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Shawn Severson: Surprising Opportunities in Cleantech
Source: Brian Sylvester of The Energy Report (9/30/10)
Cleantech goes far beyond solar power, according to Shawn Severson. As a managing director of cleantech research with ThinkEquity in San Francisco, he finds mainstream companies poised to cash in on common-sense technologies that save energy and money. In this exclusive interview with The Energy Report, Shawn makes the case that cleantech is as much about saving money as it is about saving the environment.
Shawn Severson: I have been a technology analyst most of my career. In London, I actually switched roles from research to institutional sales. I worked with a variety of industries and companies as I approached my clients with ideas. That's where the cleantech aspect grabbed hold of me. In the European market, there is a very different approach to cleantech. I saw a tremendous opportunity to focus research on cleantech in the U.S.
My goal has been to look at traditional companies, such as Cooper Industries Ltd. (NYSE:CBE) or Acuity Brands Inc. (NYSE:AYI), and identify cleantech trends that are going to benefit those types of companies. I want to find strong cleantech tailwinds and underappreciated or overlooked companies as cleantech plays. These are certainly great companies in their own right, but some of the trends that are happening inside these organizations aren't always fully recognized by cleantech investors.
TER: What about the European market got your attention?
SS: Investment in the cleantech industry is much more developed in Europe and Asia. They have a more comprehensive view of what cleantech is and how to invest in it. My experience with clients in London expanded my knowledge on how to invest in cleantech and other opportunities on a global basis.
Looking at companies like Impax Asset Management Group Plc (LON:IPX), Ecofin Water and Power Opportunities Plc (LON:ECWO) and many others in Europe gave me a comprehensive approach to cleantech research that goes way beyond a few solar companies here and there. Cleantech is encompassed in numerous different aspects of water treatment, water conveyance, energy efficiency and encompassing things like lighting and heating, ventilation and air conditioning (HVAC) companies. I've developed a much broader perspective on cleantech and how to invest in it.
TER: How would you define "cleantech"?
SS: Cleantech is generally anything that's involved in improving energy efficiency and energy consumption, or in looking for renewable sources of energy. But I believe U.S. investors need to broaden this definition. Companies can benefit from all those aspects of cleantech and have product that people don't always think of. Take wastewater treatment, for example. How does that play into cleantech? Well, it certainly does because it addresses water shortages, pollution, environmental concerns and regulations. Companies that are involved in that aspect of the market certainly can benefit from those trends.
TER: Could such a broad definition of cleantech lead some companies to brand themselves as cleantech in order to leverage on the burgeoning industry when perhaps their strategy isn't really cleantech?
SS: For a company to qualify as cleantech in my universe, it must have 25% of its revenue coming from cleantech products or services.
The index company FTSE in London and Impax Asset Management, a former client of mine, developed the FTSE Environmental Markets Index series. They meticulously broke companies down into cleantech percentages. The indices have a broad definition of what an environmental technology is, but they require that from 20% to 50% of a company's business be derived from those technologies.
In Asia and in Europe, that's very important because the indices are a benchmark for a lot of cleantech funds. However, in the U.S., we have a very underdeveloped market of cleantech funds. We have some exchange-traded funds and a few funds define themselves as investing in cleantech, but it's still a very early stage market for the U.S.
TER: Why should U.S. investors start taking notice of this relative unknown sector?
SS: One of my favorite areas of investment is in "smart" buildings. About 30% of the operating costs of a traditional commercial building on an annual basis is from electricity. Lighting in a typical building accounts for nearly 39% of an electricity bill. There is a lot of potential to reduce that by doing something as simple as turning the lights on and off automatically. That's where investors should focus.
We spend billions and billions of dollars in areas like solar and more speculative areas of alternative energy, but wouldn't it be simpler to figure out how to use less electricity first? These are the types of things that cleantech can offer in terms of energy efficiency. Turn the lights off first. Figure out how to do that. The economics of that are pretty straightforward. That's also the beauty of cleantech for investors and for companies that participate in this market.
I try to find products that offer a return on investment that will create demand. There are some interesting and compelling growth stories driven on an ROI basis from products in lighting, HVAC, insulation and windows. There are a number of applications and products that are not speculative technologies and that aren't being "green" just for the sake of being "green." These are financial decisions that can drive demand.
