Energy Focus: A Compelling Contrarian Investment Opportunity
Summary
- Energy Focus has seen increasing demand from the military with multiple large contract wins recently and remains operational during the pandemic.
- EFOI's share price trades at a meaningful discount to its peers, providing a large margin of safety.
- Liquidity and leverage are in much better shape than what stock screeners would indicate, giving EFOI the balance sheet strength to support its turnaround.
- A new suite of product offerings will help improve sales and margins going forward.
Energy Focus Inc. (NASDAQ:EFOI) is a deeply underappreciated and undervalued nano-cap stock with the potential for large growth in the coming years. The Company designs, manufactures, and sells light-emitting diode (LED) products that are used by military and commercial customers, the latter of which primarily consists of U.S.-based hospitals and schools (K-12 and universities). Mr. Market's pessimism about this stock has caused him to ignore important value enhancing dynamics occurring at the business, including 1) a shareholder aligned leadership team with a turnaround strategy that's already showing signs of success, 2) over $5M in military contract wins disclosed since last quarter's end, 3) a near-term high-margin product release, and 4) the fact that the business has been deemed an "essential critical infrastructure workforce" and continues normal business operations during the coronavirus pandemic.
Business Overview
Founded in 1985, Energy Focus, Inc. produces and sells LED products, which are more sustainable and energy-efficient than other traditional lighting products such as fluorescent, incandescent and HID lamps. Given their energy efficiency, LED products are able to reduce long-term energy and maintenance costs relative to traditional lighting. EFOI sells its products primarily to customers in commercial and military maritime markets (MMM) where the economic benefits and technical specifications of their product offerings are most compelling. The Company's commercial customers tend to focus on quality, efficacy, total cost of ownership and return on investment, while MMM customers require more rigorous military specifications pertaining to durability and dependability. The Company has been a US defense contractor since 2007, demonstrating the reliability and quality of its products and its large potential for sales growth as it begins its relaunch efforts to grow sales back to historical levels. Energy Focus reports that its commercial products have extremely low failure rates of less than 0.1 percent, compared to an industry average of 3 to 5 percent.
One of the ways Energy Focus differentiates itself from other commoditized LED producers is by investing in the development of proprietary, high-tech LED solutions, which include controllable LED technology that integrates occupancy sensing, data processing and network interface hardware and software into their LED products. By integrating dimming and various sensor-based capabilities into its lighting products, Energy Focus can generate significant cost savings for its customers. Management believes that the economic and environmental benefits that can be gained by using its LED technologies are not well understood in its markets, so they've invested in building a direct sales team to better educate end-users about these benefits. The Company also indirectly sells through third-party sales agents that represent the Company in regions where they don't have a direct sales presence.
COVID-19 Impact: As mentioned above, Energy Focus is considered an essential supplier and remains operational to fulfill orders for customers. In the last earnings call, while acknowledging the immense economic uncertainty introduced by the pandemic, the CEO stated his view that the pandemic would be less disruptive for Energy Focus than many of its peers in the lighting industry thanks to the Company's focus on government, military, school, and hospital customers, which are all essential operations and have budgeted requirements and demand for LED lighting in the mid to long term.
LED Market Opportunity and EFOI's Product Capabilities
The LED market is intensely competitive with a number of large dominant players with international reach and smaller players across the US and Asia. Larger lighting companies include Philips Lighting (PHG), Osram Sylvania (OTC:OSAGF), and GE Lighting (GE), and smaller companies in the space include LED Smart, Revolution Lighting Technologies (OTC:RVLT), Orion Energy Systems (OESX), Green Creative, and Keysight Technologies, Inc. (KEYS) among others.
Over the last decade, the trend in lighting use has been marked by a gradual shift away from traditional lighting products like incandescent and fluorescent bulbs and towards more energy efficient LED lights as users' orientations have tilted toward sustainability and lowered total cost of ownership. As the rapid pace of LED lighting adoption continued in 2016 and 2017, a large number of new entrants spurred price competition that drove down profitability for most incumbents, leading many of the larger, dominant players to restructure, spin out, and/or sell off their lighting businesses. Management believes this has created a vacuum of leadership that opens up a window for smaller competitors with more specialized products, like Energy Focus, to gain market share. As a result of price competition and the increasing commoditization of LED lighting products in recent years, Energy Focus made the strategic decision in 2019 to focus on developing more advanced LED products designed to achieve specific technical capabilities.
