Company Overview and History
Echelon was founded in 1988 by Clifford “Mike” Markkula Jr., who also has served as CEO of Apple in its early days. For years, the company operated in two divisions: Internet of Thing (IoT) and Grid. Both sides suffered operational difficulties and wasn’t able to turn to profit. New CEO Ron Sege was brought in October 2010 to try to turn the ship. In August 2014, Echelon agreed to sell the whole grid business to a European company S&T AG. Around the same time, it also made an acquisition of Lumeware, a smart lighting startup. It was essentially an asset swap, so that the new company can get rid of non-core business and focus on smart lighting – the area management thinks has the most potential.
The troubled operation was reflected by the stock price as it lost almost 95% value since 2007. Also noted, that the firm had a 10 for 1 reverse split in December 2015, so you are basically looking at a penny stock to some extent ($0.6 if adjusted for the reverse split).
After the changes, the business operates in two segments: 1) embedded systems and 2) smart lighting. Embedded systems include the legacy IoT division’s products which are the networking products (chips, routers, gateways & software etc.) for Industrial IoT devices (smart meters, refrigerators, etc.), however this side of business kept deteriorating on a continued basis. Smart lighting, on the other hand, consist the acquired Lumeware products plus the existing lighting control IoT products (wired & wireless controllers, gateways, servers & software etc.) In the most recent investor presentation, management indicated the lighting business has seen 4 straight quarters increase (however, without further details). Clearly, the management has identified the lighting business as the future of company and allocated resources accordingly to pursue this opportunity (e.g. hiring lighting controlling sales veteran Rick Schuett on April 2016)
Basically, it is an unloved business by Wall Street as the legacy businesses are doomed and the turnaround seems to take much longer than expected, if not impossible. When a stock looks like a road kill, it may be a great opportunity for investor who can see through what appears at the surface. Next thing is to examine whether the price is attractive enough to make this crappy business (suppose it is for now) an attractive investment.
Valuation – Downside
The first question is always what if it doesn’t work out, how much you could lose? Thanks to the restructure and asset write down in 2015 and 2016 (unfortunately at the cost of the prior equity holders), Echelon had a quite clean and strong balance sheet. Assuming 25% discount on the Receivable, Inventory & Other Current Asset (0.75*$7.6M = $5.7M), plus $23M Cash and Short Term Investment, less Total Liability of $8.5M, you get net current assets (Ben Graham’s net-net) of $20.2M, that is $4.56 per share. This suggested a 24% downside. However the operation is still burning cash, though at a much slower rate thanks to the aggressive cost cutting. According to 2106’s filing, cash burn rate is about $3M/year. That translates to $0.68/share (11%) annual net current asset erosion if they could not turn the lighting business to profit. Overall, it is a very risky position (warranted that using net-net is conservative already), which means investors should request a very attractive upside to consider buying in.
Valuation – Upside
To get the upside of such a business is by default very speculative, given there is no operation history (both for Echelon and for similar businesses in the same industry). To do so, we attempt to figure it out by thinking through following key questions.
1. How’s the outlook for the “smart lighting” industry?
In short, looks pretty good.
According to Echelon’s own investor presentation in February 2017, the connected outdoor lighting market is expected to be a $2.5B market by 2022 with a 40% CAGR, based on researches from Strategies Unlimited.
Of course, you don’t only take words from the company’s presentation. Another study about LED & Smart Lighting industry from Northeast Group [link here], concluded that “LED and smart streetlights are projected to reach 89% and 42% of the total streetlight market, respectively, by 2026. This will total a $69.5 billion market opportunity over the next decade.” And “global investment in public LED street lighting will be $57 billion with a further $12.6 billion invested in “smart” networked streetlights from 2016 to 2026”.
Among the largest US cities, City of Chicago has taken an initiative to its first smart lighting project. [link here]. According to the RFI [link here], “goal is to convert as much of the City’s and Parks’ lighting to LED and modernize as much of the lighting grid infrastructure as possible without the use of public capital; i.e. all PROJECT costs are funded from utility savings, new sources of revenue, available rebates and grants, and/or other cost savings.” And the total fixtures count is 348,500.
Additionally, one of Echelon’s direct competitors in smart lighting network industry, Sensity Systems, was acquired by Verizon [link here] in September 2016 with an undisclosed amount. The question is whether it is a distressed disposition of Sensity or a growth investment of Verizon. It certainly looks more like the latter, so it’s an indication of Verizon’s opinion of the industry.
