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Stem Inc. and the Future of Battery Storage

By Jason Hall – Dec 1, 2021 at 2:27PM

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Batteries: packed with power from renewable energy.

On today's show, Motley Fool contributor Jason Hall joins host Nick Sciple to talk about Stem Inc. (STEM 3.09%) and how it's using software to stand out in the emerging market for battery storage technology. 

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

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This video was recorded on Nov. 18, 2021.

Nick Sciple: Welcome to Industry Focus, I'm Nick Sciple. This week, Jason Hall joins me to take a look at Stem Inc., which aims to use Athena software to stand out in the emerging industry of large-scale battery storage technology. Jason, thanks for joining me.

Jason Hall: Nick, I thought we were talking college football today.

Nick Sciple: That's our other show. That's our other show. [laughs] We need to figure out a name for it, still in the development phase, but we could. Everybody's got a podcast now.

Jason Hall: That's the truth. Why not? A couple of finance guys talking about college football, absolutely. Nick, I'm really excited to be on here talking about Stem and I tell investors that have been trying to figure out a way to invest in batteries really should look at this company because the bottom line is, and we'll talk about this. Batteries are terrible business. [laughs] It's a race to the bottom. Stem has something special.

Nick Sciple: Let's talk about that. What does Stem do? I said in the intro they are trying to stand out in large-scale battery storage technology. How are they doing that? As you say, batteries tend to be a commodity business.

Jason Hall: Yeah, it's funny because the thing that really is unlocking the opportunity for Stem is like that commodity rates, the fact that prices continue to fall for storage, that the technology is getting better too, that companies are spending billions of dollars to increase manufacturing capacity so you're getting to scale. That's making this far more viable. You think about the larger renewable energy shifts. The two biggest drivers for renewable energy going forward are going to be wind and solar. Hydro-electric has been around forever and it's important, but we just need to deploy more wind. We need to deploy more solar. Of course, there's the old saw. The wind doesn't blow all the time, the sun doesn't shine all the time. What do you do? You store the electricity. Batteries are the key here. Battery prices are coming down, scales going up, power users whether it's a utility, whether it's a grid operator, whether it's a large power user like a large manufacturer or Walmart or Home Depot, one of these companies that uses solar power. They have these carbon initiatives. They want to reduce their carbon imprint. It's good for business, it's good PR, it's good for the world. Same thing is happening with utilities. They want to improve their carbon profile. But at the end of the day, a lot of this is just being cost driven because the cost of batteries are falling, but also the cost for solar panels, wind turbines, all of that's coming down and the efficiencies are going up. Competing against hydro-electric or excuse me, fossil fuels, you can deploy these wind and solar assets, produce power more cheaply and also get those environmental benefits. As battery costs fall, you can store the energy. When the sun's not shining, the wind's not blowing, you still have energy that was produced from renewable assets that you can then deploy.

Nick Sciple: There is increasing demand for batteries as a supporting industry to renewables. As you mentioned, you need to store the energy that you produce while the sun's out so that you can keep the lights on when the sun that goes down. That tends to be when I turn the lights on in my house, in the before times when people commuted to work, usually you would have a bigger demand when you come home, which is when you need to really deploy that energy that you're producing during the day. Where is Stem playing into this industry? How did it to get to where it is today?

Jason Hall: Here's the backstory for Stem, it's been around since 2009. It's founded with a lot of private equity backing. It's really focused on the real key to this kingdom and that's software. For Stem, its software applications called Athena. It's really powerful, AI powered software, software as a service so lowers the capital cost upfront for the customer. As they go they pay as they use it. The idea is the software helps maximize those storage assets. It depends on who the user is and what their goal is, what maximization really means. Having an AI powered tool to help you optimize what you are getting. If you're say, a utility, obviously you want to use that storage to fit within your total strategy and your power capacity. You want to use it for peak demand. Nick, you were talking about back in the old days when everybody would drive home from work and we would get home and then there was this massive increase on the grid, particularly in the summer when everybody turned on the air conditioner and fired up the oven to cook dinner and all that stuff. 