Why the Stock is Cheap
It could be argued that as a nano-cap stock with a market cap of ~$6M and limited liquidity, EFOI has fewer investors interested in analyzing the business, which reduces the market's efficiency for its stock price and can lead to mispricing. But beyond this tendency for nano-cap neglect, there are a couple of specific attributes of Energy Focus that create misunderstanding and undue investor fear, as described below.
The Debt Load Appears Worse Than It Really Is: In its most recent 10-k filing, EFOI reported ~$3.4M in current debt obligations in the form of $715k in credit line borrowings, $1.7M in convertible notes, and $885k related to a note (the "Iliad Note"). However, in January 2020, after the balance sheet date, the Company's $1.7M balance related to the convertible notes was converted into Series A preferred stock, removing more than half of the latest reported near-term debt balance. This preferred stock is convertible on a one-to-one basis into common stock and carries a liquidation preference of $0.67 per share.
Also, in January 2020, Energy Focus executed an equity and warrant issuance that raised ~$2.8M in gross proceeds (before expenses). 10 percent of the gross proceeds from this issuance (approximately $275k) was earmarked to pay down debt related to the Iliad Note. Lastly, EFOI recently disclosed that it has been granted a forgivable loan under the Paycheck Protection Program (PPP) in the amount of ~$795k. As a result of these factors, the financial risk in Energy Focus's capital structure is much lower than what is reported in stock screen tools. The Company's liquidity is also in much better shape with a cash balance of $2.6M as of March 5, 2020, according to its most recent 10-K filing, compared to only $350k reported on its last balance sheet.
"Going Concern" Doubt Since 2016 Due to a History of Losses: In 2016, Energy Focus's revenues were cut in half after military demand dropped off for its LED products, and the Company generated a massive loss of over $16M. In its 2016 year-end financial report, EFOI auditors determined that as a result of continued losses that there was substantial doubt whether the Company could continue as a going concern. In the years following, the Company's sales continued to decline as the LED market has been flooded with commoditized products, compounded by the distraction of management turnover and subsequent discontinuities in strategy and decision making. But, as described in the next section, there's now a stable management team in place, and the Company's strategic direction to focus on advanced LED products and upcoming product launches (also described below) will help put the Company back on track to profitability. With EFOI's net debt position being in much better shape than reported on their latest balance sheet, default risk is much lower than the "going concern" language would imply.
2019 Relaunch and Path to Profitability
In early 2019, Energy Focus saw management turnover and a resulting shift in strategy that both created important ramifications for shareholder value. Before describing these recent developments in detail, a brief background will help the reader understand why this was important. In 2012, James Tu was appointed as Chairman of the Board and later became CEO and President. Under Tu's leadership, EFOI's sales grew from ~$9M in 2013 to ~$64M in 2015. 2015 was a landmark year for Energy Focus as it benefited from a large US Navy contract and reported its only year of profitability in the last decade. In FY 2016, with the entrance of a large number of competitors and lowered military sales, the Company implemented a turnaround/restructuring program of sweeping cost cuts and shifted to a sales model that relied increasingly on third-party sales agents as opposed to direct selling. After a disagreement over strategy with the Board, Tu resigned in early 2017 and Dr. Ted Tewksbury took his place as Chairman, CEO and President. During FY 2017 and 2018, sales continued to decline, and the Company continued to report losses. In November 2018, James Tu and a group of investors filed a 13D disclosing an ownership stake of ~17.6 percent of shares outstanding. In April 2019, the CEO, CFO and three directors resigned from their positions, and James Tu was re-inserted as CEO and interim CFO going forward. By the end of 2019, most of the Board was reconstituted, and Tod Nestor had been appointed CFO. With its new leadership team in place, the Company has renewed its focus on improving LED product designs related to the MMM market, with the goal of significantly reducing product costs in order to re-grow this portion of their business.
Recapitalizing the Business, Reducing Costs, and Restructuring the Sales Organization: Upon taking the reins in 2019, the current management and Board retained Craig-Hallum Capital Group as their financial advisor to review strategic alternatives and, in March 2019, concluded the review with the decision to finance a business turnaround by raising $1.7M in convertible notes issued to James Tu and other investors. In addition, this leadership team began executing various cost cutting initiatives that saw operating expenses decline 30 percent from Q1 to Q2 2019, and another 9 percent from Q2 to Q3 2019. By Q4 2019, EFOI had reduced YoY losses from operations by ~60 percent, from $3M in Q4 2019 to $1.2M in Q4 2019. Management continues to cut costs opportunistically and expects that operating losses will continue to shrink as sales grow in the coming quarters.
