Booth Laird Q1 2015 Letter

+1 (225) 767-1439 [email protected] www.boothlaird.com

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April 13, 2015

Q1 2015 Newsletter

Topics and Companies Discussed:

I. Primer on melting ice cube investments

A. Examples - Western Union (WU) and Outerwall (OUTR)

B. Weight Watchers (WTW) update and why not a melting ice cube

II. Hidden gems within larger companies

A. Past examples Hartford Group (HIG), Oshkosh (OSK), and Vocus (acquired)

B. EnerNOC (ENOC) new Investment Idea

I. On Melting Ice Cubes

In the investing world, a melting ice cube is any investment vehicle whose value is expected to decline

over time. The term is usually applied to stocks, but a prime example is a bond with a fixed interest rate

that also pays off some portion of the principle annually. The value of the bond will decline each year as

the principle is paid down, reducing future annual interest payments, until the full principle is paid off. An

annuity is another example. While the individual might receive payments for a lifetime, it will be worth a

little less each year as the individual ages and his expected remaining lifespan declines (assuming no

advances in medicine prolonging his life longer than originally anticipated).

Declining value might sound unappealing. You would likely be less inclined to rush out and buy a new

home if you knew its value would decline each year. Yet many people invest in bonds and annuities. The

obvious reason is that the cash flows received over the life of the bond or annuity are expected to be

higher than the original cash outlay for those investment vehicles and at an acceptable rate of return.

Bonds and annuities offer fixed or at least minimum payments over a preset period of time. How does

this apply to stocks, which offer neither minimum payments nor a maturity date?

Since businesses have existed, industries have been born, grown, matured, and then declined to oblivion

as new industries were born that rendered the original industry obsolete. Not every industry can be

replaced the look and feel of banking today would be recognized by Giovanni de Medici were he

transported from the 14th century. Also, often old industries take a long time to die many businesses

still use fax machines.

Every few hundred years, a disruption allows for a wave of new industries killing old ones. The industrial

revolution is the perfect example as its name implies. The advent of machines and manufacturing

techniques replaced hand production methods. For instance, the Spinning Jenny destroyed the home

sewing business that was the primary method for textiles. Fast forward to the modern age of computing

and the internet, which has seen the disruption of many businesses. Encyclopedia Britannica and Kodak


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are two prime examples of business destroyed by new technology though those darn fax machines are

still holding on.

I have mentioned fax machines twice as it is the image of a melting ice cube. It is not suffering a quick

death but instead a slow and steady decline. Fax machines should theoretically have died instantly with

the wide adoption of the internet in the late 90s, but it was and continues to be too ingrained in the

processes of the many businesses that existed before the internet. Change often takes time. A proprietor

who sells and services fax machines for a living is well past the years of caviar dreams and champagne

wishes. However, if the business is appropriately sized and well run, it continues to earn a profit even

today. His revenue and profit will undoubtedly continue to decline, but at a steady pace. If you bought

the business cheaply enough today, you could likely earn a reasonable rate of return on the remaining

profits you receive until the business eventually is put out to pasture.

The sticking point with stocks not as prevalent with bonds and annuities is determining how quickly the

ice cube will melt. It is impossible to predict with 100% accuracy the future revenue and profits for any

business. With businesses expected to be around indefinitely, an inaccurate prediction on the downside

is not punished as severely as a business perceived as being in steady decline. For melting ice cubes, the

market gets comfort over a certain level of decline, so one quarter with worse decline than expected gets

extrapolated to the life of business. For example, if a company is expected to see a 5% annual decline in

revenue but then declines 7% in one quarter, the market assumes the decline is accelerating and will sell

off the stock in droves. Melting ice cubes are also a beacon for short sellers expecting the decline to be

quicker than the market is anticipating, further putting downward pressure on the stock price.

Melting ice cubes can still make good shorter-term investments. The sell off after a bad quarter often

creates a buying opportunity if you can get comfort that the decline is not nearly as quick as the market

has priced into the stock. A subsequent revenue and earnings estimates beat or a positive business

development can cause a short squeeze whereby short sellers have to buy back the stock to cover their

short positions, putting upward pressure on the stock.

Western Union and Outerwall are two companies perceived to be melting ice cubes in which we have

invested.

Western Union

Western Union is a 150+ year old company that has transformed itself a few times it started as a

telegraph company. It is now the world leader in money transfer services. However, new technologies

allowing for easier transfer of funds electronically without having to physically go to a Western Union

agent has put the company into a perceived melting ice cube status for many investors despite the fact

that revenue has been stable the last few years.

