NOTE: This initiation note contains information regarding an enterprise currently listed over the counter and which trades irregularly; which brings with it inherent risks of illiquidity, highly-inefficient pricing, volatility, potentially lower reporting requirements, and/or reduced shareholder rights. This note will also cover an enterprise with operations having substantially NOT reached scale - which brings with it its own set of non-traditional risks. Please consult an advisor prior to making an investment decisions.
Ener-Core (ENCR) - which licenses its proprietary, patent-protected"Power Oxidizer"technology - has been in transition from a manufacturing model to a licensing model dating back ~36 months. During this transition period the enterprise has been under constant pressure: financial pressure, capital market vehicle pressure, and even activist pressure. This is despite having made substantial developmental progress along the way; at least dating back the last few years. Further, at times during this transition period it appeared that Ener-Core was a serious going concern risk.
However, in late November-2016 Ener-Core executed a Payment-in-Kind (aka "PIK") fundraising event which, to me, pulled forward the urgency in evaluation of the investment thesis at the enterprise. The PIK note execution meant many things to me, to which I detail within this initiation, but most importantly the PIK note stabilized the Ener-Core balance sheet. It also, in parallel, provided a degree of visibility into continuing operations that has not often been afforded to the enterprise; more a function of proving out a new, potentially disruptive technology than poor management. In the context of other multi-year strategic initiative completions, I believe Ener-Core to have reached a real AND symbolic inflection point. I believe now, post-PIK note raise, Ener-Core should be considered for capital deployment.
The Power Oxidizer: Ener-Core's Technology…
Substantially, all of Ener-Core's non-debt enterprise value resides in the technology and IP that comprise its Power Oxidizer. Ener-Core has spent the better part of a decade and considerable capital [$32 million in Additional Paid-In Capital, $38.7 million in Accumulated Deficit (as of the last ENCR 10-Q filing)] developing what it believes to be a disruptive technology.
Ener-Core's Power Oxidizer is an oxidization vessel that converts both rich and poor-quality greenhouse gases into utility grade power. At its unique core, this is what the Power Oxidizer is and does. But, that description, while concise and accurate, doesn't necessarily encapsulate all that the Power Oxidizer does and how it does it; both of which are key in establishing the defensible position which the Power Oxidizer occupies.
Ener-Core's Power Oxidizer [when coupled with purpose-built turbines via its licensing partner(s)] turns greenhouse gases of wide quality spectrum, as noted above, into utility grade power. What differentiates the Power Oxidizer is its unique ability to operate at the far-ends of the quality spectrum. In particular, at the poor-quality end (i.e., the "non-rich" end).
In many cases, greenhouse gases are emitted as a by-product of the industrial processes of many industries: pharma, wastewater treatment, petrochemical refining, food processing, painting, etc. In these cases, these greenhouse gases are "weak" (i.e., the greenhouse gases don't have the high-energy density per cubic foot that is required to use the gas as a fuel) AND they are also contaminated with lots of other bad actors that you would never want to run through a combustion chamber (the greenhouse gases would cause damage the combustion chamber, etc.). Ener-Core's Power Oxidizer can create power from these weak and contaminated greenhouse gases.
Ener-Core can also work with other toxic gases; such as "solvents" from industrial paint booths (think of the paint booths used to paint cars or aircraft) and also the Volatile Organic Compounds that result from industries that process organic waste (wastewater treatment, food processing, landfills, etc.). Ener-Core makes these toxic, poor quality gases, useful. Additionally, Ener-Core generates the converted power - the end result of its Power Stations - with almost zero emissions; which makes it easy for the owner/operator to obtain environmental permits for on-site power generation. It should be noted that these are often difficult to obtain and that the difficulty in obtaining these environmental permits prevents many industrial companies from being able to install a cogeneration plant on their site). In a way, this hurdle prevents a barrier to entry for Ener-Core/Power Oxidizer competitors.
Obviously, the utility grade power converted and created by the Power Stations can then be used as a fuel source (on-site for the end-customer of the technology) or in some instances it can be sold back to the grid (thus creating a "cost-plus" mechanism for the end-customer of the technology). Both end-uses for the utility grade power created by the Power Oxidizer, in conjunction with a purpose-built turbine (in creation of a "Power Station"), help create the IRR value-prop of the Power Oxidizer technology (i.e. the ROI or payback period).
