Stem (STEM) Analysis
A fascinating play on the clean energy industry offering their customers energy-as-a-service
Disclaimer: the opinions expressed are my own and should not be mistaken for financial advice. Do your own due diligence before purchasing any equities mentioned in this article.
So far in this series I have reviewed stocks from my personal portfolio, but this week I wanted to take a deep-dive into an interesting company that has been on my watchlist for a long time. I’ll discuss why I think this could be a long-term winner, as well as the various reasons why I do not (yet) own shares.
Overview
Stem (STEM) is a fascinating play on the clean energy industry. This company provides digitally-connected energy storage systems, as well as a software-as-a-service (SaaS) platform that optimizes energy delivery. Their software, called Athena AI, uses machine learning to monitor and forecast energy usage to determine when to disperse stored battery power, employ on-site generation or tap into grid power. It then automatically switches the energy delivery method based on which power source will provide optimal efficiency based a variety of conditions. Athena provides a ton of value to customers by lowering energy costs, stabilizing the grid and reducing carbon emissions. As a provider of both energy storage and software that automatically operates the system, Stem is offering their customers energy-as-a-service.
First-Mover Status and a Sound Business Model
As clean energy and renewables have gained traction, countless energy storage companies have popped up in the marketplace and batteries have become a commodity. The hardware sector is not what makes Stem such a compelling investment. While the energy storage is certainly integral to Stem’s operations, the software is the potential goldmine. Stem is a first-mover in AI-operated energy storage systems, and this software will only get more powerful over time as it ingests data and builds a powerful competitive edge.
Stem provides the hardware and the software to run their installed systems, but they also have agreements in place that allow them to operate energy storage systems in their customers’ marketplaces. These agreements provide Stem with high-margin revenue, but more importantly, Athena is given the opportunity to ingest more and more valuable data.
The Athena software also makes it painful to switch off the platform for multiple reasons. By design, this software saves customers money by optimizing energy distribution. This means a customer would not only have to absorb typical switching expenses (training, implementation services, etc.), but they would have to find a vendor who provides a better solution. Stem also makes switching difficult because they lock customers into 10-20 year contracts to use Athena. Not only do these lengthy contracts provide extremely reliable revenue, but it reduces the odds that a customer will decide to switch off the platform. Finally, customers who use Stem energy storage systems have even less incentive to switch as they would have to replace the battery array and software. As a result, Stem offers one of the stickier product stacks I have encountered in researching countless software companies.
Financials
Looking at the company’s financial statements, I see some positives as well as the typical negative numbers one would find in a young growth company. Stem’s revenue growth has been very impressive - boasting a CAGR of 168% since 2018. Management also expects to continue posting 50%+ top line growth through 2026, but it could turn out to be markedly higher than these estimates. The graphic below demonstrates the extremely high demand for Stem’s products. Actual bookings are blowing away management’s estimates, and the contracted backlog last quarter was nearly $560 Million.
The other positive takeaway is that gross margins have steadily improved each year since 2018. The company was posting deep red margins (-37%) four years ago, but has reported 6% margins in the latest quarter. This is important to watch because Stem management is aiming for ~80% gross margins, meaning they have an extraordinarily long way to go. However, this tells me that the focus of this business growth is going to be the Athena software, which is certainly the company’s strongest competitive edge.
Now for the negatives. Operating margins are in the red and nowhere near positive territory. The company is not profitable, which is to be expected at this stage, so that isn’t necessarily a major concern. It is also worth noting that they are trending toward profitability. However, they are also posting negative free cash flow figures, which would be a deal-breaker for a core holding, especially in a high interest rate environment. Stem is currently sitting on over $500M in long-term debt and less than $175M in cash and cash equivalents as of the most recent quarter. The cash reserve was actually much larger, but they funded the entire AlsoEnergy acquisition with cash. While I love the top line growth, the balance sheet leaves a lot to be desired.
A Quick Note on Optionality
Normally I would dedicate a lot of time discussing a company’s optionality, but Stem has a fairly singular focus at this stage. They are pouring money into the software business (R&D as well as AlsoEnergy acquisition) to establish a dominant market position, which I believe is the right move. They have, however, tinkered around with other uses for the software. Penske recently worked alongside Stem to pilot EV fleet charging, so they have started to make headway outside the primary market. The graphic below helps to describe how Athena can naturally be applied to new use cases:
Management Team
Despite not founding the company, John Carrington has stepped in and done a great job as CEO. He has a decorated history of relevant leadership experience, having grown First Solar’s annual revenue from $250 Million to $2 Billion as VP of Marketing and Business Development. Carrington has also garnered fairly strong reviews from his peers on Glassdoor, notching an 86% approval rating. With that being said, I normally prioritize founder-led management teams, so the lack of founders is certainly a knock against this company. Additionally, insiders only own about 7% of shares outstanding, which is a bit low for such a young company. Are these deal-breakers? Everyone has different investment criteria, and I sleep easier at night knowing the companies I own are run by executives possessing both financial and emotional interests. However, this company has so much going for it and such powerful tailwinds that I would be willing to overlook the lack of founder involvement.