One of James Tu's purported disagreements with the prior Board that led to his resignation in 2017 was with respect to the Company's decision to rely on third-party sales agents. With Tu's return to Energy Focus in 2019, he's begun investing in developing Energy Focus's internal direct sales team, an initiative that has seen the creation of four business development units each tasked to focus on major business opportunities, including: Military & Maritime, Strategic Accounts, SME Business, and Channel Partnerships. This focused sales approach is important because Energy Focus's sales growth will depend on being able to educate customers about the benefits of using their advanced LED products, including cost savings, sustainability, health factors, and technical capabilities.
Recent Contract Wins: In their last earnings call, management stated,
"We received over $7.6 million of new contract from the U.S. Navy and a foreign allied navy over the past six months, which represents our highest order rate for our military and maritime business since 2016, and which demonstrates our strengthening leadership and competitiveness in the navy ecosystem."
Since their last quarter ended, Energy Focus has publicly reported a material inflow of new contracts, including a $3.4M contract for the US Navy and another $1.7M contract for LED lighting to be used in four new Navy ships. The Company expects to begin delivery on both of these contracts beginning in Q2 2020.
In addition to the military contract wins, EFOI disclosed in a press release dated March 30, 2020, that, since the beginning of Q4 2019, the Company has installed over 200k LED lamps in 15 U.S. school districts. The installations include tubular LEDs as well as its patented backup LED Tube RedCap. Note that, in the last earnings call, management said that the RedCap product was adopted as the standard emergency lighting solution by a leading national energy services company. In the same call, they mentioned that the "Fluorescent T5 replacement LED Tube" is in the early stages of being picked up by a premium national retailer with more than 800 stores. These data points indicate an increasing pace of sales and customer demand for Energy Focus's current product offerings.
New Product Launches Will Increase Sales and Margins: Aside from the recent uptick in contract wins cited above, Energy Focus is working to boost sales and margins by introducing a new LED lighting portfolio of products called "EnFocus" in Q2 2020. EnFocus will be differentiated from other commoditized LED offerings, and according to CFO Tod Nestor, "it allows you to leverage your existing wiring without having to use Bluetooth or wifi or do a big rewiring in a facility. This is coming out in the market soon, and we think that it will be revolutionary. The people who have seen the demos have been very excited about it." EFOI has filed several provisional patents around EnFocus, and management believes that it will be the most disruptive technology the Company has ever introduced. Their largest strategic account has given the Company "overwhelmingly positive" feedback about the product, and management expects to be able to sell the product to customers in multiple verticals, including education, healthcare, government and other commercial industrial businesses. In conjunction with the continued optimization of the Company's product design and supply chain network, management expects to achieve gross margins in the "mid-20s" in the near term and begin to approach a "low 30" percent range over time, allowing for some quarter-to-quarter choppiness based on sales mix and inventory valuations.
Additionally, Energy Focus's sales stand to improve from the future roll out of its e-commerce platform. The platform should launch in Q2 2020 and will help serve as a channel for smaller orders or small to medium-sized businesses that are fulfilling orders on an ad hoc basis or for retrofit uses. Note that, as a B2B business, most sales require human touch (according to James Tu). Nonetheless, an online capability will help further sales growth and is a required capability in today's competitive environment.
Valuation
EFOI's shares trade at lower valuation multiples relative to a group of public peers. The selected peer group used in this analysis includes: Acuity Brands (AYI), Cree, Inc. (CREE), LSI Industries (LYTS), Orion Energy Systems (OESX), Osram, SemiLEDs Corporation (LEDS), and Signify NV (OTCPK:PHPPY).
On an EV/Sales basis, the public peer group trades at average and median multiple of 1.5x and 1.0x, respectively. EFOI's EV/Sales multiple is currently reported at approximately 0.8x, a material discount to its peers, but in reality, EFOI's multiple is even lower. As discussed above, in January 2020, EFOI executed an equity issuance to raise cash, which it then used to partially pay down the Iliad Notes by about $275k. As of March 5, 2020, the cash balance was reportedly $2.6M, but by quarter end, the Company will have used some of that balance for operations, so a conservative estimate of cash at quarter-end is closer to ~$1.9M. After adjusting for the notes converting into preferred stock and the $275k reduction to the Iliad Note, the pro forma debt balance is somewhere near ~$1.3M. The resulting pro forma EV/Sales multiple is 0.7x, providing a significant margin of safety relative to EFOI's peers.