For a few years, we bought Western Union after a sell off, usually around $12 to $14, and then sold after

it ran back up to $18 to $20. The stock has not reached $22 since the credit crisis. It will take a long time

for new technologies for money transfers to be fully adopted, particularly for country to country transfers


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given the compliance issues and governmental fear of terrorists having easy access to funds. Western

Union spends a lot of time and money on compliance, which to date has served as one of the barriers to

entry for the industry.

In 100 years, physical money transfers will be a small shell of its former self and so will Western Union

unless it adapts once again, but it will still be a thriving company in 5 years. That has not stopped many

investors and short sellers as perceiving the ice cube as melting quickly as evidenced by the fact that nearly

20% of the companys float is currently sold short. One bad quarter or two or lowered guidance will be

more severely punished at Western Union then it would be at, say, Google.

We are not currently invested in Western Union but would be interested if the stock drops to the low

teens again. Of course, we will need to re-examine the fundamentals and feel confident the ice cube will

melt less slowly than the market has priced into the stock.

Outerwall

Outerwall is another investment in a similar vein to Western Union. Outerwall is the world leader in self-

service kiosks and owns Redbox, Coinstar, Coinstar Exchange, ecoATM, and SampleIt. The company

started as Coinstar, which converts coins into cash or gift cards, but the lions share has become Redbox,

which has 50% and growing market share in the physical DVD and Blu-ray rental market. Coinstar

continues to grow at a steady 3% annual rate and produce steady cash flows with little risk of being

replaced anytime soon (physical money is not going anywhere for a while). However, Redboxs industry

is in steady decline by managements own admission. The result is a highly volatile stock price as investors

oscillate between various levels of expected decline in Redbox.

Redbox experienced significant growth over a short period of time even as physical video rentals were

declining and Blockbuster was going out of business because Redbox was taking market share left and

right. As revenue began to level out in 2013, the market suddenly had fears of Redbox becoming the next

Blockbuster and declining rapidly, causing the stock to drop from a high of over $62 in August 2013 to $46

by September 2013.

An activist investor became involved at that point, and, as a result, Outerwall shed 4 underperforming

kiosk concepts and focused on managing the business for maximum profit and cash flow over revenue

growth, agreeing to return 75-100% of free cash flow back to investors. The stock then rose quickly back

to over $60 by October 2013 and eventually to over $70 by February 2014. In June 2014, a report from a

sell-side analyst was published causing a renewed fear that Redbox sales would soon be plummeting,

causing the stock to drop once again to as low as $51 by October. However, much of the data was taken

out of context as it relates to Redbox and ignored the fact that Redbox had sustainable price differences

to digital rentals that traditional brick and mortar stores like Blockbuster could not come close to

matching. The price difference between Redbox and digital rentals was so significant that Redbox even

announced a 25% price increase across the board. Once again, the anticipated level of decline was re-

adjusted and the stock soared to as high as $77 by January 2015.


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Then the CEO was fired without warning, creating the uncertainty the market so despises. Preliminary Q4

earnings and guidance for 2015 was issued in the same press release in an attempt to dispel any fear it

was due to a bad quarter. However, the market had expected slightly more growth in 2015 than what the

company was guiding to, causing the stock to drop to $61 from $77 in one day. The stock steadily rose

back above $65 and has varied between $65 and $68 for a few weeks.

The recent history of Outerwall clearly shows the volatility inherent in stocks perceived as melting ice

cubes. Those types of investments can provide strong short-term returns if purchased near peak

negativity and sold when relative optimism has returned.

Weight Watchers

The discussion to this point is prologue to an update on Weight Watchers, a stock we have discussed a

good bit recently. We knew Weight Watchers would have a bad earnings report based on our due

diligence, but we were surprised by the low implied guidance for 2015 free cash flow as well as by the

markets severe reaction. As we noted in our annual letter, the new marketing campaign did not have the

impact the company hoped for, causing a further 20% decline in membership, which typically sets the

tone for the entire year given the significance of January sign ups (similar to gym memberships). We were

encouraged by the fact that the company changed its marketing by the end of January and saw a

significant increase year-over-year for the month of February as a result, proving the importance of

marketing to get new members.

A few items bothered us, however. For starters, management blames a new consumer that doesnt care

as much about weight as they do about feeling healthy. That news would come as a surprise to most of

the people I know and most of the people likely reading this newsletter. The company reached record

membership levels just three years ago. I do not think the typical Weight Watchers member was the same

for the first 50 years of the companys existence and then suddenly changed in the last three. Weight

Watcherss typical member is being bombarded by wave after wave of fitness device and free apps, each

promising an easy way to lose weight and finally get that body you so desire. Weight Watchers responded

by focusing on how hard it is to lose weight, even on the Weight Watchers program. People do not want

to be reminded it is hard. They want to be reminded it is doable. That is why we think they should return

to celebrity endorsements, which our due diligence indicated was highly effective.

