Stem: Short-Term Pain But Moving Towards Increasing Profitability

seekingalpha05-06

Stem Inc. has struggled to deliver on its promise of becoming a high-margin recurring revenue play in the renewable energy and electricity storage sectors.The company suffers from project delays, ...

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(NYSE:STEM) has fallen out of investors' grace as management did not deliver on the promise of turning it into a high-margin recurring revenue play in the once booming renewable energy and electricity storage sectors. Yet, I believe there is an opportunity developing here at a time when many investors have turned their backs. Stem has used the last year to reduce its cost base and lift its CARR. With interest rates expected to decrease, Stem might be able to propel out of the current lows with a boost: first by further reducing costs within its capital intensive business, and second, through a change in perception of the interest rate sensitive renewables sector. Expected FCF generation and profitability metrics in 2024 should also reduce worries about its bumped cash position - the company does not plan to raise equity in the future. Stem's Business Model Stem is a software and services company in the clean energy space, operating an AI-enabled software platform which is regularly being recognized as an industry leader. At the moment, however, Stem generates most of its revenue from low-margin hardware sales, where it predominantly supplies solutions for electricity storage through batteries. Software and services are usually long-term customer arrangements which provide the company with reliable and high-margin revenues. STEM's Business Areas (March 2024 Investor Presentation) Stem has experienced strong growth over the years, yet as sales for now still depend strongly on hardware, the company's revenue publications are rather volatile. Additionally, and also due to these low margins, Stem has consistently been reporting losses and burning cash, resulting in increasingly negative sentiment towards the company's stock. From highs in the mid-double digits in 2021, its share price fell to lately way below $2. But for the current year, Stem expects to be able to publish a positive operating cash flow for the first time. Data by YCharts While some investors experience wild mood swings when Stem publishes revenue numbers, I believe its performance is better judged by the growth in recurring revenue. In the end, Hardware sales are, according to management, only a means to generate high-margin long-term software and services contracts which represent the company's core business model. Stem has published its CARR since Q1 2022 and has managed to consistently grow this number up until Q4 2023 from $52 to $91 million. Q1 2024 Update As you may have already guessed from the wording in this last sentence, Stem's most current Q1 figures did not continue this growth and brought the first QoQ decline in CARR since the KPI was published. Also, more generally, the developments that the recent earnings report revealed were just dreadful. Stem reported record low revenue of $25 million with an expectations miss of about 60% (in part due to hardware price guarantees made in the past with a negative impact of $33 million), almost unbelievably low bookings of $24 million, and about $300 million QoQ drop in contracted backlog. The following stock price crash of almost 30% on May 3rd did thus not come as a particular surprise. However, while all this is yet another hit for investors' trust in the company's management to deliver on its promises (which has been an issue for a while now), there were also positive developments: due to the difficult funding environment for cash-burning startups, management has been focussing more strongly on profitability in the past few months. These initiatives, while impacting growth negatively, led to a \"near break-even performance\" on operating cash flow (as per the CEO) and an expected positive operating cash flow for the full year 2024. Non-GAAP margin was also at a record level. Subsequently, management expects to reach its future growth targets without the need to raise additional equity. Moreover, in the earnings call, they attributed the negative Q1 2024 performance for CARR and contracted backlog to the profitability-boosting initiatives:  In the quarter, we implemented a proactive effort to upgrade the backlog to focus on the most profitable opportunities, which caused a slight reduction to CARR. This underscores our unwavering focus on driving cash flow generation against our full year target of more than $50 million for 2024. (John Carrington, CEO) The decrease in the contracted backlog in the quarter was driven by a proactive effort to upgrade the profitability profile of the backlog, focusing resources on the most compelling opportunities. We cancelled around $257 million of contracts that were lower margins or expected to utilize working capital based on this review. (Bill Bush, CFO)  Stem's business regularly experiences strong volatility, with the majority of bookings and revenues usually being realized towards the end of any given year. This time, however, the Q1 bookings figure came in at a by far record low level and cratered even on a YoY basis. Management attributed this to increased volatility and reiterated its full-year guidance while emphasizing continued \"strong commercial momentum\" and \"sufficient pipeline\". Regarding the impacted revenue figures, Stem is still negatively affected by contractual obligations made in late 2022 and early 2023, where its management decided to grant hardware price guarantees \"in order to gain a foothold in the public power and large front-of-the-meter markets\". These guarantees impact revenue negatively but have no cash implications. According to the CFO, management expects that the projects for which these guarantees were granted will