TER: Many investors might think that cleantech is too specialized for a diversified portfolio. Is this true of your coverage?
SS: Inherently, I try to find diversification. An interesting aspect of my approach is that these companies are mainstream but have significant parts of their business that benefit from cleantech applications. Take a company like Cooper Industries. It is a major player in supplying utilities with products like transformers and is also a major player in smart-grid applications. Cooper is one of the top four suppliers of lighting fixtures in the world, as well. It sells thousands of products to the refinery and manufacturing sectors. About 30% to 40% of their business is driven by cleantech, but they also have traditional exposure.
TER: What percentage of an investor's portfolio should be in cleantech?
SS: If it was just pure cleantech, such as solar companies, natural gas vehicle companies and lithium-ion battery maker A123 Systems Inc. (NASDAQ:AONE), an investor probably wants to keep about a 15% interest in that type of allocation. However, the way I think an investor can enhance that, while at the same time reducing risk, is investing in companies like Acuity Brands and Cooper. Those types of companies provide the cleantech aspect, as well as diversification through industrial growth.
Investors should be careful about piling too much into a very narrow segment of cleantech, however. Those investments have a role, but it is a small role, like 10% to 15%. Then boost that exposure through other growth ideas that can benefit from the more obvious cleantech tailwinds without being pure plays.
TER: Are there any cleantech myths you would like to dispel?
SS: One myth is that light-emitting diodes are the only way to play enhanced lighting. It's certainly true that over time LEDs are going to be a very significant part of the market, but there are other ways to improve energy efficiency, such as an occupancy sensor. I would encourage investors to keep an open mind and not focus exclusively on LED suppliers like Cree Inc. (NASDAQ:CREE) as the only way to play this trend.
On the fuel side, I've looked at a number of private liquefied natural gas (LNG) companies and others trying to find alternative fuels. These things take a lot of time and a lot of development. Solar was supposed to be the thing even back in the 1970s and it's just now being implemented in the marketplace. Investors should be focused on products in cleantech that offer a legitimate ROI to the user and to the customer.
TER: In a recent ThinkEquity report you wrote, "Energy efficiency is an ROI-driven decision that is viable even in slow-growth economies." In 2009, about three-quarters of the retrofit activity on existing buildings worth about roughly $30 billion was related to energy efficiency. By 2014, that's expected to grow to almost $50 billion. What are some companies poised to benefit from that growth?
SS: Acuity Brands and Cooper are the way to play this. Lighting is one of the first points of attack for energy efficiency in smart buildings. Both of these companies have excellent plays into smart buildings and energy efficiency because they can offer paybacks within three years. A company making an expenditure on upgrading a lighting system can be paid back in as few as three years through energy savings and everything after that is dropping to the bottom line.
In terms of the green angle, this is good for the environment. The building could be certified as a Leadership in Energy and Environmental Design (LEED) building or through the ENERGY STAR program. That's why these companies offer a unique opportunity. They're cleantech because they save energy, but energy is money. These products save money and that's something everybody can relate to—green or not green.
TER: Let's talk more about Acuity, which you have rated a "buy" with a target price of $51.
SS: Acuity Brands, one of the leading lighting companies in the world, makes lighting fixtures or luminaries. It does not make bulbs or LEDs. It sources those from other companies like Cree. Acuity also makes sensors and switches for energy-efficient lighting systems.
Historically, this business has been focused on new commercial construction, but now retrofitting and energy conservation are on the forefront of people's minds. Acuity Brands is one of the companies that will benefit from a three-year or longer trend of retrofitting commercial buildings. The footprint of existing commercial buildings is significantly larger than the new construction that's put in place every year.
In fact, Cooper, one of their competitors in lighting, just pre-released positive numbers for their fiscal third quarter recently. One of the major factors that they specifically cited in my conversations with them was the fact that retrofit commercial lighting is significantly better than they had anticipated. Acuity Brands is scheduled to report in early October.
TER: We're not talking about small companies here. Cooper had revenue of $5 billion dollars last year. You have a "buy" rating on Cooper as well, with a target of $59. It's trading at about $48 right now. Do you believe that we're going to see a short-term catalyst right now for share appreciation with Cooper?
