Fluence Energy: An Underappreciated AI Data Center Play

seekingalpha06-28

US companies' 100% renewable mandate is going to boost solar installations and demand for battery systems like FLNC's.Incremental load from AI data centers is projected to grow 175TWh by 2030, ...

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FLNC's.Incremental load from AI data centers is projected to grow 175TWh by 2030, providing long-term demand visibility.The renewable sector has been underperforming the market due to rate volatility and election uncertainty. This creates an opportunity to add exposure to beneficiaries like FLNC.   funky-data Investment Thesis Investors are underestimating the demand impact for renewables from AI data centers. Companies like Amazon and Meta committed to 100% renewable power procure additional renewable electricity at an inverse proportion to the renewable percentage of the electric grids in which they operate. I believe this is potentially a massive amount of incremental renewable power demand and will be a share price driver. Fluence Energy, Inc. (NASDAQ:FLNC) has positive exposure and is positioned to be a large beneficiary with continued margin improvement. Buy.  How 100% Renewable Energy Is Achieved When it comes to renewable energy stocks, one of the most common pushbacks is that renewables can't provide the reliable power data centers need, especially with AI workload growing exponentially. However, achieving 100% renewable target may not be the same as some investors expect it to be. Renewables in general, can’t provide reliable power to Apple’s retail stores, or Amazon’s warehouses, or Meta's Metaverse, or Google’s data centers. Yet, Apple has claimed 100% renewable sourcing since 2018, Amazon 90% in 2022, Meta 100% since 2020, Google 100% since 2017.  Corporate renewable targets are largely met by corporate procurement of Power Purchase Agreements (C-PPAs) in which the corporate agrees to buy the power generated from utility-scale solar and/or wind projects equal to their total annual nonrenewable electricity consumption. That renewable electricity is then resold by the corporate off-taker into the grid for general consumption by all customers. Apple explained how it works quite well in its 2015 sustainability report.  When it is not feasible to power our facilities with onsite renewable energy, we match our load with renewable energy generated by either Apple-owned projects or third-party projects. We put the clean energy we generate onto the local grid, displacing the more polluting forms of energy. The best way to think about it is like a bank: You can deposit $20 in one bank branch, then go to another branch and withdraw $20. Renewable energy works in a similar way. And Apple’s renewable energy approach goes a step further to make sure we \"deposit\" on the same grid as the energy we are \"withdrawing.\"  This is how Google is doing it now and how they plan to do it by 2030. Alphabet’s renewable energy methodology is a custom calculation and is based on a global approach. Percentage of renewable energy is calculated on a calendaryear basis, dividing the volume of renewable electricity (in megawatt-hours) procured for our global operations by the total volume of electricity consumed by our global operations. The numerator includes all renewable energy procured, regardless of the market in which the renewable energy was consumed. We set a goal to run on 24/7 carbon-free energy on every grid where we operate by 2030, aiming to procure clean energy to meet our electricity needs, every hour of every day. According to UBS, total US utility-scale solar installations were 77GW 5-years ending 2023, of which signed solar C-PPAs were 64GW or over 80% of installs. Although PPAs are not necessarily signed in the same year as installs, the above numbers should show how significant the magnitude is. Bloomberg UBS also projects that there will be around 175TWh of incremental load growth from AI data centers by 2030, in addition to the previously forecast 175TWh from regular data centers, totaling 350TWh, fully met by renewables (80% solar, 20% wind). With that said, the amount of power generated by renewables is still not enough to meet the increased demand for energy, evidenced by the fact that 60% of the electricity at utility scale was still generated by dirty sources in 2023 for the US. This creates a backlog of demand, extending the duration of demand visibility and I expect stocks exposed to this demand to go higher due to more certainty and greater long-term demand growth.  The Set-up What I like about the renewables set-up is that the starting point of the sentiment around this sector is so low following a downward stock price trajectory since the peak in January 2021 and an underperformance YTD (TAN down ~19% vs SPX up ~15%). Alt Energy ETF fund flows have been consistently negative since last year until last month. This period of negative outflows coincided with a 44% decline in the TAN ETF before the tick-up in May. I believe the outflows reflect a mix of increasing interest rates/rate volatility and election uncertainty. With the small positive inflow in May, achieving 2-3 months in a row would be a signal that investor sentiment or positioning is shifting, potentially signaling the early stages of the next renewables investment cycle, in my opinion.  Lipper Stock performance last year was highly negatively correlated with interest rates, but having reached a relatively more stable level YTD, I see the elevated correlation starting to weaken. In my view, this implies more opportunity for investors to be rewarded more by individual stock picking than by broader sector exposure decisions as was the case during 2023. Within utility scale, interest rate impacts have been mitigated by higher PPA pricing supported by strong offtaker demand for renewable energy, although volatility in the rate environment has likely driven some investment decisions to be delayed.  