give Stem a \"long-dated revenue stream of high-margin recurring software revenue\". There are still some contracts with these clauses to deliver upon, which will probably impact revenues for Q2 and Q3 2024, but no such guarantees have been issued since June 2023 and management committed to not issue any hardware price guarantees in the future. Altogether, the company adjusted its full-year revenue guidance downward for the $33 million impact in Q1, yet, management reaffirmed the full year 2024 guidance across all other key metrics. New Product Launch Together with its Q1 report, Stem announced its new asset performance management suite, PowerTrack APM, to foster recurring software revenues. The product builds on Stem's solar asset monitoring software, PowerTrack, and its Athena AI for energy storage forecasting and optimization. It includes individually configurable dashboards, allowing users to depict performance data in any required way. Generally, it is software for centralizing and streamlining storage, solar, and hybrid energy asset management portfolios to aid customers in understanding the impacts of technical decisions and commercial strategies. The software aims at monitoring the state of a customer's assets, tracking the performance of an entire portfolio and individual sites, managing warranty obligations, streamlining operation center processes, and measuring the impacts of technical events aiming at minimizing risks and driving returns. A beta solution is going to be released to select customers in the summer, and a final version will be available to all customers by year-end. According to Stem's management, interest from existing and new customers for such a comprehensive tool is strong, and a similar solution does not currently exist in the market. The company plans to generate high-margin solar revenue with this product, expand its addressable market, and allow for timely deployments on already operating assets. Slowdown due to Interconnection Limitations Also in the Q1 earnings call, Stem's management hinted that the protracted interconnection situation in U.S. electricity grids is one of the key issues leading to increased volatility and delays in project starts. Indeed, the Berkeley Lab for Energy Markets & Policy recently published a study according to which the grid connection backlog grew by 30% in 2023, dominated by requests for solar, wind, and energy storage projects. Queued capacity increased about eightfold in the past decade to nearly 2,600 GW of generation and storage capacity is now actively seeking grid interconnection. Bill Bush responded to an analyst's question in this regard by saying: I think that interconnection and permitting have always been a problem. And I think this year in particular, I think we've seen some additional slowdowns to what we've seen in prior periods. [...] I think we are seeing slowdowns there. But that's, you know, that's becoming a smaller part of the overall business of the company. And so, that's how we're combating that negative headwind, is by moving away from projects which are particularly susceptible to those sorts of delays. (Bill Bush, CFO) Judging from this, the current situation in U.S. grids is exerting a strong effect on the entire sector, contributing to Stem's disappointing Q1 2024 figures. Bill Bush's response clearly shows that there is not a lot that Stem can do about it other than prioritizing unaffected projects and accepting the delays. However, measures are being undertaken such as by the Federal Energy Regulatory Commission in 2023, which are supposed to take effect over time and better the situation. This would be positive for Stem. Impact of Interest Rates Stem and the entire renewables sector have also been affected by increased interest rates, both, by higher costs of capital for renewable investments, and a change in perception of the capital markets. First, the increased costs of capital have, according to Wood Mackenzie (a leading data and analytics provider), profound implications for the industry, particularly regarding the cost and pace of the transition to low-carbon technologies. Debt accounts for a high share of the capital structure for low-carbon energy sectors. Subsequently, the higher costs of borrowing leave the energy and natural resources sectors particularly exposed, as they are highly capital intensive and are often reliant on subsidies. The International Energy Agency (IEA) also highlighted this effect in a recent study. Secondly, increased rates additionally led stocks in the entire renewable energy sector to compress in valuations. The graph below depicts the Price/Sales ratio for Stem and two other exemplary companies in the renewables space. Enphase Energy, Inc. (ENPH) is a well-known provider of inverters for the solar industry and Ørsted A/S (OTCPK:DNNGY) is a leader in offshore wind energy projects. Valuations in terms of P/S ratio have clearly contracted for these three companies - with an exceptionally strong contraction for Stem which has lost more than 95% of its relative valuation compared to its peak. Data by YCharts Sector-specific indices for clean energy, renewables, and solar respectively show a similar development. The exemplary indices below are all more than 30% below their H2 2022 peaks, despite record renewable energy production capacity growth and record state subsidies. Data by YCharts All of this clearly shows that Stem's business is quite sensitive to the development of interest rates. While this is a burden on Stem's operating performance and valuation right now, it could become a catalyst for the company as soon as the FED starts to seriously consider reverting its current interest rate cycle. Prospects and Valuation In general, Stem is riding a wave of multiple megatrends which should give the company strong tailwinds. On the one hand, the prospects for the renewable energy sector and in particular solar