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EnerNOC, Inc. (NASDAQ:ENOC)

Q2 2012 Earnings Call

August 7, 2012 5:00 pm ET

Executives

Jennifer Varley – Investor Relations

Tim Healy – Chief Executive Officer, Chairman, and Co-Founder

David Brewster – President and Co-Founder

Analysts

Patrick Jobin – Credit Suisse

Chris Kovacs – Robert W. Baird & Co.

Benjamin Werner – Pacific Crest Securities

John Quealy – Canaccord Genuity

Andrew Weisel – Macquarie Capital

Operator

Good day, ladies and gentlemen. Welcome to EnerNOC Second Quarter 2012 Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operating Instructions) As a reminder, this conference call is being recorded.

I'd now like to turn the conference over to, Jen Varley, Senior Manager, Investor Relations. You may begin.

Jennifer Varley

Thank you. Good afternoon, everyone, and welcome to EnerNOC's investor conference call for the second quarter ended June 30, 2012. We appreciate you joining us today. I’m Jen Varley, Senior Manager of Investor Relations at EnerNOC, and with me on the call today is our Chairman and CEO, Tim Healy; our President, David Brewster; and our Chief Accounting Officer, Kevin Bligh.

Today's presentation contains estimates and other statements that are forward-looking under the Private Securities Litigation Reform Act of 1995 and other federal securities laws, including but not limited to, management's future expectations, beliefs, intentions, goals, strategies, plans or prospects.

These forward-looking statements include without limitation, statements relating to EnerNOC's future financial performance, the global market opportunity for EnerNOC's energy management applications, services and products, and the future growth and success of EnerNOC's energy management applications, services and products in general. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could affect actual results to differ materially from those expressed or implied by such statements.

Additional information concerning these factors is contained in EnerNOC's filings with the SEC, including our Annual Report on Form 10-K and quarterly reports on Form 10-Q, available at www.sec.gov. The forward-looking statements included in this call represent the Company's views on August 07, 2012. EnerNOC disclaims any obligation to update these statements to reflect future events or circumstances.

During this call, we will refer to non-GAAP financial measures, including non-GAAP net loss per share, non-GAAP earnings per share, free cash flow and adjusted EBITDA. These financial measures are non-GAAP financial measures that are not prepared in accordance with generally accepted accounting principles. A definition of reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measure is available in the press release announcing our second quarter financial results. The press release is available on the Investors section and on our website at www.enernoc.com.

And with that, I will now turn the call over to Tim Healy.

Tim Healy

Thanks, Jen, and thank you to everyone for joining us this afternoon on our second quarter 2012 conference call. In today’s prepared remarks, I’ll spend a few minutes discussing our second quarter performance and how we believe it positions us to maximize customer and shareholder value in 2012 and beyond. David Brewster will then provide color on our current and emerging market opportunities and some important regulatory developments. Finally, Kevin Bligh will discuss our Q2 financial results and provide an overview of a number of key business metrics in details on our updated financial outlook including our increased guidance for 2012 and 2013.

First, visibility of our top line growth increased during the quarter. In PJM’s recent base residual auction for the 2015, 2016 delivery year, we were successful in strengthening our leadership position in the mid-Atlantic by securing more than $300 million in expected future revenue. To put that into perspective, our expected PJM revenue for the 2015, 2016 delivery year is more than the total amount of revenue that EnerNOC expect to recognize this year across all of our products and markets combined.

Importantly, our growth in PJM is driven not just by more megawatts for us to manage, but by strong upward pricing trends that we see in the megawatt weighted system wide clearing prices of PJM capacity over the next four years. Specifically the megawatt weighted price of roughly 87% a megawatt day in 2012, 2013 which is the low point of clearing prices during this period, increases to $123 million a megawatt day in 2013, 2014, and $232 a megawatt day in 2014, 2015. And finally, $156 megawatt day in 2015, 2016, this represents a 79% price increase between 2012 and 2015.

We are obviously pleased with aggregated asset base that is successfully locked in that type of pricing uplift. We are also pleased that we continue to increase our operational leverage by reducing the cost of managing each new megawatt as the company continues to scale. Specifically, as of June 30, 2012, our megawatts under management per full time demand response employee, has increased to 19.2 versus 18.0 at the end of Q1. So while the fees were set to collect for managing megawatts in PJM are about to increase in our favor. Our cost of managing those megawatts has been decreasing steadily.

Lastly, our customer splits continue to translate favorably. In fact, customer splits for new customers are higher in Q2 this year than in Q2 last year, bolstering our forecast of gross margins for the year being roughly in line with last year and increasing slightly higher in 2013.

Outside of PJM, we expect continued success in Australia, New Zealand which we believe will be our second largest revenue generating region next year, further solidifying our top line growth expectations. With our 240 megawatt DR opportunity in Western Australia, we expect to generate more than $40 million in revenue for EnerNOC in 2013 in Australia.

This is just one example of a number of markets in which we are gaining momentum. Demand for our demand response and energy efficiency products in new geographies and new types of energy markets remains at all time. EnerNOC’s ability to deliver peak megawatts, the megawatt should be very top of the load curve that determine whether peaker units are united or whether a new transmission line must be built, has tremendous value to equities and grid operators.