The following is an abbreviated description of 1) the Power Oxidizer technology as well as 2) the process in which the Power Oxidizer converts greenhouse gases to utility grade power (via the FY2015 ENCR 10-K):
"In nature, methane and other greenhouse gases react with oxygen in the air and are eventually decomposed through an oxidation reaction over a period of 10 to 20 years. The speed of the reaction is dependent on three primary variables: the temperature, the pressure of the gases, and the abundance of oxygen. The oxidation reaction is exothermic (i.e., generates heat as a natural output of the chemical reaction), but since the reaction occurs slowly in natural, ambient conditions, the heat generated by the reaction is quickly dissipated and normally unnoticeable. Our Power Oxidizer accelerates the natural process by introducing a hydrocarbon-rich waste gas stream into a vessel with a high concentration of air, under pressure, and at high temperature. The combination of these factors results in an oxidation reaction occurring in 0.5-1.25 seconds. By accelerating the reaction within the controlled, steady state environment of our Power Oxidizers, the heat generated from the reaction is compounded and we are able to capture and utilize the heat output within the heat profile ranges necessary to operate standard gas turbines or steam boilers without actually igniting the gas. Traditionally, industrial heat is provided by the combustion of a hydrocarbon which generates pollution such as nitrogen oxide (NO2), or NOX, as a byproduct. By comparison, our Power Oxidizers provide similar industrial grade heat at temperatures below when NOX is generated in a combustion reaction. The combination of our ability to utilize a low quality or "waste" fuel with the elimination of NOX generation (as compared to combustion heat sources) provides our Power Oxidizers with a superior alternative to traditional heat generation sources. Our Power Oxidizers are designed to operate on gases with extremely low energy densities as compared to alternative chemical reactions, such as combustion. While the Power Oxidizers operate on waste gases, they may also be operated on commercially available natural gas or other high quality hydrocarbon gas products, or a combination of both waste gases and commercially available natural gas or other high quality hydrocarbon gas products"
via Ener-Core October 2016 Investor Presentation
Ener-Core has long marketed that it believes, based on all current inputs, that its Power Oxidizers can generate a ~25% IRR for end customers of the technology. I've found out, via interviews with management, that this IRR is excluding any end customer specific IRR contributors. That is to say: Ener-Core is NOT factoring in any real, non-core benefits (i.e., benefits not directly associated with utility grade power creation and/or pollution abatement) that its end customers (or its licensees' end customers) are realizing. I found this quite shocking, in that this alone equates to an impressive deep-value investment thesis.
One of these IRR calculation exclusions which I can call out directly is the exclusion of any D&A benefits end-customers are realizing from a tax standpoint (i.e., in the avoidance of being cash tax payors and/or in helping drive down cash tax responsibility as the Power Station is being depreciated). As Ener-Core's Power Stations age (and, really, this would be Ener-Core's licensees' Power Stations), end customers will be able to depreciate the Power Stations based on the IRS/GAAP assigned depreciation curve of the PP&E (the Plant, Property, and Equipment - as defined by GAAP). This, regardless of this NOT being a cash expense, as many well know, is a benefit to the end customer in that this is a deduction on the income statement from "earnings". What this does is lower the end customers' cash tax exposure and/or impact to NOL's being used to offset cash tax exposure; as would any GAAP defined D&A. But, again, Ener-Core DOES NOT market this into its fully baked IRR's.
I believe this, while conservative on the part of management, grossly understates the total IRR of the Power Stations utilizing the Power Oxidizer technology ( and further grossly understates the IRR to the end customer - which, in turn, overstates the payback period estimation). I believe there to be substantial deep-value in Ener-Core (from an EV standpoint) as a result of it not marketing its Power Oxidizer IRR (and further integrated Power Station IRR) at fully-baked IRR's (i.e., inclusive of non-core, end-customer IRR additions). Put another way: I don't believe appropriate levels of growth have been "priced in" to the common stock based on end-customer, fully-baked IRR's.
via Ener-Core October 2016 Investor Presentation
Dresser-Rand Licenses the Power Oxidizer Technology: Ener-Core Hits an Inflection Point…
Apparently, Dresser-Rand (NYSE:DRC) - which was recently bought out by $95 billion market cap Siemens (OTCPK:SIEGY) for $7.6 billion - was convinced enough of this IRR marketing effort to engage Ener-Core in prove-out of its technology; which eventually led to a licensing agreement. Dresser-Rand's engagement with Ener-Core, preceding its licensing agreement, dates back to 2014. Dresser-Rand is Ener-Core's sole licensee, at this point, and has licensed global deployment of the Power Oxidizer for the range of Power Station capacity ranging from 1-4 MW (of power capacity). Currently, this comprises substantially the full spectrum of power capacity at Ener-Core.
