Clean Winners in the Energy Sector
Bryce Dille thinks that companies working on energy efficiency and building the “smart grid“ have the best short-term prospects of the alternative energy stocks he follows. This trend is above all the result of the economic downturn; contributing to the interest in efficiency is the change in Washington, which has caused some short-term disruption and lack of clarity for the sector, he says. Looking ahead he thinks state regulations will drive values in the market, with California likely to take its accustomed leadership role. He believes consolidation is “probably right around the corner” for the demand response sector of the alternative energy industry, as well as for companies that provide
“smart buildings” services.
The Wall Street Transcript (TWST)
September 21, 2009
BRYCE DILLE — JMP SECURITIES LLC
TWST: Please begin with a brief overview of the sectors that you cover within alternative energy.
Mr. Dille: Predominantly it’s three sectors: One is pollution control, and that’s predominantly companies that are looking at reducing emissions from coal-fired power plants. The other space is distributed generation and distributed power storage, which includes lithium ion battery companies for hybrid vehicles or companies that will have alternative technology power storage, or essentially have some sort of distributed solution for power storage or power generation. And then the last space is more on the demand side of the equation and is related to the smart grid — they are really demand response and energy efficiency companies, whether it is EnerNOC (ENOC) or Comverge (COMV). So they are demand response providers, which is an energy efficiency-or callable-type power reserve free utility to have on the electricity grid. So everything outside of solar and wind, pretty much.
TWST: What factors trigger some growth in the mid to long term for the companies you cover?
Mr. Dille: So it’s everything from pollution control to alternative vehicles. On the pollution control side, I think what we’ve seen happen is the change in administration and broader headwinds from the economic downturn. In the short run, the administration has probably caused some disruption and lack of clarity in direction of new policy, and what the new administration is going to set out as policy for pollution control. Additionally, what we’ve seen through the decline in the economy is also a decline in electricity demand and also a decline in profitability metrics for utilities. And I believe this has really reduced capital budgets and the utilities’ propensity to spend on pollution reduction and control technologies. That being said, for activated carbon in particular there are strong incentives established by independent states to control mercury from the coal-fired power plants that operate within their territory. So despite what the lack of federal oversight looks like and despite the propensity for the utilities to spend on pollution control, the state mandates are really driving the marketplace for activated carbon. And predominantly, the control of mercury is from coal plants.
TWST: Are there any new state mandates that you expect to come out in the next couple of years?
Mr. Dille: Yes, it would be established state mandates that have deadlines that are coming up, and there are currently 16 states that have guidelines in which to control mercury. So there have been deadlines, such as July of 2009. But as for January 2010, there will be several more states that will have new mandates for coal plants to control their mercury. And the other question that remains for the mercury market is what comes out of the Congress in regard to the potential for CO2 legislation or the potential for a multi-pollutant bill that would look at a federal mercury control policy. But that still hangs in the balance at this point, in my opinion. So really the market is being driven in a short- and in a medium-term by what the state policies have set in place for mercury control.
TWST: How do you expect coal price volatility to impact the activated carbon providers over the next year or so?
Mr. Dille: I don’t believe it would be a price-driven market, per se. When the price of coal gets higher, the relative cost to use activated carbon for the control of mercury goes down as a percentage of the cost of generation. But I think it’s really, for right now, driven by both state and anticipated federal policies towards mercury control.
TWST: Moving to the electricity distribution sector, what impact will California’s demand response programs have on the space?
Mr. Dille: I think with the California Public Utility Commission setting forth a budget for demand response, which basically puts through a $350 million budget for the three utilities, or the three major utilities in California, and puts together a three-year plan, which is 2009, 2010, 2011, which is pretty material in my mind. Because I think many people, whether they are on the supply side or the demand side of the electricity equation, look to California as sort of a leading-edge marketplace. Over the past several years, in my opinion, California has been sort of lax on establishing what their outlook for the demand response market looks like by both approving and then not approving certain demand response contracts that were set up by the utilities. I think this recent passage or this recent case put through merely sets the stage for how material the demand response market can look like in California.
TWST: What other geographic markets look good for companies in this electricity sector?
Mr. Dille: I think California may not be the leader today, but it’s a pretty material market for demand response. I really look to the PJM Interconnection as the market leader for demand response at this time. Other markets that I would probably consider would be Ontario Power Authority, the Texas or ERCOT market, because as more wind is integrated to the electricity grid there, they will need more tunable electricity infrastructure to support the intermittency of the renewable electricity. I would still continue to look to ISO New England and ISO New York — these being other material markets.
TWST: What is the competitive landscape like in this space?