Demand response lowest peaks for our energy efficiency, lowers base load but they both delivered a similar net result, and so more cost effective, efficient, and environmentally responsible way to meet our energy needs, a reality that’s driving more and more utilities to look at EnerNOC, And as they do, our backlog grows. In fact across all of our markets and offerings are growing backlog of contracted revenues, exceeded $1.6 billion as of June 01, 2012, an increase of 23% year-over-year.

We expect approximately 90% of this contracted revenue to be earned by May 31, 2016. While our Q2 gross margins have declined year-over-year due largely to the timing of PJM revenue recognition, our margins on new sales as I mentioned have trended upwards over the past 12 months, and we continue to aim for our 2012 gross margin percentage to come in roughly in line with last years gross margin results.

We believe our gross margin performance continues to demonstrate our ability to command a premium in the market and to effectively manage a valuable portfolio of assets. We are not however looking at our top line growth in [vacuum]. To the contrary, we are intently focused on profitability and leveraging the most cost effective growth drivers for our business. We have a growing lean Six Sigma team who is mandate is to improve the business processes and help us achieve new levels of operating efficiency.

We’ve aligned this group with our product management organization ensuring that both existing business opportunities and as well as new products are designed and operated with an appreciation of their overall bottom line impact. Those efforts are already showing great promise and we are increasingly confident in our ability to capture new growth opportunities, more and more cost effectively overtime.

Our ability to execute and deliver value to be the CornerStone of the EnerNOC brand. 2012 is on pace to be our most active year of demand response and a time when we seamlessly adjusted to new markets rules and baseline methodologies, introduced exciting new products, and expanded into new geographies. We believe that 2012 will be remembered as the year that operational excellence firmly took hold at EnerNOC and increased our differentiation in the market.

To reiterate, there are two things you should take away from this call. One, there are very strong tailwinds that are driving our top-line growth for the business. And two, our disciplined focus on bottom-line performance and our commitment to maximizing customer and shareholder value will yield measurable results in future quarters. As a result of these two factors, we’re raising the bottom end and midpoint of our guidance for 2012. And more importantly, raising our GAAP EPS guidance for 2013, a pivotal year in which we’re very excited to return to profitability.

With that, I’d now like to turn the call over to David Brewster whose prepared remarks will provide more color around some of our Q2 highlights, and describe in more detail our progress in rolling out our energy markets compliance program, we first announced in last quarter’s conference call. This program has been a major focus of the company in the first two quarters of the year and as the worldwide demand for our products grow; we believe that having a world-class compliance program will be essential in scaling our business. David?

David Brewster

Thanks, Tim. The first half of 2012 was highlighted by what EnerNOC does best, reliably delivering cost-effective megawatts and megawatt hours. As Tim mentioned in his opening remarks, 2012 is on pace to be the busiest DR-dispatch season in EnerNOC’s history. And nowhere has this been more pronounced than within the PJM footprint.

In addition to executing dispatches, we adapted to changing baseline rules in PJM and managed our portfolio to effectively deliver against our plan while working diligently to fulfill our Act 129 commitments and helping our customers recognize value through participation in PJM’s newly announced economic demand response program. We believe that 2012 will represent a year in which EnerNOC further separates from the pack in terms our ability to deliver the DR megawatts that utilities and grid operators rely upon at scale.

Taking a closer look at our progress against our Act 129 goals, three of our five Act 129 contract obligations have already been fulfilled, and of those three, two have been expanded to help our utility partners meet their peak load reduction targets. Our performance against our most aggressive contract target has been solid despite the inherent difficulty in accurately forecasting the top 100 system hours of the summer.

Additionally, we believe that we are delivering strong results against our Act 129 energy efficiency commitments. Leveraging our industrial energy efficiency expertise, we’re delivering a program with a Pennsylvania utility targeting chemical and mixed industrial customers.

Through Q2, this program has delivered approximately 35,000 megawatt hours of savings. Last week, the Pennsylvania Public Utility Commission issued an order that outlined the state’s direction for Phase of Act 129. The order extends the requirement on electric distribution companies to reduced energy consumption through energy efficiency programs for the period of 2013 through 2015. This is good for EnerNOC.

Unfortunately, the order did not extend the peak demand reduction goals for the distribution companies. The statewide evaluator will issue a report early next year on the overall cost-effectiveness of the Phase 1 peak demand reductions, and based on that report, the commission will reconsider whether to put in place peak demand reduction goals for Phase 3 starting in 2016.

Our goal now is to execute against our DR commitment, prove the cost-effectiveness of this clean energy resource, and advocate for its inclusion in Phase 3. We also look forward to continuing to provide energy efficiency services to the electric distribution companies to help them meet their Phase 3 goals. Outside of PJM, we continue to innovate and expand our addressable market opportunity while closely inspecting how we can operate more efficiently within each of our existing programs.

Tim mentioned Australia and New Zealand where we’re tracking well against our megawatt targets, positioning this to become EnerNOC’s second-largest revenue-generating moving to next year. We see room for substantial further growth in that part of the world. As we discussed on the last call, additional opportunities are emerging for our products and services in Texas where a strain on the grid is creating an acute need for more demand-side resources.