Monthly performance correlation, selected stocks' average (LSEG)TAN & 10-year Treasury yield (LSEG) How FLNC Can Benefit Recognizing the importance of the US electric grid in driving emissions reduction, in December 2021 as part of Executive Order 14008 – Tackling the Climate Crisis at Home and Abroad – President Biden signed an executive order which sets a goal for a carbon pollution-free electricity sector no later than 2035. The Inflation Reduction Act and the Bipartisan Infrastructure Law also provide additional support to help drive a more rapid transition. With this backdrop and what is discussed above, I think FLNC is well positioned to benefit from strong growing secular demand for utility-scale battery energy storage and declining battery costs, as battery energy storage system (BESS) is an essential enabler of renewable energy generation.  BloombergMcKinsey & CompanyBattery input prices ($/t) (LSEG) To explain further, the demand impact for FLNC is not physically at data centers. Rather, it's created by the 100% renewable mandates and price volatility arbitrage. FLNC is a battery integrator that brings together hardware suppliers (batteries) and construction (EPCs) in order to deliver to the end customer (developer, IPP, etc) a finished utility-scale battery system, and here is what motivates demand for its battery systems. Deregulated electricity markets are not altruistic. Investors generally deploy capital to earn a financial return sufficient for the risk to those returns, and being able to \"help\" integrate renewables is just a side effect in my opinion. The total amount of the potential arbitrage profit is directly related to the demand for batteries including FLNC’s systems. This is how it will play out:  Increasing solar capacity on the grid depresses daytime electricity prices.  Buying electricity during the day and reselling electricity at higher night time prices creates positive revenue. An energy storage system is needed to exploit this price or time difference.  The size of the total arbitrage opportunity is measured by:  width of the price spread the volume that can be run through this spread  Data center electricity demand growth increases both factors through the mechanism of 100% renewable targets. Granted, arbitrage is not the only way batteries can make a financial return, but it is an important one.  FLNC's Recent Performance and Valuation FLNC reported 2Q revenue of $623.1 million, beating consensus estimates of $531 million, mainly driven by accelerated project timing. Adjusted gross margins of 10.6% were largely in line with estimates, while adj EBITDA of -$6.1 million was slightly ahead of the expected -$7.61 million. Margin expansion was fueled by a higher-margin product mix. Management reaffirmed FY24 guidance with revenue projected between $2.7-3.3 billion, $50-80 million adjusted EBITDA, and $80 million FY24 recurring revenue, with 90% of FY24 revenue guidance already in the backlog.  Order intake was about $713 million, representing a book-to-bill ratio of ~1.1x, the tenth consecutive quarter of larger than 1.0x. The contracted backlog for Products was 5.3 GW, up ~200MW from the last quarter. Services was 3.6 GW, up ~100MW q/q, and Digital was 6.9 GW, up 1.2 GW q/q. The total pipeline increased to $16.3 billion, up 22% or $2.9 billion q/q. Under a robust market backdrop of declining battery prices and increasing energy storage demand driven by need for grid resiliency, and a pipeline of opportunity now exceeding 16.3 billion and contracted backlog of $3.7 billion, I see the FY24 guidance and FY25 revenue growth target of 35% as readily attainable. The below model is used to derive the price target for the stock.  A 34% revenue growth in FY24 based on management's guide of $3 billion mid-point and street estimates, and a CAGR of 30% through FY26, expecting it to grow at the same speed as the market growth predicted by McKinsey & Company. Gross margin of 12% based on management's target of 10-12% in FY2024. I believe the high end of the guidance is achievable due to a drop in battery input prices. Opex growth not more than 50% of revenue growth based on management's guidance. Target price is based on an assigned multiple of 14x my FY26 EBITDA estimate, discounted back one-year. The assigned multiple largely aligns with the average forward trading multiple since the company’s fiscal 2023 year-end in September 2023.   As a result, the implied target price for the stock is $22 per share, representing 18% upside and 30% below current consensus.  Market Gems Downside Risks: 1. FLNC’s revenue is almost entirely generated by energy storage products, and the main driver is companies' mandates on using renewable energy, which is an uncertain factor itself. If there is reduced demand for energy storage products, or if deployment of renewable energy is slower than expected, demand for FLNC’s battery energy storage hardware and software services could be negatively impacted, leading to negative share performance.  2. FLNC’s sales depend on a relatively concentrated customer base. In fiscal year 2023, its top 2 customers accounted for 49% of total revenue. A loss of any significant customer or a reduction in pricing or order volume could have a negative impact on the company's financial results. 3. FLNC sources components and materials from various international vendors including those in China, Korea, and Europe. Interruption of the flow of supply could disrupt FLNC’s ability to deliver products to customers, and significant changes in the costs of raw materials necessary for the company's products could negatively impact its financial results. Conclusion  Considering the growth of utility-scale solar installations and AI workload, plus the fact that more and more companies are working towards using 100% renewable energy, I believe FLNC's potential is underappreciated and it is well-positioned to capture this demand with its battery system. My target price for the stock implies 18% upside, but still rather conservative compared to what the street thinks it should be trading at. 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