However, Ener-Core does in fact have smaller power capacity deployment in the 250 Kw-333 kW range. The smaller capacity power range was the first range developed by Ener-Core. This power range was developed in the period preceding the model-transition period. While this period, the pre-transition period, is in fact responsible for a large majority of the model-stress that exists even today (pre-PIK execution), it did in fact yield this junior power capacity. Remember, it was this junior power capacity that eventually led to the (currently) senior power capacity being developed (which led to an eventual licensing agreement with Dresser-Rand). It should be noted that Ener-Core has only deployed its smaller range of power capacity in abbreviated scale and that it, per interviews with management, is not aggressively promoting this range of scale. Rather, Ener-Core is focusing all enterprise efforts into development of larger power capacity ranges. Again, Ener-Core developed 8X power capacity growth (from junior to senior power capacity) in the three years spanning from 2013-2016. I mention this to provide context to power capacity growth expectations.
Dresser-Rand, which branded its Power Station variation " KG2-3GEF/PO", sold its first Power Station in January 2015 to Pacific Ethanol (NASDAQ:PEIX) - a two-unit total purchase order. Ener-Core, having since met and/or exceeded all concept prove-out demands of Dresser-Rand, has completed delivery of the purchase order (via Dresser-Rand delivery). Pacific Ethanol has noted that the Power Stations delivered are intended to significantly reduce the quantity of energy currently purchased by Pacific Ethanol's Stockton-located plant and are expected to reduce its energy costs by an estimated $3 to $4 million per year; representing a significant reduction in operating expenses for the plant.
via Ener-Core October 2016 Investor Presentation
Per its licensing agreement, Dresser-Rand will have a worldwide license to manufacture, market, commercialize, and sell the Power Oxidizer as part of the Combined System (i.e., the Power Stations) within the 1 MW to 4 MW range of power capacity. Initially, the license will be exclusive and will remain exclusive for so long as Dresser-Rand sells a minimum of number of units of the Combined System in each calendar year beginning in 2017 (i.e., the "Sales Threshold"). If Dresser-Rand does not meet the Sales Threshold in any calendar year and the Sales Threshold is not otherwise waived, Dresser-Rand may maintain exclusivity of the license by making a "true-up" payment to Ener-Core for each unit that is in deficit of the Sales Threshold; provided, however, that Dresser-Rand may not maintain an exclusive License by making a True-Up Payment for more than two consecutive calendar year periods. In the event Dresser-Rand does not meet the Sales Threshold, does not qualify for a waiver, and elects not to make the True-Up Payment, the license will convert to a non-exclusive license. Given Dresser-Rand's substantial investment into developing a purpose-built turbine and into the process of concept-prove out (which was multi-year), I consider a lapse of licensing to be extremely low probability (and of extremely low risk to any investment thesis). Additionally, it should be noted that Dresser-Rand paid an initial license fee of $1.1 Million; so, Dresser-Rand hasn't solely made a substantial investment into developing a purpose built turbine but also it has spent cash upfront to obtain this exclusive license.
Now, upon a sale by Dresser-Rand of a Combined System unit to a customer, the licensing agreement requires Dresser-Rand to make a license fee payment to Ener-Core equal to a percentage of the sales price of the Combined System purchased; in accordance with a predetermined fee schedule that is anticipated to result in a payment of between $370,000 and $600,000 per Combined System unit sold. For clarity, the "$370,000" and "$600,000" ranges are the contractual bounds of the fee schedule payout; however, management believes the likely range of per-unit license fees to be between $430,000 - $480,000 per unit. I well-prefer management's estimates in that the lower-end of the range is substantially higher than the lower range of the contractual bounds. This management-estimated range provides a much higher baseline monetization expectation than that of the contractual bounds; thus, increasing financial visibility. Again, this is something that has alluded Ener-Core largely dating back to inception.