A recent report out of Brattle Group predicted that Texas will fall below its 10% reserve margin in the next few years without significant intervention. The Electric Reliability Council of Texas has responded by inviting more demand response resources into the market, and recently augmented its 10-minute program with new rules that allow for a 30-minute dispatch window, which facilitates participation by a broader range of C&I customers. Additionally, as mentioned on our last call, the electric distribution companies in Texas have increased their procurement of demand response by roughly threefold this summer over last.

On the technology and enablement fronts, our capitalized install costs over the trailing 12 months have come down by more than 30% per site thanks in large part of the innovations from our hardware team and the introduction of more cost-effective EnerNOC site servers. Additionally, across markets our C&I customers have adopted EnerNOC’s first mobile app to monitor demand response dispatch performance and keep tabs on real-time energy consumption on both iOS and Android devices.

Looking now at our energy efficiency business, as Tim mentioned, energy efficiency remains a core focus area for EnerNOC. and in Q2, we continued our trend of increased traction for EnerNOC’s efficiency-smart suite of products and services. On the customer adoption side, we’ve recently surpassed several important milestones. More than 2000 buildings are now realizing the benefits of continuous energy savings from our efficiency-smart product suite. We’re now monitoring and analyzing real-time data for more than 200,000 million square feet of property with our efficiency-smart insight application.

Perhaps most rewarding, we’ve identified more than 500,000 million kilowatt hours of energy savings annually, which translates to more than 50 million in savings per year for our customers. In tandem with our ability to deliver this tremendous value to our customers we’re also improving the operational delivery of our EE products and services. Our enablement time for energy efficiency has improved by more than 40% since last year, and our sites per non-demand response full-time employee metric also continue to improve, from 12.2 at the end of Q1 of 2012 to 13.4 at the end of Q2.

Like the early days of demand response, our ability to execute, coupled with favorable market dynamics has us bullish about the future market opportunity for our efficiency smart suites. The number of states adopting policy frameworks to support energy efficiency has ticked up in the past year while spending and budgets on en efficiency continue to grow. According to a report by the Institute for Electric Efficiency, annual utility budgets for energy efficiency will exceed $12 billion in the U.S. alone by 2020. In short, utilities, grid operators, and C&I customers around the world are embracing our solutions.

As we continue to grow and diversify into new markets around the globe, we recognize the importance of scaling our regulatory compliance infrastructure to manage the array of different regulatory requirements to which we and our customers are subject. We have made important strides this quarter in enhancing our energy markets compliance program informed by learnings from our 2011 compliance audit by the Federal Energy Regulatory Commission. Since launching this initiative at the beginning of the year, we’ve established a centralized compliance program based on Deloitte’s Integrated Compliance Risk Management Guidelines. We’ve established an internal risk management committee to oversee all the Company’s demand response risks and provided council to the executive management team and the Board of Directors.

And additionally, we’re excited to welcome Tom Birmingham as our Director of Regulatory Compliance. Tom brings with him more than 20 years of regulatory compliance experience in the energy sector, most recently as the Director of Regulatory Compliance in National Grid. Tom will spearhead an effort to continuously assess and enhance our compliance protocols and processes and we’re proud to be setting the benchmark for compliance in the new and evolving demand response and energy efficiency industries in which we operate.

With our strong performance track record, a heightened compliance program should serve as a competitive advantage for EnerNOC in the marketplace for utility end-use customers. I’d also like to take this opportunity to provide some additional color on a proposed EPA rule related to the use of backup generators. Under the RICE NESHAPS proposed rule, the EPA has proposed to allow property permitted existing backup generators to participate in emergency demand response programs for up to 100 hours per year.

These emergency demand response resources are an important last line of defense for grid operators and utilities to prevent blackouts and ensure electricity is delivered reliably and economically. Dozens of organizations, including many of EnerNOC’s customers, have filed comments in support of EPA’s proposed rule. In fact, roughly 90% of the comments filed through yesterday afternoon, support of EPA’s proposed rule regarding the use of backup generators for emergency demand response, which makes sense for the environment, our economy, and our nation’s electric power infrastructure.

The comment period closes this Thursday and the agency is expected to make a final decision by the end of the year. We’re encouraged that the EPA has spent the last two years, thoughtfully crafting these proposed changes to the RICE NESHAPS and recognize the environmental economic, safety and national security benefit of these important emergency demand response resources.

In sum, as older coal-fired power plants continue to retire in response to EPA rules and demand response and energy efficiency resources continue to become a larger and more important of the overall energy landscape. The outlook for EnerNOC in 2012 and beyond looks bright.

With that, I’ll pass the call over to Kevin Bligh, who will provide color on our Q2 financial results and our outlook for the rest of the year in 2013.

Kevin Bligh

Thank you, David and good afternoon everyone. I’d like to provide some additional details on our Q2 financial performance as well as outline our financial guidance. For Q2, we achieved revenues of $33.3 million; GAAP net loss of $1.10 per basis and diluted share, and non-GAAP net loss of $0.91 per basis and diluted share.