Mr. Dille: Right now the competitive landscape includes certain utilities that provide demand response services in their territory. There are independent third party administrators or third-party demand response aggregators that participate in the marketplace, and they are public companies such as EnerNOC, Comverge and EnergyConnect (ECNG.OB). And then there is a basket of private companies that are participating at this time, and they are largely second-tier demand response aggregators.
TWST: Do you expect to see any consolidation in the midterm?
Mr. Dille: Yes, I believe consolidation is probably right around the corner for demand response, but also in regard to companies that provide services to commercial and industrial buildings, especially for commissioning of “smart buildings.” One reason for this likely consolidation is that it is an emerging market where a fair amount of the market opportunity is being controlled by either geographically centered or sort of a mom-and-pop-size companies, where the bigger players may want to move into the space as rapidly as possible. Additionally, I think just because of the attractive economics, where some of the efficiency providers mimic the software as a service model, and due to the lower or shorter-term ROI on these projects versus multiple-year-type ROI investments, I think there could be consolidation in the space both from the utility side, where the utilities will want to kind of steepen their learning curve for either smart grid-type applications or energy efficiency-type applications, or we’ll see networking companies or hardware companies, let’s say the larger technology IT companies, trying to enter the cleantech space and acquire them in order to establish a footprint in the utility marketplace.
TWST: What are the top regulatory concerns right now?
Mr. Dille: I would say my concern is that demand response has had such a strong regulatory tailwind that has really created and enabled demand response to become a material participant in the electricity market. If that changes, where the regulatory support isn’t so strong, I think that could be a potential headwind. I think realistically, where we stand now, and especially with demand response being in focus — from a national level either through FERC or on a regional level through the ISOs and RTPs, or on a state level through the public utility commissions — there seems to be really a gathering consensus that this is something that needs to be supported. The barriers to entry need to be lowered and this stuff really needs to be integrated. So if that trend changes, that would be my concern. From a regulatory side, I really don’t see too much of concern at this time. That being said, because it’s a highly regulated market, there is always the opportunity for this to change on a dime.
TWST: What changes do you think will be necessary to trigger widespread adoption of the hybrid and electric vehicles, and how far away do you think that is?
Mr. Dille: I think a couple of things. I think the most immediate thing that would be very helpful for enabling a more widespread adoption of any type of hybridization of a vehicle is to see higher gasoline prices, just to make them more of a cost-competitive solution to the average consumer. I think the other key and kind of crucial thing would be what we see happening in the European Union, where they are monitoring tailpipe emissions from vehicles. I believe there will be a faster uptake in lithium-ion-based hybrids in Europe, where they have emission standards in regard to CO2 per kilometer. In the United States you have the CAFE standard which is set to increase by 2016. So I think the CAFE standards that are in the pipeline from the Obama Administration will really help the adoption of plug-in hybrids and electric vehicles. And lastly, Obama has set a goal of having 1 million plug-in vehicles on the road by 2015.
TWST: What developments do you expect to come from the $2.4 billion in stimulus money for the development of electric vehicles that was announced in August?
Mr. Dille: I think it will be a goal of the administration through any type of funding, whether it’s from the $2.4 billion or the potential for the $25 billion under the advanced vehicle manufacturing loan initiative. It’s called the ATVMLP, Advanced Technology Vehicle Manufacturing Loan Program. That’s a $25 billion program that was in place under the Bush Administration and could potentially double under the Obama Administration if the American Clean Energy and Security Act passes in its current form. But what I think is the goal of the administration is to provide funding to enable each portion of the whole vertical of the plug-in or electric vehicle market to have an adequate supply chain. So what that means is I think they want to provide capital to the raw material providers; they want to provide capital to the lithium-ion battery manufacturers; they want to provide capital to the OEM suppliers, and they want to provide capital to the OEM. Essentially, I believe they want to hit each portion of the supply chain from basically raw materials to end automotive product. The first loans under the $25 billion ATV loan program went to three leading plug-in electric vehicle manufacturers — Ford (F), Nissan (NSANY.PK) and Tesla. And with the recent $2.4 billion, I think what they have done is they have tried to fill out the midpoint to that supply chain, where they want to enable the battery guys and the electric-drive guys, and provide the capital in order to produce domestic manufacturing and ultimately support U.S. jobs. But also just to bring domestic capacity online, because what this is coming down to here, and the way this appears, is that it’s in essence trying to balance supply with anticipated demand.
And because you are creating the market theoretically from scratch, it’s very — I don’t want to say a tricky game — but it’s a very touchy game where they are trying to make sure that each piece of the puzzle is in place. By the time you can bring or get a material amount of vehicles to market — and material, in my mind, could even be 50,000 cars — if you look at a battery cost of say $20,000 per vehicle, at 50,000 vehicles that’s a billion-dollar battery market. So it ramps up pretty materially. So I can even say 50,000 cars on the road that would be either electric or heavily hybridized lithium-ion-based cars would be pretty material for the marketplace. And especially to — looking at, say, a few hundred thousand vehicles on the road — that’s a pretty large number when you move into the lithium-ion battery space. And because the performance characteristics are just far greater and the numbers get much larger much more rapidly, I think this area is emerging as a pretty material cleantech sector.