Second, management is heavily focused on technology and online coaches as being the key, but the

strengths of the company are its meetings and program. The company needs to focus on the strength of

the meeting and make it as available and convenient as possible. The app and technology are a necessity

in todays world, and Weight Watchers has done a good job of developing the app and of integrating

wearable devices and the Apple health app into its program. However, the meetings and program with

its unique and highly effective point system should be what management is harping on, not the

technology.

Finally, and most importantly, management implied 2015 free cash flow of as low as $75M, well below

the $200M threshold they had not crossed below in at least the last decade, even when revenue was


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lower than what they are anticipating in 2015. We think a part of the low free cash flow projection is due

to the investment and focus on technology rather than on the meetings. Management said they are

looking to cut $100M in costs as a result. We hope it is not primarily at the expense of the meetings.

As a result of the above, we decided to trim our position shortly after Q4 earnings were released.

However, we think the price has now reached a ridiculously low level. Based on articles and comments

of other analysts, we think Weight Watchers is now perceived as being a melting ice cube becoming

obsolete due to technology, an issue exacerbated by the high debt load on the balance sheet. Three years

of declining membership that coincides with the rise of fitness devices and free apps might lead one to

that conclusion. However, an understanding of the typical Weight Watchers consumer and of its history

reveal that while Weight Watchers might be losing the battle, it should win the war.

Technology renders an older industry obsolete when it creates a cheaper or more convenient process

with a similar result. The Spinning Jenny replaced sewing by hand for mass production because it

produced the same quality of product at a fraction of the time and cost. E-mail will fully replace fax

machines eventually because it just as effectively sends the intended message but far more conveniently

and cheaply. However, the free apps and fitness devices do not produce the same weight loss result for

the typical Weight Watchers customer as the group meetings because those free apps and fitness devices

require the self-discipline and habits that prevent someone from becoming overweight to begin with. If

you have the discipline to use a fitness device to track your exercise and diet long enough and religiously

enough to actually lose weight and keep it off, then you are highly unlikely to have ever considered or

needed Weight Watchers.

The United States has a high obesity rate, and it is not due to the lack of technology to manage ones

exercise and eating habits. Technology does not prevent you from eating that extra cupcake at a party or

getting that second roll of bread at dinner. Weight Watcherss group meeting with multiple touch points

aided by its technology are clinically proven to be the best way to lose weight for the typical overweight

individual. The group support is the key, and it focuses on behavior modification rather than just a diet.

That group support cannot be replaced by technology. No one is considering replacing Alcoholics

Anonymouss current format of group meetings and sponsors with apps. Weight Watchers serves a similar

role helping the individual to modify her behavior, such as portion control and reducing snacking.

Human nature has not changed in 250,000 years and it is unlikely to start now. We are a communal

species. Our ancestors survived by forming communities. Studies show that being a member of a

community, such as a Church, can prolong your life significantly. Conversely, isolation in jails is reserved

as the harshest punishment for inmates short of lethal injection. The point being that the group support

is powerful and is precisely what makes Weight Watchers the largest weight loss management program

in the world even after three years of membership decline.

An independent study was just released this past week in the Annals of Internal Medicine comparing

eleven different weight loss programs. It found that only two programs Weight Watchers and Jenny

Craig have proven to help members lose weight and keep it off for at least twelve months. Weight


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Watchers is less than 1/10th the monthly cost of Jenny Craig, however, creating the better value

proposition of the two.

Weight Watchers has weathered competitive storms before, such as the no carb diet fad from the early

21st century. It should weather this one as well, but management needs to re-focus on what makes the

company so strong. We do not think it is an accident that membership decline largely coincides with the

current management team. We highly encourage the board to consider if this management team truly

understands what makes Weight Watchers such a strong program and to consider if changes need to be

made in the C-Suite.