As previously communicated in Q2, we saw a significant year-over-year revenue decrease, which is primarily the result of a changing timing of revenues recognized from our participation in the PJM ELRP demand response program. For 2012, our capacity revenues were related to our participation in this program, where we recognize in Q3 instead of distributed in Q2 and Q3 as well as the case in past years. Excluding PJM ELRP revenues from Q2 2011, we saw a year-over-year revenue increase of $4.5 million primarily due to strong megawatt growth in our Texas and California demand response markets, the addition of PJM at 129 programs, and Q2 revenue grow of approximately 12% in our non-demand response business.

Gross profit was $8.3 million and gross margin was 25%, both down from Q2 of last year, primarily due to the change in PJM revenue recognition timing, higher depreciation expense year-over-year and the recognition of cost of revenue in certain programs where revenue was deferred. As in the past, our gross margin will follow a similar seasonal pattern to our revenues, as we expect that Q3 will be our highest gross margin period of the year. Remember that PJM contributes negative gross margins, outside of Q3 because cost of revenue from depreciation of installation cost and related operational infrastructure is booked ratably in all quarters, while revenues recognized only in Q3. Our demand response business in Western Australia is also accounted for in a similar manner.

Operating expenses were at $36.1 million for Q2. We ended the quarter with 625 full-time employees, a net decrease of five compared to the prior quarter. Our megawatts per full-time employee, excluding employees dedicated to non-demand response products, was 19.2, compared to 18.0 at the end of Q1 2012, and 17.6 at the end of Q2 2011. Once again highlighting the operating leverage, we are driving our demand response business.

We use the additional non-GAAP measures, adjusted EBITDA and free cash flow to monitor growth trends in our business. For Q2 2012, our adjusted EBITDA was a loss of $18.2 million. Free cash flow for Q2 was a negative $1.2 million as compared to $5.1 million in Q2 of last year. We ended the quarter with $79.4 million in cash and cash equivalents, and $17.9 million in restricted cash and deposits.

We provided notice of termination of our existing corporate headquarters lease and entered into a new lease in July. As a result of our election determinate, we are required to make a termination payment of $1.1 million, of which 50% was paid upon exercise of the election and the remaining 50% is payable on the effective termination data of June 30, 2013. As required under accounting guidance, the entire termination payment was charged to expense in Q2. We are required to continue to pay our lease payments through the lease termination data and since we currently intend to use this space through that date, we will record the remaining payments ratably through that date. While the lease payments on our new corporate headquarters will not commence until August 2013, we will begin recording rent expense in July 2012.

Now let me turn to guidance, starting with some key assumptions. Given the continued volatility of foreign exchange rates, our Q3 guidance assumes an Austrian dollar pegged at US$1.01 and a Canadian dollar pegged at US$0.98. We expect nearly all of our Western Australia revenue to be recognized in Q3, so the impact of fluctuations in the Australian dollar could have a greater impact on that quarter. We have not included any potential goodwill impairment charge in our guidance.

For the full-year 2012, we expect a tax provision of approximately $2 million to $2.5 million, consistent with Q1, we have determined that we are currently unable to make a reliable estimate of our annual effective tax rate due to unusual sensitivity to the rate as it relates to our forecasted 2012 U.S. loss.

As a result, we recorded a tax provision for Q2 based on our actual effective tax rate for the quarter. The guidance provided for Q3 is based on following a consistent terminology with that utilized in Q2. However, if we determine that we are able to make a reliable estimate of our annual effective tax rate in Q3 it could result in a tax benefit in the quarter.

Under the previously stated assumptions, we expect Q3 revenues between $160 million and $176 million. We expect Q3 GAAP net income of $1.60 to $1.90 per diluted share. These estimates are based on diluted weighted average shares outstanding of $27.3 million.

For the full year 2012, we are raising the bottom end of our guidance provided on our Q1 earnings call. We expect full year 2012 revenue in the range of $260 million to $280 million. We expect to generate full year GAAP net loss of $1 to $1.40 per share based on basic and diluted weighted average shares outstanding of $26.6 million.

Full-year 2012 adjusted EBITDA is expected to be between $5 million and $20 million, with estimates stock-based compensation between $14 million and $15 million. Estimated amortization of intangibles of approximately $7 million, estimated depreciation between $18 million to $20 million, estimated to $1 million to $2 million of interest and other expenses net, and an estimated tax provision of $2 million to $2.5 million.

Turning to 2013, we continue to expect full year 2013 revenue to be in the range of $350 million to $400 million consistent with our previously stated guidance. We are raising GAAP net income guidance for 2013, which is now expected to be in the ranges of $0.15 to $0.75 per diluted share, these revised estimates are based on diluted weighted average shares outstanding of $27.7 million.

Full-year 2013 adjusted EBITDA is expected to be between $50 million to $75 million, we expect stock-based compensation expense to be between $12 million and $14 million.

Amortization of intangibles to be approximately $7 million. Depreciation expense to be between $21 million and $23 million, and interest and other expenses net to be between $0.5 million to $2 million, and estimated tax provision is expected to be between $5 million and $8 million.

I appreciate your interest. We're ready to take your question at this time.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Patrick Jobin of Credit Suisse. Your line is open.

