The Energy Report: Let's talk about growth in the energy sector. How well is the cleantech investment sector positioned during the next six to eight quarters?
Pavel Molchanov: The cleantech index has been the best performer of the energy indexes over the past two years. Since the beginning of 2012, cleantech has outperformed oil services, E&P companies and MLPs, and has dramatically outperformed coal. 2012 was a tough year for the cleantech space. But 2013 was fantastic, and year-to-date cleantech is outperforming again, despite the choppy market. I doubt that cleantech will continue to perform at this pace during the next two years, but there are many opportunities. In 2013 the cleantech index was up 58%, but there were plenty of stocks that doubled and even tripled. There were also stocks that were cut in half. This is a stock picker's market.
TER: Do you categorize cleantech stocks as intrinsically high risk?
PM: There are a number of cleantech companies at the low end of the risk spectrum, so we have to look at them case by case. As a matter of investor perception, the cleantech space appears to have a fair amount of volatility, and in some cases it does have a very high beta. But generally speaking, cleantech stocks, like most tech stocks, will outperform in a bull market and underperform when the Dow is under pressure.
TER: What cleantech companies do you like right now?
PM: EnerNOC Inc. (ENOC:NASDAQ) is currently my strongest Buy recommendation in cleantech. It is at the lower end of the risk spectrum, and it has done quite well for two years. It is still not priced for perfection, currently trading at about six times EBITDA. The company has no debt, and it has been throwing off free cash flow year after year.
TER: What is EnerNOC's business?
PM: EnerNOC is an energy software company that fits nicely into the cleantech category because it enables energy efficiency solutions using proprietary technology. In other words, it is not weatherizing windows, or building diesel generators. It uses advanced software to improve stability on the grid. EnerNOC connects utilities to commercial and industrial power users and enables demand-side energy efficiency solutions, particularly when the grid is in crisis. Imagine a hot summer day when the grid is overburdened. Normally, there could be rolling blackouts. EnerNOC prevents blackouts with its automated demand-response software. It is essentially a service company with regularly recurring revenue, and it earns extra revenue during times of crisis on the grid.
It has created a nicely diversified revenue mix. In 2010, it only operated in the U.S. Last year, 20% of its revenue came from Australia and New Zealand. And in the last 90 days, it has expanded into Japan, Germany, Austria and Ireland. Demand response is an effective strategy for countries such as Germany that generate a high amount of renewable power. Renewables can be intermittent on the grid; demand response reduces this intermittency by filling in the gaps.
TER: Is EnerNOC's software proprietary?
PM: Absolutely proprietary. A secret sauce, so to speak.
TER: Does it have competitors?
PM: EnerNOC has competitors in all its markets, but it is the largest demand-response provider in the world. In the U.S., it enjoys a 30% market share. There are other demand-response companies out there, but they are either not public, or they are not pure plays. Johnson Controls Inc., for example, runs a demand-response business, but it is a small part of a very big company.
TER: Does EnerNOC pay dividends?
PM: No dividends, though it throws off so much free cash that it could. The firm does have a very acquisitive track record, and most recently it has been implementing a share buyback program.
TER: Do you have a target price for EnerNOC?
PM: EnerNOC's share price has doubled in the past year. Right now it is at $21/share and we have a $26/share target price on it.
TER: What is new in solar power?
PM: 2013 was a good year for the solar industry. It was a year of recovery after the tough years in 2011 and 2012. Two big swing factors in 2013 were China and Japan. China became the largest solar market in the world because the government dramatically ramped up domestic installation of solar. Japan became the second biggest market because it also prioritized solar adoption.
There are various dynamics informing these new pro-solar policies by both of these nations. China wants to provide a backdoor bailout to its troubled solar manufacturers, but there is also an environmental element at work amid the epic pollution. Japan, on the other hand, is literally running out of power. After the Fukushima disaster and the shutdown of the country's nuclear industry, it needs every watt it can generate, and solar is a big part of that. In 2013, global solar installations totaled approximately 35 gigawatts. That may not be dramatic, but it was up 12% compared to 2012 levels.
TER: Do you have any picks in the solar power sector?
PM: We like a billion-dollar company called Advanced Energy Industries Inc. (AEIS:NGS; AEIS:BSX). It makes inverters, the cash registers of solar energy systems. Inverters connect the generating system to the grid. Inverter manufacturing is a competitive market; there are a lot of players, including some new entrants. But it is experiencing a more benign form of competition compared to companies that make cells and modules. The gross margin structure for inverter companies is around 25% to 30%, which is double the typical margin for module makers.
Advanced Energy is not 100% solar, though. It has a legacy semiconductor capital equipment business that makes up half of its revenue. The solar inverter business is the other half of revenue, but the solar part of the sales mix is growing much faster than the semi. We are looking for earnings of over $2 in 2014. The stock is in the mid-twenties and trading at a relatively moderate multiple. The firm is debt-free and throwing off a lot of free cash flow. Like EnerNOC, Advanced Energy is using some of that cash to make creative acquisitions.