The large debt load is also putting downward pressure on the stock price. The company has the cash today to make its next maturity payment of $291M due April 2016. In fact, because the debt was trading at a discount on the open market, the company offered to pay up to $75M of it early at market prices. Bondholders representing face value of $63M accepted the offer, for which management paid $57M and realized a $6M gain on bond redemption. The remaining April 2016 debt payment should not be an issue, nor should the annual interest payments. The company owes a further nearly $2B in 2020, a full five years away. Rarely do you see the market so concerned about a debt payment so far in advance, further supporting our belief that the market has incorrectly begun to perceive the company as being a melting ice cube. We are encouraged by the fact that management voluntarily chose to accept one third of its 2014 bonus in stock compensation rather than cash. They were contractually owed hard cash, and the management of most other companies would refuse to make that concession, especially if they thought there was risk the 2020 debt payment would force the company into bankruptcy. The company continues to generate substantial free cash flow even after a 33% decline in revenue over a three year period. We believe the company will continue to produce well more than enough to make interest payments and will, therefore, be able to roll over its debt in 2020. The stock is currently trading for a free cash flow yield of 18% based on the implied guidance of $75M for 2015. If the company is able to find only half of the $100M in cost savings it is targeting, that increases the free cash flow yield to over 26% using the after-tax impact of a $50M reduction in annual cash costs. The company is expecting 50% gross margins even at the low 2015 revenue level, providing ample room to cut costs and to right size the organization. We remain optimistic on the stock and continue to believe the upside is tremendous, especially at current prices. II. Hidden Gems within Larger Companies Companies often compete in more than one line of business. An investment opportunity potentially arises when one part of the company is doing exceptionally well but is overshadowed by other parts of the business that are larger, riskier, or more prominent. The market sometimes has trouble looking past the worst part of a company to see these hidden gems, which is the primary reasons spinoffs can often unlock value for shareholders whereby the sum of the parts exceeds the whole. We certainly keep an eye out for spinoffs. However, sometimes management is not so accommodating or the businesses are truly better together than they are apart. As a result, we are even more interested when a hidden gem is underappreciated by the market and management has no announced plans to force that appreciation via a sale of the subsidiary or a spin-off in the near-term. In those situations, the subsequent spin-off or sale


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or slow market realization of the value of the hidden gem can serve as a catalyst to increasing the stock price. Past Examples Some of our best investments to date have been stocks falling into this category. The one we have discussed the most is Hartford Group, which was a financial conglomerate when we invested in early 2012. It housed a property & casualty insurance business, a life insurance business, and a wealth management business. The company was synonymous with life insurance, but its variable annuity products nearly bankrupted the company during the financial crisis and forced the company to accept a TARP bailout. We were not a fan of the life insurance business but felt the property and casualty business was exceptionally strong, particularly the exclusive relationship with AARP that alone was worth a few billion dollars. However, the majority of analysts on the stock were exclusively life insurance analysts, which is a very different business from property & casualty insurance. We felt the analysts did not appreciate the wonderful property & casualty insurance business. Hartford Group was selling for 35% of net book value at the time, and we felt it was worth at least 60% of net book value. The company ultimately sold the life insurance business, significantly reduced the risk of the legacy variable annuity products, and saw its stock price increase over 200% over a couple of years. We finally sold our remaining interest in the stock and TARP Warrants in 2014 at a substantial profit. Oshkosh was another opportunity in the same vein. The company is a world leader in specialty vehicles and has a number of reporting segments focused on different markets Defense, Access Equipment, Fire & Emergency, and Commercial. We looked at the company in September of 2011. The defense segment had been performing exceptionally well due to its contracts for the wars in Iraq and Afghanistan. Meanwhile, the other three segments were down significantly, as much as 60%, from pre-crisis levels. The company was able to utilize the excess capacity available in its non-defense segments to fulfill the elevated demand for its defense segment. The wars in Iraq and Afghanistan were winding down and those contracts did not have much life left in them. As a result, the defense segment would soon decline substantially and the market sold off the stock. We felt it was highly probable that the non-defense segments would see a strong comeback as the defense segment was declining, resulting in the company maintaining revenue and substantial free cash flow. Our expectations played out, aided by a proxy battle initiated by Carl Icahn shortly after we invested. We ultimately sold in early 2012 for a 64% gain in under a year. We sold well below our valuation even after the run up because we felt management was obfuscating the impact of the defense contracts by running part of it through the non-defense segments. We also did not like the way management fought the proxy battle. Despite these concerns, the stock went on to more than double from our sale price at its peak as our predictions continued to play out. Vocus is another company where the market had difficulty getting past one particular segment when we invested in the summer of 2013. In fairness to the market this time, that segment represented the entire history of the company until recently and still comprised the large majority of revenue. Vocus is a leader in cloud or digital marketing, and for a decade its sole product was a digital press release offering. This small company few had heard of was actually responsible for more press releases than any other company in the world. It was a pioneer in the digital press release market so was able to gain substantial market share. By 2013, the digital press release market was fairly mature, especially compared to the far more nascent and broader cloud marketing industry that comprised e-mail, search engine optimization, and social media, among other facets.