Patrick Jobin – Credit Suisse

Hey, good evening. Thanks for taking my questions, it's great to see visibility improve.

David Brewster

Thanks, Patrick.

Patrick Jobin – Credit Suisse

So just following up on the splits. Can you provide any color about the percent of your portfolio that might be on multi-year contracts, so just anyway refresh on that might be helpful? Thanks.

Tim Healy

I don't think much has changed on that, Patrick. We've been averaging approximately 40 plus month contract terms with our C&I customers, and there hasn't been a real trend change on that. So it still trends to over 40 months on average for these customers, roughly 3.5 to 4 years in the length.

And again what we're seeing is, really solid share splits as customers continue to look at us with the expertise, the technology that we bring to the equation. And then I think we may have mentioned this a little bit, but we'll just sort of reemphasize the fact that we are going into some new regions that also help us out with some of the split activity, because in those regions, we bring a lot to the equation. We bring a lot of expertise from other regions. We have talented salespeople that are doing what they need to do help educate customers and get them engaged and certainly if you like to (inaudible) seeing Australia for one.

Patrick Jobin – Credit Suisse

Perfect. Now that makes sense, I appreciate that. And then also in regard to the backup generator rulemaking, is it fair to assume any potential impact from that would be in your guidance range or how should we frame the impacts considering we won't have ultimate clarity until the end of the year or the earliest? Thanks.

David Brewster

Yeah, Patrick, we continue to feel good about where the EPA is, they spent two understanding issue and have issued a proposed rulemaking, which I think makes great sense for continuing to faster emergency demand response as a last line of defense. And so we feel good about where it's going. It's hard to predict any sort of adverse impact on the negative side, but we tried to encapsulate that in our thinking in terms of our full guidance.

Patrick Jobin – Credit Suisse

Any sense for magnitude of backup generation within your portfolio or?

David Brewster

We haven't broken out, Patrick. We don't break out the percentage that is – any type of response and what percentage is lighting or what percent is HVAC. So we haven't disclosed that. But I can't say that it is in terms of our percentage of our overall portfolio, generation has become significantly less and less as we continue to diversify in markets. And really gain traction with customers in terms of – in response in all sorts of response. I think it's probably, as a percentage of our portfolio, decreased by about two thirds over the past eight or so years.

Patrick Jobin – Credit Suisse

Great, thank you.

Operator

Thank you the next question is from Chris Kovacs of Robert Baird. Your line is open.

Chris Kovacs – Robert W. Baird & Co.

Hi guys, thanks for taking my question. Obviously you've done a great job, executing on you move into Australia, New Zealand. Is there anything about new markets opportunities particularly in Japan, mainland Europe? Would you consider potentially looking into a JV strategy to just some these markets?

Tim Healy

Certainly in every market that we look at around the world, we're hoping that we exploring different go to market strategies and in some parts of the world suddenly JVs (inaudible) Samsung would be potentially an attractive path to market for quicker scale and growth for EnerNOC, but we sort of have looked at all different model that are actively pursuing a variety of different models that are going to be most effective for our shareholders as we continue to grow.

Chris Kovacs – Robert W. Baird & Co.

Okay, thanks for that. And then, following up on Patrick’s questions about the backup generation, can you maybe discuss how – if this ruling ends up going through, does this change your strategy for charting some of this backup generation capacity out there, and where do you see a potential opportunity for you guys in terms of potentially adding to your portfolio based on the new ruling?

Tim Healy

I think David articulated pretty well that there has been a decrease in the percentage of our portfolio that’s backup generation, that’s due to a number of factors, some that are directly because of our strategy and others because they’re probably indirectly a consequence of the strategy. When EnerNOC first commenced operations, there was percentage of our customers that saw the use of emergency backup generators as one of the lowest-hanging fruit means to get involved in demand response and it was basically viewed as a stepping-stone for them to other forms of demand response that they could provide to the grid. So we have a lot of customers that may start with backup generation, but that leads to them finding more opportunities to curtail above and beyond their back generation.

So I think it’s not surprising that we’ve seen the type of reduction of emphasis in backup generation. That said this is an important rule. It represents an important last line of defense for grid operators. So we think it’s important not just to the demand response industry, but to the health of the grid overall. And we think that we’re well positioned, and now again with 90% of the comments coming in to-date in favor of what the EPA is proposing, and spending two years looking at this and being advised by folks who really have the EPA’s interests in mind, not their own self-interest in mind. We feel confident that this headed in the right direction.

We also look at who’s leading the charge on the other side, and it’s folks that seem to want to focus primarily on operating their own generators, their own peaking power plants at peak times. So it’s a little specious to us to have them leading the charge on trying to adjust these rules to anything other than the way they’ve been laid out today. So we feel pretty good about where that stands. But we’ve got to be thoughtful about the fact that we have to manage the portfolio according – I’m not sure that it changes the strategy all that much.

I think we have experienced helping customers in certain regions where they have to equip their backup generators with emissions control technologies, not some of the networks for every backup generator, but it works in certain instances in certain locations. So, we can certainly fall back on that in certain instances. But right now our hope and our expectation is that that this is nothing more than that a matter that’s put behind us at the end of the year and isn’t really a focus of investors or customers once the EPA makes its final ruling. So we feel pretty good about it.