I believe Ener-Core's model to have hit an inflection point. Post "R&D"-phase (i.e., "pre-model transition), Ener-Core has made substantial developmental progress:
1) Additional Technical Development: Ener-Core has scaled up its technology from 250kW to 2MW (an ~8X increase in capacity).
2) Completion of Siemens Due Diligence: Ener-Core accommodated and supported the extensive due diligence efforts of the Siemens team leading up to the eventual Dresser-Rand Licensing Agreement; including:
- IP Due Diligence: to ensure Ener-Core's patents were legally sound and that Siemens would not run into issues when deploying the Ener-Core technology globally under its Dresser-Rand brand
- Scalability/Reliability Due Diligence: Siemens mobilized its "aero-derivative" turbine engineers, which typically design aircraft turbines, for testing and analysis of the Ener-Core technology; Ener-Core's team had to prove to these engineers that the technology could scale up to 2 MW and could operate reliably in the field
- Market Value-Prop Due Diligence: Siemens reached out directly to many of its own existing customers across a wide range of verticals to discuss a "hypothetical" future product and assess how these customers would react to such a product being launched; taking on substantial reputational risk in the process
3) Negotiating and Structuring the License Agreement
I believe the capital markets agree with my assumption, based on recent financial engineering executed by Ener-Core.
via Ener-Core October 2016 Investor Presentation
Ener-Core Executes a PIK Note: Sentiment Has Turned Positive…
First, to take a step backward, it should be noted that the model switch at Ener-Core has not been cheap; and it has not gone without hiccup. Ener-Core has been forced to participate in several dilutive, some would argue punitively-expensive rounds of financing. Theses rounds have created what could be concluded as substantial cap structure overhang. Put another way: without substantial forward, financial engineering transactions - there will be share float expansion if/when Ener-Core equity pricing moves higher. Now, it should not go without mention that these expansions - at least to some degree - will also be funding events as much of the dilution will come via warrant and/or option monetization. Still, unless accretive, most market participants generally consider share float expansion a negative.
But, it isn't all bad. Ener-Core is still a going concern as a direct result of its ability to raise funds in prior rounds- punitively dilutive and/or expensive or not. Ener-Core, in that, achieved exactly what it intended to achieve; it is still a viable (and growing healthier) enterprise. Ener-Core knew, or at least this is my suspicion, that if it could simply reach monetization (and further - cash flow breakeven) that it could reward shareholders in time (dilution included). The technology, as is represented by Ener-Core's global patent portfolio (inclusive of 41 issued patents and 29 pending patents), is real. This is the point that I believe Ener-Core to have reached as an enterprise, the point of rewarding shareholders. I personally believe, and the market has confirmed that it shares this belief with me (see below), that Ener-Core is now worth capital exposure.
In late-November 2016 Ener-Core executed a debt restructuring that was led by a $4.5 million, in total, convertible PIK note issuance. PIK notes, for those unfamiliar, require zero ordinary interest (as per the terms of the specific PIK note). PIK notes, generally, are considered extremely risky (in that there is zero "return" on the notes to offset the risk of the note itself) and are generally only purchased by those with extreme confidence in the underlying enterprise. Again, this is because the PIK note is an "all in" investment; owning a PIK note is a bet that at maturation (or conversion in this case) you're going to be made whole on the principal and interest accrued. Given the size of the face value issue, again $4.5 million in total, I take this to be a meaningful endorsement of Ener-Core by the participating parties. I myself, had I been privy, would have participated in these PIK notes (based on the above outlined Bull Thesis).
The PIK notes were issued at a 10% Original Issue Discount (or "OID"), meaning net proceeds to Ener-Core will be ~$4.0 million in net (assuming the total PIK note issuance does not fluctuate). Additionally, each PIK note was issued with a five-year warrant to purchase 400 shares of common stock for each $1000 of notes purchased (at an exercise price of $3.00). While ultimately dilutive, the monetization of these warrants will in fact act as a future funding event. (Reiterating, the net dilution of the funding event will be a function of the capital deployment by Ener-Core and the ultimately realized IRR on that capital).