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So when the company announced lower than expected guidance after the first quarter of 2013 and stated its legacy digital PR business would actually see a decline in revenue for the first time after a 32% revenue CAGR for the previous 12 years, the market responded by dropping the stock price 37% to $8.38. Our analysis indicated the market tends to value Software-as-a-Service (SaaS) companies like Vocus based on multiples of revenue, and we felt the market was ignoring the fact that Vocus was one of the few actually generating positive free cash flow. We also concluded the market was ignoring the rapidly growing full cloud marketing suite Vocus had only recently launched after a number of acquisitions. Many of Vocuss peers had been recently acquired by large companies such as Oracle at an average price to sales multiple of nearly 8x sales. Most, if not all, of those companies had yet to generate a cent of profit or positive free cash flow. Furthermore, Marketo, a company that had only recently gone public, was experiencing significant losses but trading at over 11x sales. Vocuss full cloud marketing suite was growing just as rapidly as these larger peers, yet it was trading at a 10% free cash flow yield and less than 2x sales. Further, the company was taking the strong cash flows from its legacy digital PR business to invest in the infrastructure needed (namely sales and marketing) to support substantial growth in its nascent, higher margin cloud marketing suite business. We presented the stock as our best idea at the 2013 Annual Meeting. Within a year, the company was acquired for $17, a nearly 100% increase from its low of $8.38 after Q1 2013 earnings. New Investment - EnerNOC So far in 2015, we have invested in two companies we believe fall into the hidden subsidiary gem category. The first one is highly reminiscent of Hartford Group. We are still adding to this position, however, so will keep the name close to the vest for now. If it remains at current levels through July, it will be a strong candidate for our best idea we present in-depth at our Annual Meeting. The second company is EnerNOC (ENOC), which itself is reminiscent of Vocus. Like Vocus, ENOC began roughly 12 years ago as a pioneer in a new industry that grew substantially for over a decade and became a cash cow, announced weaker than expected guidance after its first quarter earnings and saw its stock drop 40% as a result, yet has a rapidly growing second business tangent to its legacy business for which the markets assigns substantially higher multiples of revenue for the companys peers. It is almost identical to what we encountered with Vocus two years ago. ENOC is a small cap stock with a $350M market cap currently trading for $11.40 per share. The company was founded in 2003 and trades on NASDAQ. ENOC began as a pioneer in the Demand Response industry, which, per the Federal Energy Regulatory Commission (FERC), is defined as changes in electric usage by end-use customers from their normal consumption patterns in response to changes in the price of electricity over time, or to incentive payments designed to induce lower electricity use at times of high wholesale market prices or when system reliability is jeopardized. A Grist article by David Roberts dated October 7, 2014 titled Radical judge kneecaps clean electricity under cover of boringness provides a good explanation of demand response in laymans terms:


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The idea is, during times of high electricity use and grid congestion, you can pay people (or businesses) a little to reduce their consumption. If you get enough people to agree to this and develop a way to coordinate their reductions, you can reliability produce negawatts, i.e., canceled electricity demand. The companies that organize a bunch of people to do this are called aggregators [e.g., ENOC].

Now, negawatts are pretty great, generally speaking. The cleanest electricity is the electricity that never has to be generated. But reliable, responsive negawatts are even better, especially for the electricity grid. They can reduce demand precisely during those periods when it usually spikes (usually in the afternoon, especially on hot summer days, or in the evening when people are arriving home from work, cooking dinner, starting the laundry.) Power for those daily peaks in demand is supplied by peaker plants, usually natural gas turbines, which produce the most expensive power on the market. By reducing the size of those spikes peak shaving in the lingo demand response can take pressure off the grid and hold down the overall price of power.

So just about everyone the earth, the grid, utilities, ratepayers benefits from having more demand response available. [emphasis in the original]