Chris Kovacs – Robert W. Baird & Co.

Okay, thank you for the color.

Operator

Thank you. The next question is from Ben Schuman of Pacific Crest Securities.

Benjamin Werner – Pacific Crest Securities

Hi, guys. This is Ben Werner on for Ben Schuman. Thanks for taking my questions. Just a couple of things; first, is there any additional commentary you can provide around the visibility in 2013 and the guidance as well as what kind of gross margin target you might look at for that year?

Tim Healy

Well, we mentioned that starting with the second that the gross margin target continues to increase. There is great margin visibility in light of signing multiyear contracts in light of a fact that it’s when our Australian project or Australian 240 megawatts of activity there really start to come into play in the financial contribution of that region become more significant. So the high margin splits there is part of the color, is part of the picture.

It’s really the promising splits on new sales, better visibility into OpEx, lower installation costs that are driving some of the higher 2013 EPS guidance. There is an emphasis still on PJM and the portfolio there that we’ve very effectively managed under new measurement and verification rules. I think we’ve done really well. We probably have surprised some folks external to EnerNOC and I think there’s been a sense of, not so much for leaf, as much as just pride that we’ve been able to shift gears as quickly as we’re able to shift gears to focus on the right set of customers in PJM, bring them into our portfolio, effectively view it without having sacrificed margins and if anything we’re seeing a little bit of margin split premiums occur as we readjust the portfolio.

So it’s a number of factors. We feel good about what we’re doing there. We have had some good trends in the energy efficiency part of our business, where we’re seeing gross margins in that part of the business trend very favorably in our new contracts. So it’s a combination of solid execution and then I think we’d really be understating if we didn’t point out the fact that we put together a new team at EnerNOC. I talked about a little bit it in my comments.

But this team is focused on profitability, it’s almost like having a Chief Profitability Officer at EnerNOC in effect that is taking a look region-by-region, program-by-program, operational activity by operational activity. Finding where there’s duplication, finding where there are unintended consequences of focusing our efforts on going after one set of customer when in fact we should focus on a different segment of customers, because those customers can contribute more to our bottom line, and we can also satisfy that customer better under certain arrangements. So, I think that initiative is a key part of the story and we’d like the results for the first five or six months of that activity and based on the pipeline of profitability initiatives that are in that group. I think we feel cautiously optimistic in that part of the story in ‘13 as well.

Benjamin Werner – Pacific Crest Securities

Great, that’s very helpful. One other question was any update on activities in the UK and/or on new utility deals in U.S.?

Tim Healy

The UK continues to be a region that EnerNOC is active in. I think the primary focus of that activity right now is working with national grid with other demand response aggregators to focus them and continuing to evolve the market rules. So that they can do things to bring more demand response capacity and meet the needs of the C&I while at the same time, meeting their own needs.

Certainly, we’d love to be able to report that that region has seen some of the same trends and dynamics that maybe David pointed out in Texas where the landscape and the opportunity and the visibility into increased economic opportunity for demand response providers fairly clear right now that there has been a positive trend.

I would say that hasn’t necessarily been a positive trend in the UK. It’s been more sideways activities at this point in time. But I think we’re optimistic that in light of not just EnerNOC, but other aggregators spending time in that market and the fact that there are many macro trends that support continued investment in the UK that that’s a place that might not have significant amount of contribution in the near-term, but remains one of the places that we’re looking and want to maintain that beachhead that we have there, not just for the UK, but also for the rest of Europe. I don’t know if you have any extra color on that?

David Brewster

Well, just in terms of the second part of your question, in terms of the other new utility deals, we have nothing to announce right here on this call, but the pipeline continues to be robust, and we think there is a lot in the works and we hope and expect to announce some additional utility wins in the quarter’s end.

Benjamin Werner – Pacific Crest Securities

Great. Thank you very much.

Operator

Thank you. The next question is from Sean Hannan of Needham & Company. Your line is open. (Operator Instructions) Okay, we’ll go to the next question from John Quealy of Canaccord. Your line is open.

John Quealy – Canaccord Genuity

Hi, guys. You got me?

Tim Healy

Yep. Yeah, yeah.

John Quealy – Canaccord Genuity

Hi, good afternoon. Sorry, I’m jumping on late here, just a couple of questions. So the adjusted EBITDA guidance for ‘13, can you help us reconcile to perhaps a free cash flow proxy. What would CapEx be, do you think in ‘13, just ballpark?

Tim Healy

That’s still a year ahead, I’m not sure that we’re going to benefit anybody by trying to speculate on the ballpark of 2013 CapEx spending at this point in time, especially in light of the fact that we’ve not given some visibility obviously into the top-line and bottom-line. But there’s a lot of things that we still need to focus our attention on and I think we’d be premature in spelling out some of the details with that level of precision at this point in time. Certainly as we get closer ‘13 and have a little bit more sense of some of those important moving parts and exactly how big the range on those things might be based on different strategic decisions we want to make. Different trade-offs that we might have still yet to determine. We want to provide some color on that, but I hope you can appreciate that, it’s just still a little premature on that.