are great. Major institutions like the IEA predict total global solar capacity to double from 2024 to 2028 which would mean that net additions would almost triple compared to 2022 levels worldwide and in the U.S. The DoE expects that solar generation could represent 40% of the entire U.S. electricity supply by 2030. On the other hand, the volatile nature of these renewable sources necessitates an increasing need for flexible storage. IRENA thus estimates a required worldwide flexible storage capacity of 11.9 to 15.7 TWh at an 80% renewables share to mitigate generation variability. For the U.S., battery storage only started being utilized on large scales in 2020, but is expected to take on most of the capacity needs in the future. Stem's software solutions are right at the epicenter of these megatrends and are regularly being awarded for e.g., Top Product, Innovativeness, or Best Predictive Analytics Platform (all just recently in 2023). Additionally, as the largest energy storage virtual power plant operator in North America, Stem is in a good position to strongly capitalize on these growth opportunities so that the current hick-ups in the company's operating performance might actually only be temporary, like the management claims. Nevertheless, the sector downturn and declining trust in the management's promises have led to an incredible compression in Stem's valuation which is now for instance at a forward PS ratio of only 0.3. Considering that the company is aiming to be a recurring software revenue play in the above megatrend markets with a market-leading position and award-winning, innovative AI products, this valuation seems to really account for a lot of negativity and worst-case scenarios. I've seen this with quite a few small-cap stocks lately that are actually in a good competitive position in a megatrend market but are surrounded by a lot of negativity. These stocks at very low valuations tend to explode once positive catalysts like announcements or analyst ratings materialize (here is an example from two weeks ago that I analyzed in February) and I could imagine Stem being one of them in the future. Data by YCharts While Seeking Alpha's Quant rating for Stem is a Strong Sell (mostly due to the incredibly negative momentum and recent issues with growth/profitability), Wall Street analysts are quite positive. Of the 15 analysts covering the company, no one rates it a sell while 10 and 5 assign a hold or buy rating respectively. The average price target is at $4.05, implying an upside of about 200% from current levels - though I could imagine some analysts revising their outlook for Stem downwards after the latest Q1 results. Since Stem is currently in a transitional period and future profitability levels are difficult to predict, I am not quite ready to calculate a price target for the stock. However, like already hinted above, I believe the company is too cheap and the current price suffers from a lot of negativity. Particularly if the latest management initiatives work out and Stem finally turns into a profitable high-growth recurring (AI-)software revenue play, the current valuation could turn out to be a serious mispricing. In this case, the share price should move back above $5 fairly quickly and still have further potential upside. Conclusion To be clear: Stem's recent quarterly results were bad - particularly the latest Q1. Management believes this to be a convergence of unfavorable circumstances and when taking a deeper look, the interest rate environment, the situation in the U.S. electricity grid, and legacy contract obligations do contribute to explaining the predicament that the company currently finds itself in. But the management has also made mistakes in my view and communicated too optimistically in the past. This and the overall sentiment for the sector have led to a collapse in Stem's share price from beyond $45 in 2021 to just above $1 today. Yet, the quality of and demand for Stem's products still seem to be good and the majority of the huge share price decline is attributable to a multiples compression. Stem is right at the epicenter of two of the largest megatrends at the moment, namely the energy transition and AI, and is positioned as a market and innovation leader. Also, there was a lot of management optimism in the recent earnings call regarding recurring software revenues (\"a significant uptick\" expected when the first sites of the Ameresco project go live in May) and commencing profitability. Additionally, and this should come as a surprise to some analysts, Stem expects not to require any further equity issuance in the future. All in all, I feel the management is trying to execute what has regularly been criticized in the past years and if it delivers, this will let Stem become the recurring revenue play that everybody wanted it to be in the past, leading to a re-evaluation for the company's perception. Also, a change in the FED's interest rate policy could lead the entire sector upwards. With regard to its depressed valuation, I rate Stem a BUY - being aware that I might be a bit early to the party and the currently unfavorable sentiment and momentum could still drive the stock a bit further down before finally forming a bottom. Additionally, the next two quarters are still going to be affected from hits to the company's revenue due to legacy contractual obligations (yet no cash implication) which might dampen any evolving positivity.  This is a risky and highly volatile play at now and any position in the company should be taken in a risk-aware manner. I already hold a small first position and plan to add cautiously before the next earnings release. After this, I'll evaluate if my thesis shows the first signs of playing out and if so, I will add more.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.24.0","shortVersion":"4.24.0","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2433268954"}