This is called the duck curve. When renewables fell off, production fell off and then demand shot right up. If you're a utility being able to meet peak demand is really important. But also being able to maximize storing energy when it's optimal to store. Some of that storage is going to come from fossil fuel production too. It's expensive to ramp up and ramp down power plants. If you can just take that excess production store it, there's another way that you can use it. The AI can help them. Now if you're another user who's trying to maximize when you're buying power. If you're a corporate customer, you can use Athena to help maximize when you're buying power from the grid or using your own renewables to store that power or for power generation. It's about integrating all of those things together and that's where they fit in. The company's done a really good job. They have, I don't know, more than 950 deployments of Athena. That's a large number. It has a pretty large number of customers. I think they have more than 40 utilities that use their products. Half dozen or so grid operators that use it for 20 million hours. Lots of deployments out there. So far it seems like their business model is working pretty well.

Nick Sciple: Yeah. As we said, off the top of the battery, business actually of manufacturing batteries is a little bit of a commodity business. What Stem is doing is using its software differentiation Athena as a magnet to draw in customers, but they don't really care or particularly are sensitive to the types of batteries they use, which is part of the story you told earlier of taking advantage of oversupply in the market that could potentially be realized in the next couple of years. Can you talk about it that better agnostic approach where that plays into the company's business model.

Jason Hall: Yeah. That's the key. Battery agnostic is the best way to describe it. This is a company that has deep relationships with lots of different battery suppliers. Because at the end of the day, I think the company almost wants to set the stage for customers. The batteries are a commodity, they're just a fuel tank. There's not a lot of competitive advantages with a fuel tank. It's just the thing you put fuel in. This is something that they really lean on. But they do want to make money when they sell batteries. They aim to get 10-30 points of gross margin, depending on the deployment, depending on the customer. But again, when you take that and you think about deploying batteries and you stretch that out over the operations that are involved. The operating margins in a best-case scenario, are going to be low double-digit. Most likely high single digit in a lot of cases when you factor in all the operating cost. By setting that stage that these are just commodities and really leading with Athena as the differentiator. It's really the tool that helps its customers leverage and make the most of all of their assets. It's not just making the most of their batteries, but making the most of renewable energy production assets they have, or making most of their natural gas power production assets. 

Or if they're not producing their own power or maybe it's Walmart, and they have rooftop solar all over the place. That's it. Then they're buying the rest of their power from the grid helps them optimize. When they are buying power, they're buying it at the lowest possible price. Then they have their market participation product, which is actually taking the arbitrage opportunity to be able to resell power and to maximize the dollars that you earn when you do sell power out of your storage. It's a really powerful way that they're doing it. If you think about the opportunity, it is absolutely enormous. By 2030 alone, between 2020 and 2030, battery storage capacity globally is going to increase 25 fold. That's gigantic, but it's also a reminder of how early we still are in this. By 2050, over the next 30 years or so, Athena in the estimate some of the large companies that follow this space are estimating that $1.2 trillion is going to be spent to deploy integrated storage in between now and 2050. I think that the number could be bigger, I really do, as costs continue to fall and as more and more parts of the world look to leverage this technology. But again, that's the target. There that $1.2 trillion integrated storage target over the next 30 years.

Nick Sciple: When you talk about maybe there's going to be some oversupply in batteries, that's a condition in this market. This huge tailwind, as capacity grows, 25X by 2030. Also this market participation side, which sounds to me energy trading it's out. When I put all this in contact, it sounds to me you look at oil and gas or historical energy markets. A lot of these things have developed over time. You see a capital cycle where there's points oversupply and under supply, you have folks in the market who participate in trading relationships. Historically, you had this huge swing up as you developed that supply chain. When I look at all these things emerging, I start to think about this battery storage business. We're really laying the groundwork for a new energy supply chain in a similar way to maybe what we saw in the past with oil and gas.