I think the good think that we can describe is that, we’ve been able to afford ourselves that the flexibility, because of the momentum where we feel really comfortable that we can plan now for the type of year that we’re planning for on the bottom line in 2013. and we’ve taken obviously in this guidance we’ve taken the idea of not being profitable on a GAAP basis next year. We’ve taken that off the table and we’re now able to go to our Board of Directors and plan around a year that has us at the profitability levels that we described in our guidance. And I think obviously, we still need to talk about where some of the discretionary spending occurs next year. but it’s still on the table for us and there would be some CapEx spending that could part of that discretionary spending. So, let us get to that point and then we’ll certainly try to provide as much color there as we can.

John Quealy – Canaccord Genuity

Okay. But in terms of the qualitative in that adjusted EBITDA guidance, there isn’t any sort of major build-out that you haven’t talked about. I know you’re moving to just a new headquarters or something like that. but there’s nothing different strategically from that number than it was before, correct?

Tim Healy

No, no.

John Quealy – Canaccord Genuity

Okay.

Tim Healy

Good point, good point, no.

John Quealy – Canaccord Genuity

And then secondly, I’m sorry if you said this earlier. But can you talk Tim, about sales force productivity? How happy you’ve been with them, whether it’s for megawatt or per gross margin dollar, they certainly seem to be delivering for you folks. So, if you could just give us some qualitative discussion around those folks?

Tim Healy

Yes. there is some good story on sales force. in particular, this year we continued once again to try to increase the focus on non-demand response part of the sales activity, and some of the things that we’re very encouraged by is the number of sales reps that are selling not just demand response, but they’re selling supply agreements there.

Expertise has increased significantly in selling our energy efficiency product suites. We’re seeing more and more sales reps that are hitting the top of the leader board, not just top of the leader board in demand response, but they’re now climbing up to the top of leader board in their energy efficiency sales continued to like the trend in the energy efficiency sales activity especially over the last three quarters.

The total contracted revenue for [EE] business is a really good story. I know we didn’t break that out specifically on this call. I think we’ll tend to take a look at that on the third and fourth quarter earnings call, and see how that story continues to shape up. especially since we know that the first couple of quarters of the year are generally where we emphasize more of the demand response sales activity, because we’re striving hard to reach some June 1 deadlines in certain programs and some summer period opportunities that will sometimes put the emphasis on our demand response activity. but even amidst that over the last three quarters. We’ve seen more and more energy efficiency sales.

So, I think the productivity story is a productivity and diversity story of the effectiveness of selling. We’re also spending time just figuring out how to best train the sales force. One of the things we are fortunate about was that we did receive some training grants recently and we’ve increased the amount of training budget that we have here. Overall and certainly, we’re looking for our sale leaders to hire the best and train the best. and we still feel good that we have one of the leading, if not the leading sales and marketing forces in the energy management space.

So, I don’t know if there is a specific trend to point to, it’s probably a little bit encapsulated in the fact that the demand response megawatts under management per full-time demand response employee continues to trend up and obviously counted in that are an army of demand response sales reps. So, we clearly are continuing to see operating leverage in all areas of the business including some really strong activity on the sales force.

John Quealy – Canaccord Genuity

And just one last one, if you could, so with the Constellation Exelon merger if you would, have you seen any sort of dislocation in their DR focus? Because obviously there’s a big mash-up and I know they’re trying to grab accretive customers in Pennsylvania for example. But have you seen any dislocation from that from a channel perspective that you guys are benefited from, or is it just too far up the food chain on the generation side? Thanks guys.

Tim Healy

Yeah, it’s a good question. I think it’s probably still too early to tell exactly what’s going to occur there. I think I’d probably pay attention more to what Exelon said it’s going to do with the non-generation assets in the retail business of Constellation rather than have EnerNOC speculate what that might be. I think that’s probably more to hear from Constellation’s ads. Obviously, there are always going to be employees out there that are – that might be circling around at various companies, and when change occurs some of those employees might want to change operations. But other than that, I'm not sure that there is a story that quite yet.

Operator

Thank you. And the next question is from Andrew Weisel of Macquarie Capital. Your line is open.

Andrew Weisel – Macquarie Capital

Hi, good evening guys. Two topics, I was hoping you could elaborate on a little bit. First, you mentioned ERCOT and that's definitely a market that’s probably among the tightest in the countries. Historically we’ve had a lot of different flavors in programs for demand response, and historically the PUCT and ERCOT have been cautious to rely too much on demand respond relative to physical generation. So any high level thoughts to what you might expect as far as the types of programs and the magnitude of how big DR could get in Texas?

Tim Healy

Hi Andrew, it's Tim. It's a great question; I think we are encouraged by the same dynamics that you’ve just talked about. I don't think you're at all off to say that Texas has on the one hand has embraced demand response; on the other hand, there certainly was some room for further opportunity to expand what demand response was able to contribute in that market. So obviously they’ve made some initial steps, I think one of the good things is we feel like we have really good relationship and by we. EnerNOC and I think others in the demand response industry tend to have a good relationship with ERCOT, and with the Texas PUC, they seem receptive to hearing what it would take to improve market rules and to improve settle piece around the edges that can have fairly meaningful impact on how much demand responses in the market.