TWST: Several analysts believe alternative fuel is a more viable solution than hybrids or plug-ins. What are your thoughts on that?
Mr. Dille: I think right now the ethanol marketplace is probably entering a new stage where we are beginning to see traditional oil companies enter the market and there have been acquisitions of production plants in the United States by these guys because they understand that renewable fuel fits into and integrates very well into their existing supply chain. I think the one thing that’s changed the dynamic a little bit is that the utilities understand that if a car needs to get plugged in, it’s going to be purchasing electricity from the utility. So I think you are going to have more of a bifurcated outlook on the vehicle market, where you have the traditional petroleum guys understanding the supply chain for renewable fuels either from ethanol or biofuels, and then on the flip side of that, you have the plug-in hybrid vehicle mindset being driven by the utility marketplace. Just one other thing, too, is I think the lessons learned in the ethanol market have really helped that market come back or could help that market come back much more intelligently. Lastly I believe both industries will garner continued support from the administration — either from the fuel side on the renewable fuel standards, or on the plug-in side from tax incentives or stimulus funding.
“Focus on business fundamentals,
companies that are still able to grow top
line and bottom line through both the
strong markets and weak markets.”
TWST: Of the three sectors you cover within alternative energy, which do you believe has the greatest potential for nearterm growth, and which would you say has the least right now?
Mr. Dille: I think the one with the greatest near-term growth and, considering the predominant market environment, the companies which provide technologies that offer conservation and a very short return on investment should have the more immediate benefit. We are operating in an environment of capital constraint. And just from the capital constraints either from the utility, the capital constraints from the commercial industrial customer base or capital constraints from the residential marketplace, I believe that short ROIs and low-cost solutions probably will benefit first. And then longer term, I think technologies that are leveraged more toward policy will follow. Just because right now, where I think the Senate is basically set on the — I think the Democratic Party looks like they are going to try to get the American Clean Energy Security Act back on the table by the end of September. I believe this could turn out to be a highly contentious bill, especially on the heels of the health care environment.
And I think it’s viewed in United States that policy towards taxing CO2 or putting any type of cost associated with limiting CO2 on a marketplace that’s suffering job losses and unemployment could be very challenged in the near term. I think ultimately it’s the right solution, but the ability for our country to digest it at this point could be difficult. So near term I would look to energy efficiency. In the intermediate term, I believe advanced lithium-ion storage for on-grid storage or distributed storage in vehicles could stand to benefit, and companies that provide technologies to monitor, measure and potentially offset CO2 could be longer-term stories.
TWST: What is your overall advice to investors who are interested in alternative energy right now and what are your top-rated names?
Mr. Dille: I guess my overall advice would be to focus on business fundamentals, companies that are still able to grow top line and bottom line through both the strong markets and weak markets — those are probably the right technologies to go with. Keep bearing in mind, a lot of alternative energy and clean technology names are sensitive to policy. I think that’s all I have to say there, and my top names would really be EnerNOC, Comverge and the demand response side of the equation, because they provide a solution that is essentially free to the customer and becoming a more essential part of a utility or grid operator’s power portfolio. So you have a pretty short return on investment there. I also like Calgon Carbon (CCC) because they are leveraged to both the water market for purification to the coal market for the reduction in mercury. And lastly, and one that could take a little more time to unfold but offers a compelling investment opportunity is Ener1 (HEV). I think they are one of the leading companies for lithium-ion batteries, both in the United States and globally, for the application in plug-in hybrid and electric vehicles.
Note: Opinions and recommendations are as of 09/04/09.
BRYCE DILLE
Research Analyst
JMP Securities LLC
600 Montgomery Street
Suite 1100
San Francisco, CA 94111
(415) 835-8900
http://www.jmpsecurities.com/
About the Author: BRYCE DILLE is a Research Analyst at JMP Securities, where he covers clean technology and alternative energy companies. Prior to joining JMP, he spent nearly three years at Encompass Fund, serving as a buy-side Research Analyst focused on oil and gas, mining, industrial technology and emerging energy technologies. Mr. Dille previously served as an Assistant Portfolio Manager at Mellon Financial. He has also worked as a chemist at EIC Laboratories in Massachusetts on polymer chemistry, lithium battery technology and photovoltaic solar technology for Department of Energy-funded and Department of Defense-funded projects. Mr. Dille holds a B.A. from Carleton College in Minnesota.
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Posted on Monday, September 21st, 2009 - BlogConnect