The Northeast Group report also mentioned that East Asia will be one of the largest markets for networked lighting, next to US and Europe. Some basic research (i.e. googling) can find that two largest network/IT players in China, Huawei & ZTE, both started their smart lighting projects in second half of 2016. Some links below (in Chinese):
https://xueqiu.com/2145387690/68795152 [Huawei & ZTE set off the wave of smart city, LED smart street lighting sees big opportunity]
http://www.huawei.com/cn/news/2016/3/City-Lighting-Solution [Huawei released lighting networking solutions, which can save 80% of urban lighting electricity consumption]
https://www.youtube.com/watch?v=uHMbkQ3ORHk [Huawei and Enika Smart Light launched Connected City Lighting Solution]
http://enterprise.zte.com.cn/cn/cebit2016/news/05_0314/ [ZTE released the “Blue Pillar” smart street light program]
http://finance.sina.com.cn/roll/2016-08-03/doc-ifxupmws1616657.shtml [Smart street lighting construction will become the focus of smart city development]
If these largest network/IT players around the globe, as well as the largest municipals in US start to invest in smart lighting, I’m comfortable to take a favorable view of the industry.
2. How does the management think of Echelon’s prospect?
To get the answer for this question, we don’t look at management’s statements in filings or presentations. Rather we look at their stock based compensation plan to see how the management voted by their feet. In August 2016, the company arranged a special shareholder meeting [proxy statement link here], with primary goal to approve a new equity incentive plan (note that the last equity incentive plan was from 1997, prior to its IPO). According to the proxy document, Echelon asks for another 500,000 shares (that’s the shares after the reverse split), which accounts for 11% dilution if fully used, for the next 3 years. The question is why now (as opposed to a few years ago)?
Two take-away in layman’s language are:
- Because of the stock price drop, the old stock based compensation executives and employees held are worthless now. Thus the executives and employees are not incentivized at all by these old packages and desperately need new equity incentives.
- Even the company is still losing money, the executives and employees are now willing to take the new equity incentive (which had grant/strike price at least 10% higher than the fair value, i.e. market price) as another type of currency, in replacement of some of the salary sacrifice due to recent aggressive cost cutting strategy.
Although the dilution is generally a bad thing for equity holders, we take it as a very positive sign as the insiders think it’s a good deal for them to take the share as part of compensation at this price level.
3. How much potential upside are we looking at after all?
Given the nascent nature of the industry and negative cash flow, traditional valuation approaches may not be applicable. EV/Revenue ratio might be the most relevant, albeit still not perfect.
We reached out to the investor relation team, asking for breakdown between legacy embedded systems and lighting business. However, they indicted they haven’t done the breakdown and can only confirm the majority of the revenue is still from embedded side. This is not surprising because if lighting revenue is material, they would’ve disclosed it already.
To get some base line, we have to get an estimate of the stable revenue Echelon can generate. This is a hard call, but any number is better than no number at this point. We speculate that Echelon may keep experiencing 10% decreasing until growth of lighting start to offset shrinking embedded business in 2 years. That gives a revenue number of $26M in 2019.
There is no public company in the same smart lighting network pure play business (most of them are still private, Telensa, CIMCON, Digital Lumens to name a few), we have to use following public approximate comparable to get the EV/Revenue ratio:
Silver Spring Networks
Description: a broad IoT network player, shares the same IoT industry tailwind
EV: $585M Market Cap+(-$105M Net Debt) = $480M
TTM Revenue: $331M
Description: Smart meter IoT player, shares the same IoT industry tailwind
EV: $2,340M Market Cap+$156M Net Debt = $2,496M
TTM Revenue: $2,013M
Description: LED lighting pure player, shares the same LED Smart lighting tailwind
EV: $2,440M Market Cap+(-$445M Net Debt) = $1,995M
TTM Revenue: $1,509M
Description: LED lighting pure player, shares the same LED Smart lighting tailwind
EV: $7,830M Market Cap+(-$58M Net Debt) = $7,772M
TTM Revenue: $3,433M
If taking the average of 1.57 EV/Revenue, Echelon could worth $41M EV in two years. You add back the net cash of $16M (burned $6M more cash in 2 years) to get a market cap of $57M, then divide it by fully diluted 4.95M shares, you get $11.5 per share, a 90% upside from current level of $6.
With more transparency and disclosure of the lighting business performance from the company, we will be able to come back and revisit this valuation. But so far the upside (speculative though) looks pretty attractive, even considering the risky downside. The good thing about its strong balance sheet is that even it may need another year or two to ramp up the lighting business, their net cash position can still comfortably support that (just a lower return rate for investors).
Turnaround Execution – The key risk is still the execution of expanding the lighting business, as the whole thesis is based on a profitable and growing smart lighting business. The bet is that hopefully the industry tailwind could propel the business even if the management does an average job.
-Market realization of the business model transition
-Performance numbers from the smart lighting business
Echelon is a promising business hidden in an underperforming legacy umbrella. The micro-cap capitalization and scarce liquidity caused it under-covered and under-appreciated from the street. Even though in the midst of a stretched turnaround execution, the company actually has a strong balance sheet and starts to see some positive signs of the new smart lighting business. The new 2016 equity incentive plan confirms the insiders’ view about the stock price in relation to the intrinsic value of the business. Even though very speculative, it worth a small position to start with, and potential add on once more concrete performance numbers are disclosed on the smart lighting business.
Disclosure: I hold long position of ELON. Also, beware of the micro cap (only $27M) nature and illiquidity of stock.