Hopefully also picked up on some of them that we highlighted, which is that we’re also able to work with some of the electric distribution companies there that have their own demand response initiatives and those have picked up fairly significantly, we’d like to see that those are not just temporary pick-ups, but those are sustaining pick-ups. And it remains to be seen whether that's the case not. But certainly it's a progressive market, it's one of the markets that people look at and say they really take competition on the retail side, and obviously they’ve embraced lot more on the demand side than ever before. And we like the trends that we're seeing, I think it's just a matter of let's see what next year brings, and let’s see what other impacts we can try to have.

Certainly at the end of day demand and stock continues to be a very compelling resource for those that are looking at it from an economic basis, and I think that's generally what we lead with there. Not necessarily leading with whether it's clean and whether its environmental benefits are the No. 1 thing to pay attention to, I think what we really like to pay attention to just not everywhere, but it particularly is important in a market like Texas. It's demand response it's very cost-effective resource, and I think it will continue to be in that region and elsewhere as well.

Andrew Weisel – Macquarie Capital

Okay, great. And then just one other thing – I was hoping you could elaborate about the EPA policy change, or proposed change. I understand from the physical generators there is still some push to have the backup generation be compliant with other EPA standards. So two parts, question number one, do you see that something that may actually survive in the final rule later this year? And number two, what are you talking about your portfolio at a country in general, how much of this backup generation would you say is compliant, what the EPA rules versus that which would either need to add retrofit or be retired if that was a requirement?

David Brewster

Andrew, this is David. I mean, the rule that EPA has proposed would be the final rule and what that basically allows for is the use of these resources for emergency demand response purposes for up to 100 hours per year. And so that is what triumph all. I mean, states would still have the ability for their own environmental rules, but the EPA rule if it goes forward like we expect it will, will be the rule for these resources, and essentially what the EPA is saying is that these resources have always been allowed to operate for 100 hours per year for testing and maintenance purposes, and it makes sense to allow great operators to actually harness and coordinate the use of these engines to prevent blackouts. And in the case of blackouts, every single generator in the effective service territory will run for an extended period of time. So EPA has scrubbed it diligently. They understand the importance of these resources, they’ve proposed to change the rule to allow these units to run for 100 hours per year, and that's what we expect will be the outcome.

And in terms of I think you said – you asked your second part of the question, Andrew, was the percentage of the market (inaudible) is what you said?

Andrew Weisel – Macquarie Capital

No, it was a question of the backup generators, how much of them are scrubbed and environmentally retrofitted if they were to be a change, which it seems like you aren't expect change, but if they were to be change in the wording of that?

Tim Healy

Yeah, I don't know that we necessarily of track that number in part, because it hasn’t been – actually haven't been a meaningful number two us, because of the fact that when we're working with customers that have backup generators, we’re looking to make sure that they are compliant with their state rules. We're obviously, we've been operating these in the past in association with the rules that David talking about, that they have the ability to run to be tested, the ability to be run for emergency demand response purposes and still be compliant the EPA without necessarily going through the hurdles and the added cost of additional emissions reduction mechanism.

So not sure we have taken a look at the market, I don't know who would have a reporter setting on that. I think, my sense of things is that in situations like this it doesn't surprise us when the other side of an issue tend to want to exaggerate some of the claims out there, and we have seen many exaggerated claims in the marketplace about the percentage of backup generation to the existing demand response, I don't think that we’ve seen anywhere near the number that has been – there's been down to around in certain very charged dialogues and reports, I think that's been exaggerated over the blip, and I think that demand response is something that made again continues to have a tremendous economic and environmental benefit to good operators, and the majority of studies that we've decided and the majority of the studies that we think have done the most work on this issue have come out aligned with our position on it.

I guess that’s not surprising, we are a leading clean energy company, we have clean energy of evangelists, at EnerNOC, it's important to us, not just obviously we are in business to make money on the bottom hand, but we are also very much mission driven organization that cares deeply about finding the right environmental solutions to certain energy challenges, and in this particular one we had to spent a lot of time early on, we’re beginning to spent a lot of time with this to make sure [silicon] continue to be on the right side of this issue both on a bottom line basis, but equally important to us, I think in this one that we're on the right side on an environmental basis. So we feel good where we are obviously we can’t control some of these outcomes, and we got to manage them closely, because they can have an impact on our financial performance in the future. This one feel for like it's not something that is likely to become a bigger issue for us at this point in time.

Andrew Weisel – Macquarie Capital

Sounds good. Thank you very much.

Tim Healy

Thanks Andrew.

Operator

At this time, I’m not showing any further questions. I'll turn the call back over to management for closing remarks.

Tim Healy

Okay. Thank you very much everyone, and half way through the year, we feel really good about where we’re head it, obviously on the call we articulated where that is, and where we're going. We appreciate your questions today for taking the time to listen to our second quarter conference call. We looking forward to connecting with you in the coming weeks about many of the exciting things on the horizon, and I want to thank our energy Olympians here at EnerNOC that are doing fantastic work at world over, and appreciate everybody here going for the gold medal. So thanks very much. And have a great one.

Operator

Ladies and gentlemen, this concludes today's program. You may now disconnect. Good day.

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