Jason Hall: It's funny you mentioned that, Nick. It's almost like you're setting this up for me to talk about some of the key players with the company. Stem went public earlier this year via SPAC, the blank check company that led this back and it was the acquirer with Starr Peak energy transition. It just so happens that the name might be familiar to people that follow oil and gas industry. The Chairman of Starr Peak Energy Transition his name's Michael Morgan. Morgan might be a familiar name. William Morgan, who I don't know for sure, but I'm pretty sure they're related is one of the founders of Kinder Morgan. Michael Morgan was part of Kinder Morgan from the very beginning when it was founded in 1997. Eventually he became its president. Left the company, I think in 2005, but has been on the board of directors, is actually the Lead Director at Kinder Morgan. He has a pretty successful investing track record as well. But he led the SPAC as the Director and he is now the largest shareholder of Stem directly through interest that he controls. Talking about the energy infrastructure, Kinder Morgan they're part of the pipes, literally the pipes, the power, the American energy grid. I think it's really important to understand that some of the people behind this company, we don't have any founders involved. We don't have Stem founders that are involved here, but we have people that understand how energy works. I think that's really important. John Carrington, Stem CEO, he's been the CEO since 2011. Stem was founded in 2009. John Carrington has been CEO since 2011, so he's been around for a decade. Very central to the company's growth and its development basically since its formative years. I think that's important. He has about a three percent stake. That's worth noting that most of that stake is a product of equity incentives that he's earned as CEO and not him putting his own money on the barrel head, so to speak. But nonetheless, that's a pretty sizable stake that helps align his long-term interests as the CEO. Then again, you have Chairman of the Board and other board members who come from the private equity groups that are large backers. That helps align that incentive with investors as well. I think that's important.

Nick Sciple: Yeah, one of the key Rule Breaker traits is good management and smart backing. If you look at folks who have had some success in energy industry in the past certainly is a point in their favorite. One of the other Rule Breaker traits is a sustainable competitive advantage. To have a sustainable competitive advantage, you need to be able to hold back competitors. One of the questions David Gardner likes to ask there, is there a Pepsi to this company's Coke? When you look at Stem Inc. and the competitive landscape, who are those potential competitors?

Jason Hall: There's a lot of companies that are involved in this. First I think any company that's manufacturing batteries for utility scale deployments has some sort of software. They're all going to. You just have to do it. Right now I think probably the closest thing is Tesla. Tesla has as a pretty robust software package, I just completely drove like here, sorry about that. They have a software package called autonomous control that has lots of different modules, different chunks depending on what that particular user is going to deploy. It's been deploying over 50 companies, uses AI for different things like one of their offerings is what they call it auto bidder is their market participation product. But it's also built for all of the various and sundry different ways that people are going to deploy these assets in large-scale or scale ways. But here's the key. Tesla does a ton of stuff and they don't really break this out. In terms of the revenues that are generated in the margins, that kind of thing. It's not really clear how they're positioning it and what it means for Tesla on the bottom line. But what we do know, at least based on the data that we're getting from Stem, Stem from 2014 through 2020, in the key part of their like commercialization, had more deployments than anybody including Tesla. Tesla was number 2. My assumption is that, that probably excludes Tesla's distributed solar. Like their residential storage probably excludes that distributed storage. It's just really focused on the utility scale storage, but that says a lot. Really what it says the most is a lot of customers view the batteries as a commodity and the differentiator is the software. Because that again, that's the key. Athena is the key here. This is the thing that's going to drive its uptake. This is the thing that's going to make it sticky. This is that recurring revenue, again, they're targeting 80 percent gross margins. That's the margins a company like Microsoft gets. That's their goal with Athena, is to get 80 percent gross margins as they scale it up. They're onto something, they went public to raise the capital to accelerate growth. They're really doing that right now. They are burning a lot of capital to do it, but there's some pretty big players that they're competing against.

Nick Sciple: Yeah. If you look at those installation numbers or deployment numbers that you mentioned that signals that Stem maybe a partner of choice in the industry and that's certainly what you needs for the company to continue to maintain its growth. You mentioned gross margins, one potential thing to be on the watch for with the business. If you're a shareholder or potential shareholder and you want to keep score on this business quarter-to-quarter, see if it's delivering on its potential, in its markets, what are the things that you would be tracking?