SS: I do. Cooper has a cleantech theme, but it's not the only reason to own its stock. They also participate in the utility industry.
There was actually a decline in the demand for electricity in the U.S. recently, which is the first time that's happened. A lot of stress came off the grid and utilities deferred expansion and upgrades that they had planned.
Going forward, however, there are limits to how long utilities can go without spending on expansion. Cooper is in a very interesting position because it will benefit from the lighting trends we talked about and it's also a significant player in the utility grids—smart grids, traditional infrastructure and transmission.
An investor in Cooper gets great participation in lighting and great participation in the grids.
TER: In the same research report you wrote, "A large portion of the cleantech industry is focused on driving new ways to generate energy, but we believe this sector offers a large body of product and services capable of significantly reducing energy consumption TODAY." What are some companies with those game-changing products and services?
SS: Capstone Turbine Corp. (NYSE:CPST) manufactures a micro-turbine that generates clean energy. It can be used during peak times instead of paying very high prices for energy coming from a grid.
The interesting aspect is that it's not just a generator. It works very well in what's called CHP, or co-heat and power generation. Think of all the heat that comes out of a generator. It can be used to heat a building or water, or for any industrial process. Taking the energy-efficiency theme one step further is capturing that heat and utilizing it for any one of those applications. Products like the micro-turbine capture all of this potentially lost energy otherwise just emitted as heat. It's green and it's clean, but the fact of the matter is it is a financial decision. It reduces electricity consumption for heating.
TER: Capstone's a pretty small company, with a market cap of around $250 million. You rate it a "buy" with a target price of $1.50. It's trading around $0.70 now.
SS: It's very speculative.
TER: Is there something about this technology that makes it a clear winner above similar technology?
SS: The problem with the micro-turbine industry has been that upfront costs have been very high. They're more efficient over time and total cost of ownership. The key is to drive down the upfront costs versus a reciprocating engine.
A micro-turbine is significantly cleaner, however. A company could spend hundreds of millions of dollars and make very, very little improvement on the emissions of a reciprocating engine. In areas like California, where there is California Air Resources Board (CARB) certification, most reciprocating engines can't even qualify. To get to a new level, we have to change the technology. Micro-turbines are a proven technology. I expect that over time there'll be a greater adoption rate of micro-turbines in the overall marketplace.
Capstone just happens to be a market-share leader. Bear in mind there are plenty of turbines out there, but they're not micro. This is a smaller unit generating about 250 kilowatts versus 1 megawatt. It's a smaller portion of the market in terms of the size, but nonetheless a very interesting technology.
TER: You said in a report that investors should view water as an "investable theme" because of supply/demand imbalance. Can you give us a couple of names that match with that thesis?
SS: Some people believe that water is an inalienable right and they're not going to pay for it. But every study indicates that we're going to have an increasing problem with water as agricultural needs rise, the population expands, and as standards of living increase in developing countries.
PICO Holdings Inc. (NYSE:PICO) owns a significant number of water rights in the Southwest—the Las Vegas and Phoenix areas and the Colorado River corridor. That area has seen a big boom in demand over the years. The real estate bubble drove demand because you can't build a new subdivision or development until you have access to water. PICO is subject, to some degree, to what's happening in the real estate market, industrial production and growth of the southwestern states. As an investment theme, PICO is an interesting way, and perhaps the only way in the public market, that an investor can get access to a water-rights play.
Another play on long-term water shortages is Energy Recovery, Inc. (NYSE:ERII), which I have rated a "hold." The company has a product that's used in the reverse-osmosis market to turn saltwater into freshwater. The product is about 60% more energy efficient than older, traditional technologies. Areas like Australia, Spain, North Africa and developing nations rely on seawater as one of the primary sources of incremental freshwater. Those areas require reverse-osmosis plants.
Energy Recovery shares have a fair-value estimate of $7.50 and were trading in the $4 range recently.
TER: PICO just agreed to build and operate a canola processing facility in Minnesota, but the stock has come under pressure recently and come down quite a bit.
SS: Yes. It was trading around $28 today. I have a "buy" on PICO with a $48 price target.
TER: What are some small-cap cleantech names that investors should be aware of?