Just how beneficial is demand response to ratepayers? One of the largest grid operators is PJM, which serves the mid-Atlantic region of the United States. Demand Response saves consumers in that area over $10 billion annually. Further, the FERC estimated in 2009 that demand response could reduce peak load by as much as 150 GW by 2019, or the equivalent of 2,000 peaker power plants. Utilities and grid operators could interact directly with its power users for demand response management, but they have discovered it is easier to outsource this function to aggregators like ENOC. Aggregators commit to a certain level of capacity, often 2 or 3 years in advance, either through direct negotiation or via auction. An aggregators capacity comes from the businesses or individuals that have signed onto that particular aggregators platform. The committed capacity is tested periodically and any shortcomings are penalized. The aggregator typically pays the fine without passing any of it on directly to the power users signed onto its platform. The alternative is for utilities and grid operators to sign up tens of thousands of individual power users and to fine its own customers for any shortcomings on committed capacity. Not many businesses want to fine their own customers, so holding an independent third party accountable is more palatable. ENOC started providing demand response in just the state of Arizona in 2003. Today, ENOC provides demand response throughout the United States as well as an increasing number of international locations, such as Australia, Canada, Germany, Ireland, Japan, New Zealand, and South Korea. Overall, the company has leading market shares in 14 grid operator markets around the world with 35% market share in the wholesale market and 80% market share among utilities outsourcing demand response directly. Further, the company realizes gross margins near 40% for demand response despite providing a pure commodity. The high margins and market share is sustainable for one simple reason network effects. ENOC focuses exclusively on commercial and industrial users of power rather than residential. Each business that signs up for ENOCs demand response program increases ENOCs capacity, thereby making it more valuable to grid operators and utilities. Each utility and grip operator that signs a demand response agreement with ENOC makes the program more valuable to the commercial and industrial users that either have numerous sites or who have multiple utilities from which to choose at a specific location. It becomes a


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virtuous cycle. Each year, the program becomes more valuable as it continues to add commercial and industrial user sites, utilities, and grid operators. As a result, demand response revenue has grown $10M in 2005 to over $370M in 2014, a ten year CAGR of 43.5%. There are still utilities, grid operators, and countries that have not yet bought into demand response. The number of grid operators the company provides demand response management to grew from 8 to 14 in 2014. Demand response has become a cash cow for the company given the high margins and the limited investments in capex and infrastructure needed to support it. However, the future of the company is an even newer industry Energy Intelligence Software (EIS). EIS is bringing the utility and energy consumption market to the modern information age, one of the last industries to make the transition. Technology has been utilized in other industries to increase productivity and reduce costs Customer Relationship Management, Enterprise Resource Planning, and Human Capital Management, to name a few. However, the utility and energy consumption market remained in the 19th century (not a typo still resembled its 1800s origins) until very recently. The creation of smart meters and the smart grid, alternative sources of energy, and demand response management just in the last decade have made it possible for energy to no longer be a fixed, unavoidable cost. Enterprises can now do much more via EIS to control energy costs, and utilities now faced with greater competition and/or incentivized to maximize customer satisfaction are also embracing ways to help their customers reduce energy costs via EIS. The EIS market is still relatively small at this point less than $1B annually in the U.S. As a result, there are no SaaS giants like Oracle, SAP, or Salesforce in this industry. ENOC is seizing the opportunity and is leveraging its dominant demand response business to do so. ENOC focuses primarily on providing its EIS to enterprises. Commercial or industrial organizations with $10B of annual revenue spend on average 3 to 5% on revenue on energy, yet they have historically done very little to manage this cost. That mindset is changing. ENOC also provides its EIS to utilities, but with an exclusive focus on that utilitys commercial & industrial customers rather than residential customers. A number of smaller companies compete in the EIS industry. OPower (OPWR) is a major competitor focused exclusively on providing EIS to utilities. The utility uses OPWRs EIS to reduce energy consumptions and improve relationships with its customers. OPWRs major focus to date is on a utilitys residential customers. Schneider Electric is another major competitor focusing on both selling EIS directly to enterprises as well as to utilities. While ENOC and its competitors each have some patents, they also each heavily leverage third party technology. Each competitor touts its software as being the best. We have encountered this type of competitive landscape before. Mohawk, the leading flooring company in the U.S., Sherwin Williams, the leading paint and coatings manufacturer in the U.S., and Vocus, the SaaS company discussed above, each faced a similar landscape with all competitors touting the most unique and advanced products. What we determined was the key to success was distribution. We have come back to this theme time and again, but it continues to be underappreciated by other analysts. It doesnt matter if you invent the only time machine in the world if no one knows about it or where to buy it. Conversely, you will sell truckloads of low quality toothpaste if it is the only option available to the consumer and is easily accessible.