Gauging Performance - What to Watch
For any investor buying shares in hyper-growth speculative stocks like Stem, it is vital to closely monitor the company’s performance. I watch these types of companies much more closely than my core holdings, and the best way I have found to assess them is to pay close attention to earnings reports. In quarterly filings, management identifies several operating metrics that we, as investors, can use to evaluate how the company is performing:
Pipeline
Bookings
Contracted Backlog
Contracted Storage AUM in GWh
Solar Monitoring AUM in GWh
Contracted Annual Recurring Revenue (CARR)
Pipeline measures the potential value of contracts that the company is pursuing. At $5.2 Billion, this number has nearly tripled in just the span of a year, demonstrating how rapidly this market is growing. It is important to note that potential pipeline revenue is just that - potential. Meanwhile, contracted backlog and bookings measure the monetary value of future contracts that will at some point be recognized as revenue. Bookings and contracted backlog grew nearly 200% and 100% year-over-year, respectively from Q1 2021 to Q1 2022.
Contracted Storage and Solar Monitoring (assets under management in gigawatt hours) measure the scale of Stem’s operating energy storage systems. Stem only recently started tracking Solar Monitoring assets under management due to the acquisition of AlsoEnergy, so they currently don’t have any comps for this metric, but Contracted Storage nearly doubled year-over-year last quarter.
Contracted annual recurring revenue (CARR) refers to the annual run rate for software services under contract. This is the figure I am most interested in as this metric is an indicator of reliable revenue and will provide insight into the growth of the software side of the business. Seeing as most of my growth portfolio is comprised of software companies with a high percentage of their revenue from annually recurring service subscriptions, I want to see this number grow rapidly. In this case, that is exactly what’s happening. In Q1 2022, Stem reported 114% growth sequentially from Q4 2021, which is mind-blowing growth over the course of just three months. With such a large contracted backlog, I would expect CARR to sustain this rapid pace of growth in the near term.
Risks
While there is a lot to love about this company, I see a multitude of risks that make this one of the highest-risk stocks I have covered. One that I mentioned earlier is the state of the company’s financials. While top line growth has been impressive, the company is bleeding cash, used much of its current cash reserves to fund a single acquisition, and they are attempting to continue growing at a 50% clip in an environment where debt is not going to be cheap anymore. Stem currently has more debt than cash, so shareholders need to be wary of potential dilution or higher debt levels in the immediate future.
Another potential risk is competition. There are a lot of companies that manufacture batteries and energy storage systems, but Stem is the market leader in AI-driven energy optimization. Despite their first-mover status, competition is fierce and some of the big players may one day come after their software dominance. The most concerning would be Tesla, who manufactures the Powerwall, a rechargeable battery that can be optimized to distribute power selectively. They don’t offer a full-scale AI platform, but with their wealth of cash and resources, it would be concerning if they did come after Stem’s market one day.
The final few risks I have identified are more or less out of management’s control: impact of regulations and lithium-ion battery costs. Stem may be indirectly impacted by electricity pricing, and net metering impacting the amount of savings realized by their customers. Additionally, lithium-ion battery price sensitivity would be detrimental to energy storage system manufacturing. Management noted that they are projecting battery costs to continue to decrease at a steady rate, but if that rate does not decline as quickly as they anticipate, it could negatively impact the ability for the business to grow.
Summary
My assessment of this company is that Stem is a high risk but potentially extremely high reward opportunity. This business is growing rapidly, and its market opportunity is vast - with battery storage capacity expected to grow 25x between 2020-2030. Stem also boasts a strong competitive advantage in its Athena AI software, which will only to continue to become more powerful as it consumes more and more data.
There are plenty of hardware companies in the clean energy space, but Stem management is aiming to build a high-margin software business, which is why this company initially sparked my interest. The energy-as-a-service proposition is enticing, and I will be closely watching this company’s growth story. I don’t have a position at this time as I’d prefer to wait a few more quarters to watch how they manage to grow in this macroeconomic environment. However, with a forward sales multiple below 3 as of this writing, it could certainly be a great long-term buying opportunity for more risk-tolerant investors.