On a Price/Book Value basis, the average and median multiples for the peer group are 2.2x and 1.7x, respectively. In comparison, EFOI trades at just 1.4x book value, but once again, this metric is based on stale financials due to the previously discussed cash infusions to the balance sheet. An adjusted Price/Book Value of 1.0x reaffirms that EFOI's stock is cheap relative to its public peers.
Based on this analysis, a conservative price target range lies somewhere between $0.45 and $0.53 per share, for an upside of roughly 25 to 48 percent relative to EFOI's last closing share price of $0.36/share. Note that the upper bound of this range implies an EV/Sales multiple of 0.9x and a Price/Book Value multiple of 1.4x, which are both relatively low multiples.
In these deep value situations, it's always reassuring to see bullish insiders aligning themselves with shareholders by purchasing shares. In April 2020, Tod Nestor (CFO) disclosed open market purchases of 150k shares for a total investment of ~$53k, and Philip Politziner (Director) disclosed purchases of 32k shares for a total investment of ~$10k. In addition, EFOI has high insider ownership with the 13D group (which includes James Tu) beneficially owning 27.2 percent of the shares outstanding, and James Tu (CEO) beneficially owning 9.2 percent of the shares outstanding (after adjusting for the conversion of the notes into series A preferred stock).
As a last thought here, it's interesting to speculate that perhaps one reason for the CFO's bullishness on the stock is his conviction that Energy Focus will reach cash flow break-even over the next 12 months, which is one of his goals, according to a recent interview he gave to CFO Thought Leader.
Catalysts
With EFOI's shares trading at a significant discount to its public peers, it shouldn't take much good news to see some share price appreciation. Regardless, two identifiable catalysts are described below.
Reporting Balance Sheet Improvement in the Next Earnings Release: Given the conversion of the convertible notes into preferred equity, the equity raise, and the forgivable loan related to the PPP, EFOI's leverage profile will look much better than its last report.
Achieving Sustainable Profitability: As mentioned above, the CFO has set a goal for the Company to reach cash flow breakeven within 12 months, and also disclosed material personal purchases of the stock in the last month. Achieving sustained profitability would lead the auditors to remove their language about going concern risk from the financial statements, relieving a great deal of investor pessimism. Profitability will be the result of the increasing sales growth from current and new products, margin expansion, and cost cutting dynamics discussed above.
Risks
Key risks to this thesis include:
Future Funding Risks: In the future, EFOI may need to obtain additional funding, failure to obtain financing could be a major issue for the viability of the business depending on how things go in the near term. There's also potential dilution from future sources of funding. However, in their last earnings call (which took place in March 2020), the CEO reported his expectation that they will not need to raise equity capital again in 2020.
Customer Concentration Risks: As disclosed in the most recent 10-K:
"In 2019, two customers accounted for 45 percent of net sales and total sales to distributors to the U.S. Navy represented 23 percent of net sales. In 2018, one customer, a distributor to the U.S. Navy, accounted for 42 percent of net sales."
COVID-19, China Trade War, and Supply Chain Risks: The pandemic introduces significant uncertainty for nearly every business model in the near to mid-term. Many of EFOI's products are sourced from China and are subject to trade war tariffs. However, in their last earnings call, management reported that tariffs are manageable for the Company with only about $140k paid in 2019. EFOI will be able eliminate 25 percent tariffs on electronic components by sourcing from alternative suppliers beginning in 2020. The Company continues to work with vendors for price reductions and is evaluating alternative sourcing locations as part of contingency planning. Energy Focus has reported that, in some cases, they rely on single suppliers for specific inputs, which introduces supply chain risk.
Typical Nano-Cap Risks: This includes lowered liquidity, potential price volatility, and other risks that can affect small businesses. EFOI has received notice from Nasdaq regarding its share price being below the $1 minimum bid price and has until July 24, 2020, to come into compliance. The Company has stated that the Board is considering a reverse stock split to regain compliance if necessary.
Conclusion
After years of declining sales, Energy Focus's business has begun to show signs of an emerging turnaround, and thanks to a well-timed capital raise, the Company now has the balance sheet strength to execute on its vision over the next year. As EFOI continues to win contracts, losses will narrow and eventually become profits, and the contrarian value investors who own this stock will be rewarded.
This article was written by
Analyst’s Disclosure: I am/we are long EFOI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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