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We think ENOC has a unique advantage in distribution over most, if not all, competitors thanks to its demand response business. ENOC packages the two products, which reduces the payback to the enterprise to mere months since the enterprise gets paid by ENOC for committing capacity for demand response. It becomes a virtuous cycle because the EIS makes it easier to commit more capacity by helping to control energy usage. Only Schneider Electric can also offer a cost-saving product along with EIS, but Schneider Electric charges for that product (e.g., automated equipment) whereas ENOC is paying the customer right out of the gate for being part of demand response. ENOC already has relationships with 6,000 enterprise customers, only 1,300 of which have also signed up as an EIS customer. Customers pay for the software per site, and most of those 1,300 customers are still in test phase. As a result, ENOC only has 3-5% penetration of the available sites for just those 1,300 enterprises. ENOC has plenty of room to grow without getting a single new customer, but of course they have and will continue to add new customers. ENOC is targeting the 2,000 largest enterprises in the U.S., which represent 40% of energy consumption in the U.S. in addition to having numerous sites internationally. Of those 2,000 largest customers, ENOC already has a relationship with 542 via demand response, only a portion of which are currently EIS customers. Those 542 enterprises average 600 sites each for a total of 325,000 sites. Currently, ENOCs EIS is only at 2,500 of those sites, or


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small percentage of revenue coming from EIS at this point. Despite that, it is also selling for near 2 times revenue. Meanwhile, ENOC is currently selling for only 70% of revenue despite being far more profitable than OPower and most other EIS competitors thanks to its legacy cash cow demand response business. The stock is selling at such a discount to its peers due entirely to lower than expected guidance for 2015 provided with the Q4 2014 earnings, which caused the stock to drop 40% in the last month. The lower guidance for 2015 stems entirely from the more mature demand response business, which will see a $100M decline in revenue but will remain free cash flow positive. $50M of the revenue decline is due entirely to accounting - while the cash will be received in 2015, the revenue will not be recorded until 2016. Another $20M of the decline is due to pricing that fluctuates year to year. The remaining $30M is due to the elimination of a program run by its biggest grid operator, PJM, which accounted for 52% of revenue in 2014. While 52% is a sizable number, it represents less risk than it would at other companies because of ENOCs network effects and dominant market share. We think we are presented a very similar opportunity to what we encountered with Vocus. Vocuss legacy PR business was expected to decline for the first time in a while but its newer customer relationship management (CRM) suite was expected to continue growing at a rapid pace. The market had difficulty seeing past the legacy PR business. Similarly, ENOCs demand response business is expected to decline for the first time in over a decade while the EIS business is expected to continue growing a rapid pace (projected 40-50% CAGR for at least the near-term per management expectations). The differences from Vocus are in ENOCs favor ENOCs legacy business is not in risk of becoming obsolete but instead will continue to grow and will be bigger in ten years than it is today. Further, ENOCs EIS business is an even more greenfield opportunity than what Vocus encountered with its CRM suite, which already had the likes of Salesforce servicing the large enterprises. While FCF might flatline the next few years as they invest heavily in growth on the EIS side and deal with

mostly temporary headwinds on the demand response side, gross margins will only increase as EIS

becomes the biggest part of the pie. Also, EIS revenue will eventually catch up to the infrastructure,

mainly of headcount and facilities, being built out now in advance of the expected substantial growth in

the coming years.

Below is a back-of-the-envelope valuation for ENOC, which requires a longer-term viewpoint given the short-term headwinds with demand response and the incredible growth potential with EIS. As background, the company has gone from a standing start to approximately $100M in EIS revenue in just a few years. While industry-wide figures are difficult to come by, ENOC estimates the U.S. EIS industry to be approximately $500M. Therefore, ENOC has roughly a 20% market share. That is for the U.S. only, which consumes approximately 25% of the worlds energy. ENOC estimates that $60B is wasted on energy costs by enterprises in the U.S. alone that could be addressed by EIS. Regardless, just based on number of sites in the U.S. and an estimate of cost per site, ENOC estimates the total addressable market in the U.S. to be $5B and worldwide to be $20B. Further, while demand response has solid gross margins of 40% or more, EIS already has gross margins of over 60% and, at scale, should top 70%. At just 20% share of the U.S. EIS market of conservatively $5B, likely to be reached within 10 years, the U.S. revenue alone should be $1B. Demand response revenue at ENOC today is a sustainable $300M to $325M with still plenty of room to grow. So just conservatively assume $500M in demand response


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revenue in addition to the $1B in EIS revenue for $1.5B annual revenue company-wide in 10 years. With average gross margin exceeding 50% and approaching 60%, operating margin should be a minimum of 15% (by comparison, SaaS companies at full scale with similar market share realize operating margins of 25-40%). Assuming operating margin closely resembles operating cash flows before changes in working capital, no impact from changes in working capital, and capital expenditure is a long-term average of 5% of revenue, then free cash flow should equal 10% of revenue (again, well below typical SaaS companies at scale) or $150M. Assuming a 10% discount rate and a 3% perpetuity growth rate, that yields a terminal value of $2.1B. Discounted to present value at 10% and assuming $0 net positive FCF over the next 10 years until year ten, that gives a valuation of $810M today, or 130% upside from the current market cap of $351M. Seven things to consider with those assumptions to explain why that is conservative:

