind them that Distributed Energy Systems single largest component of contract sales are either natural gas fed turbines or natural gas fed internal combustion engines providing base-load power to their contract sales customers. When customers can not calculate a 3-5 year payback on projects as happens when natural gas “spikes” they wait for feedstock costs to fall again before proceeding. Natural gas price volatility exceeding 100% in three months remains a risk to Distributed Energy Systems’ growth. However, we think natural gas spikes are not in the cards for the remainder of 2006, and we also think moderating volatility will create “normal” (fluctuations under 50% for three months) trend-line dynamics in the market for natural gas. As a result, we think contract revenues for Distributed Energy Systems will rebound sharply in the third and fourth quarters resulting in another record setting year in 2006.
> 2007 could easily see growth rates spike dramatically higher for Distributed Energy Systems should natural gas prices settle below $6mmbtu on average for the whole year.
Where Do We Go From Here? > Growth Returns:
We see growth returning to contract revenues and a steady progression of announcements relating to the company's new equipment and project leasing model as catalysts for an improving share price. We believe the company is now focused on finding partner to capitalize on projects in the +1MW commercial and industrial markets. Such a partner might include regional utilities that are willing to use their distribution and scale to leverage high quality and highly reliable power sales in niche applications to start. ConEd is an example of a utility in the North East cooperating with Distributed Energy Systems to interconnect a +1MW natural gas fired generator (2x-CATs) with power-conditioning electronics and switchgear for uninterruptible power backup in a commercial high-rise office building in NYC. The project was commissioned early in April and is owned by Equity Office Properties, the $12 billion market capitalization national developer and operator of office properties. We see the return of growth in project revenues driven by improving market conditions for distributed power systems, new project announcements, and catalysts like new partnerships for power purchase agreements and leasing opportunities as the premise for getting involved now.
> The worst for Distributed Energy’s financial performance is likely ALREADY behind it, but with the closing of the June quarter sometime before August 15, 2006 there remains the risk that the company’s antiquated information systems could reveal a new unforeseen wrinkle despite having closed excellent new orders in the quarter and booking rates looking better that they have in six months. That said, we think the risk to DESC shares is now set to the upside and that investors will begin to come back to the stock in anticipation of substantial upside in the coming second half and 2007.
The chart below illustrates consensus revenue estimates for DESC. We think consensus is likely too low, and that growth for the full year 2006 will be boosted by several items mentioned in this note. We think the first half of 2006 represents a bump in the road for DESC shares and with growth returning in the second half the next leg of hyper-growth will begin. We think the prospects for DESC are vastly better for new comers to the stock in part because we think the new CEO likely over stated the difficulties ahead such that he can recover from the shear embarrassment of presiding over a 30% share price decline the first seven weeks on the job. That said, we are not relying on that to make the case for DESC. The prospect of growth returning to DESC in 2007 is boosted by the recent catch-up in rates, falling NATG resulting in a advantaged environment for Northern Power's business, and changes in revenue recognition on HOGEN-H series units that will have 24 months of runtime by that point and will then see revenue upon shipment instead of deferred over 12 months. There is already approximately $5 million in large system deferred revenues that will likely be recognized beginning in the first quarter of 2007.
Short Interest: Many investors we speak to share the opinion that DESC is so heavily shorted primarily for two reasons. First, the stock is expensive. One short in particular thinks DESC should trade at a multiple of sales in the neighborhood of 2x the peer average of 1.44 to compensate for the hydrogen and energy-technology products (UPS, inverters, etc.) which would put DESC stock price approximately 2.8x ttm sales corresponding to a share price target of $3.50. We completely disagree with the notion that Distribute Energy has become an engineering, construction and procurement company trying to masquerade as an energy-technology stock.
The second group of shorts often gave financing risk as their reason to be short the stock. This group got paid but for the wrong reason (not that it matters). These shorts anticipated an offering of up to $100 mm in securities to fund the company’s ambitious equipment and project leasing plans and got a $7.5 million share sale program which the company promptly cancelled rebuking the idea of doing any capital raining for the foreseeable future.
> We think the vast amount of short-interest is now ill advised and creates an opportunity for aggressive traders who anticipate the improving fundamentals and to some extent long-term investors who also anticipate the growth ahead and are willing to establish a position ahead of the June report. We think both traders and long-term investors will ultimately be well rewarded for taking the risk.
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