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  • Investors have been slow to recognize the successful transition and significant revenue growth, gross margin expansion and narrower operating losses.
  • The reverse split last month (being mistaken as a sign of weakness as evident by the 20% stock price decrease) resulted in an uplisting to NASDAQ.
  • The stock trades at a meaningful discount to its peer group despite a more attractive growth outlook.
  • The (overlooked) IP portfolio is worth ~2x the EV of the company.
  • The sale of the non-core pool products business last year (with proceeds used to repay the line of credit) and conversion of convertible debt in 1Q14 strengthened the balance sheet.

Company overview

Energy Focus (NASDAQ:EFOI) sells energy efficient LED lighting products and turnkey energy efficient lighting solutions.

The products segment provides military, general commercial and industrial offerings. Services provided by the solutions segment include lighting/energy audits, LEED upgrades as well as design, implementation and pre/post upgrade monitoring and measurement.

Successful turnaround is seen but not believed

CEO and Chairman James Tu is probably another CFA charterholder who does not understand the dichotomy between the improving fundamentals and lower stock price. Since the beginning of 2013 (which was a transition year), EFOI has posted strong organic revenue growth and gross margin expansion, reduced operating losses, strengthened the balance sheet, uplisted to NASDAQ and sold a non-core business. Investors have "rewarded" these efforts by sending the stock closer to the bottom of its 52-week range than the top.

In 2Q14, revenue from continuing operations increased 18.5% (and 36.2% sequentially) to $6.7 million. However, excluding lower margin R&D services (which EFOI is no longer pursuing due to a focus on projects that support LED technology) revenue increased 25.8%. The 42.9% decrease in solutions revenue (due to a shift out of the energy savings companies market into commercial) was more than offset by a 70.7% increase in product revenue excluding R&D services. Government revenue increased 125.8% as the number of U.S. Navy ships purchasing its products increased >6x since the end of 2013 to >120.

Overall gross margins expanded 10.6% to 32.5% (the highest in years) due to ongoing efficiency improvements (consolidated manufacturing into one facility from three following the closing of a Mexican facility and sale of the pool products business) and economies of scale. This strong top line growth and margin expansion drove a 64% decrease in the net loss while there was a $1 million positive swing in segment operating income.

For 3Q14, management projects continued gross margin expansion (towards the long term goal of 35%) and revenue of $7.5-8.5 million (for y-y growth of 55-76%) as well as positive EBITDA in 2H14.

EFOI strengthened its balance sheet following the conversion of all convertible debt into shares in 1Q14 (which eliminated the majority of long term debt). Following a secondary offering earlier this month and 10-1 reverse split last month, EFOI was uplisted to NASDAQ.

In November 2013, EFOI sold the Fiberstars pool products business in order to focus solely on the $30 billion retrofitting market and used a portion of the $4.8 million in proceeds to repay the line of credit.

Military demand provides long term revenue growth and visibility

The recent strong growth in military orders is sustainable (certainly more than investors are assuming) due to the product benefits, low level of penetration, large market size and multiple competitive advantages.

EFOI's products eliminate the need for lamp changes over the life of a ship (due to a 50,000 hour lifespan compared to only 7,500 hours for fluorescent tubes), can be installed in existing fixtures and save the U.S. Navy $150 million in energy costs.

On the 2Q14 conference call management said it has only penetrated ~5% of the total addressable market for U.S. Navy ships and expects IntelliTube sales to double over the next few quarters from the record $2.7 million level in 2Q14. The new IntelliTube line expands the addressable market by $300 million to include new ships - not just retrofitting existing ones.

There is a significant amount of daylight between EFOI and the competition due to the advanced (and patented) technology, excellent track record (zero product failures since installation in 2007), U.S. Navy qualification (which obviously has much higher standards than commercial customers) and status as the only authorized provider for new LED installations and retrofits.

Becoming a civilian again has its perks

Obviously the U.S. Navy is not alone in wanting to save money and reduce their carbon footprint (see chart below), which explains the projected increase in global LED tube adoption from 6% in 2013 to 22% by 2016.

(click to enlarge)

Source: Company presentation

The increasing focus on multi-billion dollar "civilian" verticals including national retailers, property management companies, hospitals, universities and parking garages exponentially extends the growth runway while management expects to receive certification for its lamp for the $4 billion non-military maritime market by 4Q14. Two recent project wins highlight the success EFOI is having expanding into the commercial market.

In July 2014, Wayne State University selected EFOI to replace its fluorescent lighting with 35,000 LED lamps that will reduce energy consumption by 60%. To put the growth potential in perspective, there are 4,000 higher learning institutions in the U.S. alone. In June 2014, the largest privately held real estate services company with >4,000 properties began offering EFOI lighting products to its properties.

The following two factors should result in these wins being only the first of many. An expected announcement by the end of 2H14 regarding financing partners should be instrumental in winning new business and preserving the strong balance sheet. Second, EFOI only enters markets where it can become a market leader (its commercial line only has ~30 SKUs compared to hundreds or thousands for competitors), which results in not only higher profitability but also about a six month head start in terms of new product introduction. For example, EFOI plans to introduce a 150 lpw (lumens per watt) product in the next few months, which improves upon its industry-leading 130 lpw product.


Despite the margin improvement, EFOI is still unprofitable and continues to burn cash, which requires raising equity/debt to fund working capital requirements.

EFOI is heavily dependent on government spending (especially by the military) as shown in the chart below.

Demand for its lighting solutions would most likely decrease in the event of a downturn in the market for new construction or renovation. Lower energy prices (which typically occur during periods of lower economic growth) reduces the financial incentive to upgrade to more efficient LED lighting.

Valuation and price target

EFOI deserves at least a 1x higher multiple due to the attractive fundamentals mentioned above, which would put the valuation below that of its two closest peers RVLT and CREE. Moreover, the investment thesis could even be largely supported by the revenue growth expected over the next several years rather than multiple expansion.

EFOI has the textbook definition of a hidden asset, which not only reduces the downside risk but provides significant upside potential. In November 2012, an independent financial advisory firm valued its IP portfolio (54 in force U.S. and foreign patents) at ~$70 million or 2x the EV of the entire company. This presents three key takeaways. First, this value is not reflected on the balance sheet so it is not surprising that investors missed it. Second, this valuation has almost certainly increased in the past two years given the broad market application of the patents and remaining white space (pun intended) for LED adoption. Third, EFOI is preparing even more patent filings, which supports an even higher valuation.

The price target of $7.25 is derived by placing a 2.5x multiple on 2014E revenue of $26.2 million* for a 65% return over the next 12-24 months. This assigns zero explicit value to the IP portfolio and ignores the continued revenue ramp up in 2015. The small float (due to the high insider ownership and several 5%+ holders) means any positive news flow should accelerate gains. A stop loss should be placed below support at ~$3.90.

*This consists of 1H14 actual results, the midpoint of 3Q14 guidance and assumes zero y-y growth for 4Q14 (which is extremely conservative).

Editor's Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Source: Time For Investors To See The Light: Energy Focus Is Undervalued Relative To Its Peer Group, Patent Portfolio And Growth Prospects
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