SS: A very important part of cleantech that should be in investors' portfolios is natural gas vehicle companies. There's been lots of buzz about those companies since the New Alternative Transportation to Give Americans Solutions (NAS GAS) Act of 2009. I definitely think investors should own one stock in that space.
Natural gas has a lot of appealing aspects: It's cleaner, cheaper and abundant. Now electric vehicles are certainly interesting, but we need a bridge technology before something like that becomes widespread. The fact of the matter is that big, heavy-duty Class A trucks will probably never run off of electricity. They will still need a large engine. Natural gas provides a great bridge technology.
The adoption rate of this could accelerate dramatically if there is some positive legislation, which is likely to get passed late this year or early next year. That could create a major uptick in demand for fleet vehicles and larger trucks.
TER: What are some companies in that space that are poised to benefit from that type of legislation?
SS: Westport Innovations Inc. (TSX:WPT) is my favorite. I also think Fuel Systems Solutions Inc. (NYSE:FSYS) is a very interesting investment opportunity. There are also some companies that I don't cover, such as Clean Energy Fuels Corp. (NASDAQ:CLNE) and the Italian company Landi Renzo S.p.A. (BIT:LR), which is active in Europe and the U.S. now.
Natural gas vehicles are all over the place in Europe. If you were a European, you would have one or know someone that has one. It's more of an unknown in the U.S. Natural gas vehicles are also common in emerging markets like Pakistan and South America. It's my perspective that investors should own at least one of these names going forward.
TER: What do these companies do?
SS: They basically take a traditional engine, be it a large-scale diesel engine or a car engine, and convert them to run off of gasoline, natural gas or both. The conversion can be done right on the factory floor or as an aftermarket retrofit. There are very large aftermarkets for conversion in other parts of the world.
Westport is a little different—it is focused on the heavy-duty and medium truck market. Westport, which is partnered with Cummins Inc. (NYSE:CMI), converts engines to natural gas right on the Cummins manufacturing line.
Some of those run off of liquid natural gas, which is required for the big Class A trucks. That's a much more complicated technology that other companies like Clean Energy, Fuel Systems and Landi Renzo don't have the patents for. Westport is the only company today that can supply those types of engines.
TER: One issue that I would have as an investor is that there's no infrastructure here for natural gas vehicles. Where do you go to fill up your natural gas car in the U.S.?
SS: Right. In Europe and other markets it's no problem. China, like the U.S., does not have much of an infrastructure. However, China and the U.S. are still tremendous market opportunities. The opportunity isn't from individuals buying natural gas vehicles. The opportunity is from companies like UPS, AT&T or the post office that have fleets of vehicles that return to the same place every night. In that situation, there's no problem with infrastructure because they can have a natural gas fueling station at their sites.
TER: Are there cost benefits that would make that type of investment worthwhile for a company?
SS: Yes. Natural gas is about $1 less a gallon compared to its gasoline or diesel equivalents. If a large truck burns 20,000 gallons a year, that could add up to a lot of savings for a company. Plus, there are some excellent subsidies from the government for buying a natural gas engine. Upcoming legislation could increase these incentives even further.
TER: Do you have some final thoughts on cleantech that you'd like investors to take away?
SS: I would encourage investors to open their eyes and understand that cleantech can be a driver within a company. It doesn't have to be a pure-play approach. Look at how some of these companies can benefit from a cleantech segment of their business. The market has not yet fully recognized the growth potential that can come from cleantech tailwinds. I want to find positive surprises. Cleantech can generate surprises over the next couple of years for companies that we don't always identify as being in the cleantech sector.
TER: Thank you for your unique perspective, Shawn.
Shawn Severson has more than 16 years of experience in the investment industry as an equity research analyst and institutional salesperson. He recently joined ThinkEquity in San Francisco from Robert W. Baird in London, where he was a director in the institutional sales group and specialized in working with global hedge funds and proprietary trading desks. Previously, he worked as a senior analyst at Raymond James in St. Petersburg, Fla., where he covered the IT supply chain for more than eight years. He has been ranked numerous times as one of The Wall Street Journal's "Best on the Street" and received recognition for stock picking and earnings estimate accuracy from Starmine. Before joining Raymond James, he worked as a senior analyst at EVEREN Securities (Kemper) in Chicago covering the technology sector.
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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3) Shawn Severson: From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.