In two columns last November, I extolled the virtues of Echelon (Nasdaq: ELON), top dog and first mover in networking of control systems. The number of these systems in the world is stupefying. It reminds me of the staggering stats about the percent of the world's biomass formed by insects (high!) or the number of rats in cities (yuck). Think of train and subway brakes, thermostats, elevators, manufacturing plants, and one of my favorite examples, the sound system for a huge Buddhist monastery in Thailand -- all of these devices are part of networked control systems. A humongous market.
In the world of control systems, Echelon makes devices smart and lets them talk. Competing against those that sell systems with closed architecture, Echelon promotes its proprietary open architecture, LonWorks, and sells hardware and software that enable devices to collect and translate data from the world into electrical signals that can be read, networked, and controlled from the Internet. CEO Ken Oshman puts it this way in his shareholders' letter (viewing this .pdf file requires Adobe Acrobat) for 2000: "We see a potential market for billions of LonWorks devices.... One simple way of thinking of our business model is that, on average, we expect to sell a dollar or two of hardware, software and services for every LonWorks device that is installed." I have no doubt that Oshman firmly believes in a future where Echelon is the McDonald's of control systems -- billions and billions sold.
Echelon thrives where power is dear
While Echelon could have a bright future in the building automation, industrial automation, and transportation markets alone, the big kahuna is in the utility/home market. This is where we get to billions of LonWorks networked devices. But success in this sector depends on one thing: energy scarcity. In a world awash in power, power to waste, power to, uh, burn, Echelon will not be king because there is no reason for utility companies and their customers to care about Echelon's products to monitor and control power usage in the home.
That's why Echelon's biggest success to date has been outside the energy-wasting U.S. Italy-based utility Enel (NYSE: EN) operates in a country where each home is limited to 3 kw of power at any time and which is facing deregulation. This led Enel last year to invest in Echelon and contract to buy $300 million in LonWorks products.
To explain more, I'll descend to the lowest Dante-esque depths of journalism, and quote myself:
Enel will put $300 million worth of Echelon hardware and software to use to enable information to travel from home electric meters, through power wiring, to a data concentrator, and then to talk across the Internet. This lets Enel do automatic meter reading, manage demand (rotating brownouts, etc.), change the cost of energy throughout the day, and so on. They can tell if there's been tampering, detect power outages, and isolate occurrences -- probably before you call. Better service, lower cost. They're looking to save money. They figured they can.
Enel wants not just to save, but to make money from new businesses, too. The meter is the link -- the mole -- to bring the system inside the home, where millions of potentially smart devices live. With access to those, Enel can turn the electric power grid into an intelligent delivery platform for security monitoring, energy-related services to lower bills, and all sorts of other possibilities.
Or, as Echelon says concisely in its SEC filings: "In electric utility systems, control networks may be used to provide services including remote meter reading, load shedding, and demand side management."
Enel wants to win in the coming Italian power deregulation, and it needs something to entice customers to desire its service. Enel will offer them LonWorks'-enabled network, so that they can buy smart appliances (And if you don't believe they're out there, ask Samsung.). Why would they want them? Well, Italian utility customers already endure among the steepest power rates in Europe. Homes can obtain 3 kw at one rate level, but can only receive 4, 5, or 6 kw by paying steeply higher rates. (For comparison, a typical U.S. home with 120 amp service at 110 volts has a total capacity of 13.2 kw. Yup, we use a lot.). In this world, Italian customers might want to control their household energy -- turn off the refrigerator at night when no one's opening it, run the washer or dryer when it's cheaper, and so on, in a simple manner, rather than piecemeal. They want to closely track their power usage and control it, distribute it evenly. It's their money. Enel hopes that you will choose the company that offers you the opportunity to save.
Echelon needs more than Italy
It's easy to see how Echelon can make a lot of money in power-limited Asia and Europe, no doubt. The Enel deal alone is fantastic: A reasonable projection for Echelon, with 60% margins, is that $300 million in Enel sales starting in the last calendar quarter of this year and extending for three years will likely boost EPS from last year's breakeven to around $0.20 this year, then upwards of $0.75 in 2002 and 2003. Darn good.
But here's my Rule Breaker challenge to Echelon: Do a major deal in the U.S., the world's biggest market. Go for the gusto! With a significant U.S. contract, the company will likely satisfy a slew of Rule Breaker business and stock criteria. For one thing, we'll get real business momentum in the utility/home market -- creating market-smashing Rule Breaker returns -- and maybe even a start on having a consumer brand ("Echelon inside" or the company's own "Bringing the Internet to Life"?). With anything beyond the Enel deal, we'd likely see a big bump in relative strength from the current, miserable 23. That would send the stock's PE well north of today's 100 times estimated 2001 earnings, and earn cries of "overvalued!" from the financial media -- a Rule Breaker buy criterion.
Sure, it's tough. The California utilities who are the best customer candidates are strapped. And I don't see a lot of other cash-flush U.S. public utilities facing deregulation either. Maybe the company's U.S. time won't come. But if it does, I'll pound the table for Echelon for the Rule Breaker portfolio.
Tom Jacobs (TMF Tom9), Tom Jacobs, Tom Jacobs performance fleece. At press time, he owned shares of Echelon. Surprise, surprise. To see his other stock holdings, view his profile, and check out The Motley Fool's disclosure policy.