TER: I take it you're not too bullish on module manufacturers.
PM: Generally, no. Although we look at each company individually, the module assembly part of the value chain in the solar space does not excite me. Low-cost players can have slightly better-than-average margins, but it is a pure commodity market with very little technological differentiation. By contrast, a company like Advanced Energy has a lot of proprietary intellectual property.
TER: What about residential and business delivery of solar power?
PM: SolarCity Corp. (SCTY:NASDAQ) is the largest U.S. provider of residential solar systems. It is very well known for the success of its solar leasing model. Solar leasing is done by lots of companies, but SolarCity is the biggest. And SolarCity was one of the very best performers in cleantech in 2013. The stock has done amazingly well since its IPO in late 2012. Although it is certainly not cheap, there are many positive elements to the company, including a predictable recurring revenue model tied to its 20-year lease contracts.
SunPower Corp. (SPWR:NASDAQ) has a footprint in module manufacturing and also in the residential solar leasing arena. I suspect that during the next 12 months there will be a slew of solar leasing firm IPOs. Given the multiples at which SolarCity trades, its competitors must be salivating to go public.
TER: What about biofuels? Any picks there?
PM: Biofuels have morphed into a broader arena called bioindustrials. Biofuel companies are now trying to sell high-value materials into specialty markets. Selling the higher-value products provides more profit than competing directly with petroleum fuels. For example, KiOR Inc. (KIOR:NASDAQ) is a cellulosic fuel company that was trying to compete with commodity fuels. Unfortunately, KiOR ran into operational difficulties last year. Given the current state of its operations and its rather strained balance sheet, I am not steering investors to the KIOR stock currently.
Solazyme Inc. (SZYM:NASDAQ) is a more promising story at the moment. Solazyme is an industrial biotech company that uses algae technology to make high-value products. It is currently selling cosmetics in the skincare market. That is a very different market from the biofuel arena. These types of products have higher-value pricing and lower volumes. In the next few weeks, Solazyme will be opening the world's largest algae-based oil production plant in Brazil. Eventually the company may get into biofuels, but that is not its present priority.
TER: What about the more traditional oil and gas arena?
PM: Raymond James' view on oil prices is that there will be downward pressure on oil over the next 12 to 18 months. We are concerned about the possibility of an emerging global oil oversupply, particularly in the U.S., given the surge of domestic production. We are below consensus in our oil price forecast. In that context, the stocks that we generally prefer in oil and gas tend to be more defensive companies that have better capital discipline, pay dividends and buy back shares. In other words, we like companies that live within their means and have strong balance sheets and financial flexibility. These tend to be larger companies as a general rule.
TER: Like whom?
PM: I am a big fan of Chevron Corp. (CVX:NYSE). Its stock has been beaten down year-to-date. Not so much because of oil prices, but because the company is spending $11 billion ($11B) this year out of a total $35B dollar capital budget on two LNG megaprojects in Australia. Gorgon LNG is set to start up in 2015, and Wheatstone LNG in 2016. Because of these two megaprojects, Chevron is targeting nearly 5% annualized production growth in 2015, 2016 and 2017, which is by far the fastest in its peer group. And as production grows and capital spending flattens, the firm's free cash flow metrics should improve significantly—which is why I really like this stock.
TER: Any others?
PM: InterOil Corp. (IOC:NYSE) is a special situation in oil and gas that has my attention. The company resides in the higher end of the risk spectrum and it is definitely far from a dividend story. It has a $3B market cap. It is a preproduction E&P company that discovered one of the biggest gas fields in the South Pacific more than five years ago. It is now developing the gas field through a partnership with Total S.A. (TOT:NYSE), which is a major oil and gas company based in France.
Total and InterOil announced this partnership in December of last year and recently finalized all the terms. InterOil has received a $401 million cash payment for selling a portion of its gas to Total. InterOil will also have a stake in an LNG plant slated to be built as a part of the project.
TER: Do you have a target price on InterOil?
PM: InterOil's stock is trading in the sixties, and we have a $100/share target price. High-risk, high-reward.
TER: Thanks for your time today, Pavel.
PM: Thank you.
Pavel Molchanov joined Raymond James & Associates in 2003 and began work as part of the energy research team, becoming an analyst in 2006. He initiated coverage on the alternative energy/clean technology sector in 2006, followed by the integrated oil and gas sector in 2009. Molchanov has been recognized in the StarMine Top Analyst survey, the Forbes Blue Chip Analyst survey, and The Wall Street Journal Best on the Street survey. He graduated cum laude from Duke University in 2003 with a Bachelor of Science degree in economics, with high distinction, writing his senior honors thesis about OPEC's oil output policies.
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