The convertible senior secured notes will be convertible into common stock initially at a conversion price of $2.50 per share and will automatically convert into shares of common stock on the fifth trading day immediately following the issuance date of the convertible senior secured notes on which the weighted average price (as defined in the convertible senior secured notes) of the common stock for each trading day during a 20-trading day period equals or exceeds $5.00. Additionally, pursuant to the transaction documents, the Ener-Core has agreed to secure the listing of its common stock on a national securities exchange by no later than December 31, 2017; which I think should be looked upon as bullish by common stockholders as we're nearly within 12 months of this requirement.
As a result of the PIK note execution, Ener-Core's balance sheet is much, much more fundamentally sound. Ener-Core's Q3/2016 balance sheet showed minimal cash, ballooning payables, and what was appearing to be certain equity dilution. Now, post-raise, Ener-Core nets 10 months' worth of cash burn runway (based on my modeling), payables-reset inclusive. It should also be noted that depending on how quickly Ener-Core can optimize its structure net of remaining legacy costs associated with its legacy manufacturing model that this runway could be expanded by a month or two.
Finally, Ener-Core does have a Power Oxidizer unit on its balance sheet(its "testing" unit that has been used in concept-prove out) which it could sell; and the unit has already been paid for and accounted for from a financial liability standpoint (in previous financial statements). If Ener-Core could sell this unit, again of which CAPEX risk has already been taken and identified, I believe this could net the enterprise between $2.25 million and $2.75 million. Ener-Core could discount the unit in an effort to sell the unit faster - but even if it did discount the unit I don't expect the unit to monetize for less than $2.0 million in a discounted offering.
Ener-Core: Now Licensing, Cash Flow Breakeven Within 12-Months…
Ener-Core's licensing agreement with Dresser-Rand, its only one currently, has minimum sales contractual obligations; or the requirement of a "true-up" payment (as described above). This provides Ener-Core with substantial visibility into its financials, a luxury it has never had prior. Given that its licensing agreement also has pricing floors for units sold (on a per unit basis; it should be noted that the licensing agreement does not have a pricing ceiling), this too provides financial visibility. Again, I believe it was this financial visibility that ultimately led to the successful PIK execution.
With this visibility in hand, Ener-Core expects to achieve total fee collection in full year 2017/1H2018 (from minimum licensing fee collection) of between $4.0 million and $4.5 million. This allows for the possibility, excluding any above listed ancillary variables, for Ener-Core to be at cash flow breakeven during full year 2017. It should be noted, however, that cash flow breakeven will be a direct function of cash collection; as there can be dislocation from licensing created sales and cash collection. Ener-Core collects 50% of each "per-unit sale license fee" at time that its licensee closes its purchase order. The remaining 50% gets collected at the "earlier of" 1) the date of commissioning of the system or 2) 12-months after the purchase order. For this reason, Ener-Core doesn't expect to achieve total fee collection within full year 2017 (as Ener-Core anticipates some of the "second 50% payments" will trickle into 2018). However, I'm more bullish cost cutting optimizations as well as top-end pricing realization by Dresser-Rand.
Still though, even if Ener-Core operates at slightly less than cash flow breakeven - one would presume it would have additional access to the credit markets (via PIK note issuance) and/or the equity markets (as at this point, the point in which Ener-Core would be needing to do a funding round, Ener-Core would have shown substantial progress and prior licensing fee collection). From there, presumably Ener-Core's final raise, cash flow breakeven could be achieved on a trailing four quarter basis on a go-forward basis (that is, into perpetuity). Reiterating all of the described scenarios assume zero pricing upside for units sold and zero additional legacy model cost cuts realized.
All told, I believe Ener-Core to have reached an inflection point - both operationally and financially. Ener-Core has visibility into operating at cash flow breakeven during full year 2017 and has high visibility into remedying any cash shortfall as a result of cash collection delays prohibiting cash flow breakeven operation (on a full year basis). Any further raise, it is my opinion, would be de minimis in sizing and at favorable terms. Ener-Core having a licensee like Dresser-Rand is real and symbolic in expressing that the enterprises investment thesis has reached a point of monetization. While Ener-Core has taken longer to come to market than some had expected, it's here now. I think it's time to consider Ener-Core for capital exposure.
Good luck everybody.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ENCR over the next 72 hours.
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.