1. The company will also sell EIS software to non-U.S. customers or to U.S. multinationals with international sites the international market should be three times as large as the U.S. market;

2. Demand Response will grow more than 5% annually for ENOC as it enters new markets worldwide (those already existing and those yet to accept it) and its network effect grows;

3. The company is projecting 40% CAGR on the low end annually in EIS annual recurring revenue, which would result in $1B annual recurring revenue by year 6 rather than year 10;

4. The company also provides services, such as consulting and equipment installation, that are material and not included in the above figure;

5. Operating margin is likely to be higher if gross margin is approaching 60%; 6. The company is likely to make more acquisitions to accelerate growth (or will be acquired itself); and 7. The company most likely will make positive FCF in aggregate over the next 10 years.

There is no clear winner yet, no Oracle, SAP, Workday, or Salesforce equivalent. Those guys in part became the clear winner by buying the competition. A clear winner or two is likely to emerge within the next five to ten years. If it is not ENOC, then the winner will likely have acquired ENOC along the way. This thesis sounds wonderful on paper, but some major risks to consider are: 1. The EIS market has to continue to materialize as expected; 2. ENOCs EIS offering has to continue to be accepted by the market; and 3. The company has to execute. The last risk is mitigated to some degree by managements track record in building the demand response business. The risk of EIS not becoming fully adopted seem low given the benefits and current landscape. That leaves the second risk ENOCs specific EIS maintaining market share as the market grows as the most important risk to consider. Our valuation allows plenty of room for ENOC to capture a much smaller piece of the ultimate EIS pie and still be undervalued at todays suppressed stock price. What about a worst case scenario where EIS plateaus at current levels or even declines and never becomes profitable? We think the demand response business alone is worth more than the current market cap given the substantial free cash flow it produces. Therefore, as investors we are buying the demand response business at a discount and getting the EIS business thrown in for free. FERC 745 is a hot topic currently for the demand response business that could make it less valuable. It could be an entire newsletter unto itself, so I will not go into the detail here. Instead, I will point any interested readers to this article, which explains the issues well. We do not see it is a major risk either


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way, however, given the benefits to consumers that regulators will want to preserve. http://grist.org/climate-energy/radical-judge-kneecaps-clean-electricity-under-cover-of-boringness/ In summary, EnerNOC is a dominant leader in the Demand Response market, a market it helped pioneer a decade ago and is now a cash cow that is still being more widely accepted worldwide because it is the cheapest energy alternative at peak energy consumption times. The company leverages the relationships established with demand response over the last decade as an inside route to selling Energy Intelligence Solutions (EIS) to both utilities and enterprises. The EIS market is bringing utilities and energy consumption into the modern information age and has substantial growth potential at even higher margins than the demand response business. The company is still led by its able co-founders and other long-term executives who have already established a track record of building a dominant position in a nascent industry with demand response. The stock is down 40% in the last month due to a short-term hiccup in the demand response business that caught the market by surprise, allowing us to invest in the company at severe discounts to its far less profitable peers. We view this stock as a long-term holding and are willing and able to be patient.

This newsletter has been distributed for informational purposes only. Neither the information nor any

opinions expressed constitute a recommendation to buy or sell the securities or assets mentioned, or to

invest in any investment product or strategy related to such securities or assets. It is not intended to

provide personal investment advice, and it does not take into account the specific investment objectives,

financial situation or particular needs of any person or entity that may receive this newsletter. Persons

reading this newsletter should seek professional financial advice regarding the appropriateness of

investing in any securities or assets discussed in this newsletter. The authors opinions are subject to

change without notice. Forecasts, estimates, and certain information contained herein are based upon

proprietary research, and the information used in such process was obtained from publicly available

resources. Information contained herein has been obtained from sources believed to be reliable, but such

reliability is not guaranteed. Investment accounts managed by Booth-Laird Capital Management, LLC may

have a position in the securities or assets discussed in this article. Booth-Laird Capital Management, LLC

may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part

of this newsletter may be reproduced in any form, or referred to in any other publication, without express

written permission of Booth-Laird Capital Management, LLC.

Booth Laird Q1 2015 Letter

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Transcript of Booth Laird Q1 2015 Letter