Distributed Energy Systems Corp.: An Energy-Utility Small Cap With Big Future Plans

| About: Distributed Energy (DESC-OLD)

alternative energy investing logoFrom James LoGerfo, Michael Riedinger and Joe Berwind (Alternative Energy Investing) Alternative Energy Investing [AEI] attended the Distributed Energy System’s (DESC-OLD) open-house in conjunction with Equity Office Properties and the New York State Energy Research and Development Authority [NYSERDA] Thursday in New York. At the event, AEI picked-up several significant data points on immanent contract wins for Distributed Energy.

On Thursday AEI uncovered two contracts wins ahead for DESC representing 10 megawatts of combined heat and power totaling over $17 million or +25% of next year’s consensus sales estimate. The larger of the two, a 6 megawatt plant for Vornado Realty Trust (NYSE:VNO) has received NYSERDA funding in excess of $3 million and is slated to begin in current quarter and is values at $12 million. We anticipate DESC to have a contract announcement soon. The second project is a 4 megawatt plant for The Rockefeller Group which is currently expected to receive NYSERDA funding in “several weeks” according to one NYSERDA official. Both projects are anticipated to be completed before the end of 2007. AEI also picked up data which suggests the company's 3Q report will be excellent.


The Company
Distributed Energy Systems operates two divisions, Northern Power and Proton Energy. Northern Power is a best-in-class distributed generation design, development and services company with a vast intellectual property portfolio involving synchronous grid power electronics and power generation. Proton is a distributed hydrogen company engaged in the development and manufacturing of hydrogen chemical and hydrogen energy units to provide on-site generation of hydrogen from electricity and water.

Distributed Energy Systems is a unique combination of intellectual property and revenue growth without the technology risk often associated with energy-technology companies. Moreover, Distributed Energy’s growth is not tethered to the long-term growth of the “hydrogen economy” and its Northern Power divisions distributed generation designs, products, engineering and construction and maintenance represents well over two-thirds of the business and is growing at triple digit rates. AEI remains watchful and encouraged of Proton, but we look toward Northern Power to deliver the growth. Total company sales are reported in three categories (contract, product, service). Northern Powers sales are reported as either contract or service and represents the bulk of the growth opportunity for the company.

After the open-house, AEI hosted management and clients to a luncheon. At the luncheon company management set the stage for growth to reignite. The stage was set with a question about the company’s poor performance in the first half. In the second quarter, DESC reported sales of just over $9.4 million, a gain sequentially over first quarter’s $7.6 million, but a far cry from the company’s best quarter ever in the year ago period when sales clocked-in at $12.2 million. Embedded in the second quarter report was approximately $33 million in backlog, unbilled projects, and $38 million of projects in the paid study phase. Management stood by its previously articulated plan to return to growth which begins with the September quarter’s numbers.

Revenue estimates for September quarter sales range from a high of $15 million to a low of $11.90. The consensus revenue estimate for the third quarter is $13.61 million or approximately midway between the high/low estimates. AEI thinks the market is waiting for the company to prove it is back to growth before buying DESC stock. That said, we also think the nearly 12% short interest or 4,498,000 short shares against a 33,820,000 share float implies a bet the company will preannounce negative numbers. AEI thinks the risk is to the quarter and the year is to the upside.


During our luncheon management stressed the health of their business both in terms of the project pipeline helped by a recovery in contract design starts as well as a recovery in contract starts which will translate into improved engineering services revenues. The CEO also added “we have not lost any contracts in backlog during the first half that were delayed”. These contracts have begun contributing to the company’s conviction that it can meet guidance. Additionally, the company continues to add to its maintenance contracts which we expect to grow steadily from $25 million of which a small portion of maintenance revenue expected within 12 months included in total company backlog. Maintenance offers a large opportunity to drive stability and revenue and earnings diversification in the long term. Currently, the company has long term maintenance contracts for 72 systems producing approximately 50 megawatts of power.


Distributed Energy has cash in excess of $30 million and has estimated breakeven sales in the range of $60-$65 million. Street estimates project the company can achieve sales of $65 million in 2007 implying the company begins to generate cash. Moreover, the Street estimates the company can achieve sales of $190 million by 2010 which considering trends and the increasing size and number of CHP projects in the design phase looks right. Given the 6 MW Vornado Realty project valued at +$12 million it would require the company to build approximately 12 to 15 projects of equivalent size combined with $20 million of combined product and service revenue. AEI thinks this target is exceedingly conservative given Global Insights, Inc, EIA, Energy Ventures Analysis, Inc., Energy and Environmental Analysis, Inc, Strategic Energy and Economic research, Inc. PIRA Energy Group and CERA all estimate grid-tied CHP like Distributed Energy’s 717 Fifth Avenue project to grow significantly in addition to the standard markets for industrial CHP as shown below.

Market Drivers for CHP:
- +20% ROE on CHP projects
- Clean Air Interstate & Mercury Rules
- Black Liquor Gasification
- Lignin as fuel for CHP
- Synthetic Fuels
- Biomass

A final comment on the market for synchronous interconnected CHP coming out of the open-house event included comments by Equity Office Properties indicating the company has an additional +20 megawatts of projects which only begins to scratch the surface at EOP. The company maintained it has completed approximately 15 projects to date with 717 Fifth Avenue being the first of its kind with another 175 buildings that it believes would benefit from both interconnected and stand-alone CHP systems. Equity Office Properties expected to do more projects with an increasing number of grid-tied projects. When asked what proportion of the coming 20 MW will be grid-tied similar to the Distributed Energy project at 717 Fifth Avenue, the reply was “practically all.”

Equity Office Properties: (717 Fifth Avenue)
> Grid-tied using DESC’s proprietary electronics and software (1st. synchronous system permitted by ConEd)
> 1.6 megawatts (2 NATG fired generators)
> Total Project Contract to DESC $4.1 million
> NYSERDA grant to EOP $750,000 reduces EOP’s cost
> Expected energy cost savings per year to EOP $800,000
> 8-Year service contract awarded to Distributed Energy

CHP Diagram:
click to enlarge

DESC 1-yr chart:

DESC 1-yr chart

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