Jason Hall: It starts with revenue. This might seem obvious, but at the end of the day it's about deploying those batteries and then deploying further iterations of Athena. The battery's going to be the big hit. You're going to deploy those batteries, you're going to recognize a big chunk of revenue all at one time. Then you're going to recognize Athena revenue each financial period as you provide the service. The hardware revenue overtime is probably going to be relatively lumpy. If we look back at their utility scale, deployments of wind and solar, as a proxy for what we can probably expect to happen with storage is from period-to-period, from year-to-year. It can be very cyclical. Depending on lots of different factors, economic conditions, regulatory environment. All of those things can have an impact on how much money is getting spent to deploy it. That part of its business over time may start to get a little bit lumpy, but what we should see with its services revenue, which is really where Athena lives, is that number should, realistically, if it's not growing sequentially from quarter-to-quarter. I don't want to say that's a problem, but that's something that would be really watching closely because it gets that onetime hit when sells the batteries. 

Then literally every quarter from there for the next 10, 20, 30 years, it should continue to collect revenues for Athena. That's the key. I'm looking at those. If you look in its filings under its operating statement, you will see hardware revenue, you'll see software revenue. Then I'm looking at cost of sale. You're looking at how much you want to see the revenue for software continues to grow with the cost of revenue should grow at a much, much slower rate as it scales up. Because again, that's where the gross margins are going to come from. That's what pays the bills. That's what's going to get this business to be cash flow positive. That's the next thing I am looking at closely, is looking at its cash flow statements. Right now it's cash flows are going negative from year-over-year. It just went public. It raised a bunch of capital specifically to throw that capital at the business, to try to scale up and aggressively grow. But overtime, over the next couple of years you want to see the cash burn shrink as there's recurring revenues continue to get larger and larger and it gets to scale, and it becomes a profitable business on a cash-flow basis. I'm now looking at GAAP earnings right now. I'm not looking at that metric because there's so many financial machinations that are going to affect it. It's all about cash flows and revenue. Now then beyond that, numbers I'm looking at they can help telegraph what's going on. You think about its pipeline. 

Pipeline is the big number of potential deals that they've identified that they're playing in, that they're trying to win. That's the big number. You want to see that growing and it is growing very fast. It's over a couple of billion dollars now. I mean, it's more than doubled in a year. Then you have contracted backlog. These are the deals they've won. Inc.'s on the contract and they're just waiting to deploy it. Every quarter when they report, they're going to tell you bookings, that's deals they've signed in that quarter. That's new business that they've won. That's your cadence of things that you're looking at. Just hit that again. Looking at revenue growth, looking at where those revenues are coming from, service, revenue minus cost of revenue to try and figure out if the margins are moving in the direction you want. Looking at the cash flows from operations and then starting looking at those backlogs and their contracted business to see where things are going.

Nick Sciple: Love that. This is really a land and expand business model or maybe in razor and blade if you think about it, adding a servicing business on top of hardware business. Seeing how they make progress there, fundamental to the thesis. When you look at some businesses, there's optionality for things we don't even expect happening, expect today materializing in the future. When you think about optionality, places where Stem could surprise us, does anything come to mind for you there?

Jason Hall: Honestly, it really doesn't at this point, I think. Particularly over the next five years, this company needs to be laser-focused. Again, this market is growing at an enormous rate. We're just now scratching the surface for distributed storage. The company needs to be laser-focused on what it's doing. There's a clear mission, there's a clear use-case for what they do. They are absolutely massive tailwinds. If they're smart, they're going to stay focused on this and they're not going to try to figure out other things. The bottom line is they're burning cash. [laughs] Once this business gets the scale and becomes cash flow positive, if then there are other opportunities where they can leverage their AI, for example, they're going to build up a tremendous amount of data over the next 10-20 years. That data could be valuable in other ways. But at this point, I think they need to be a pure-play. They need to focus on what they built and get to a point where they can make money with that.

Nick Sciple: Let's put all this together. When you look at Stem Inc., the stock, today, we've not where the opportunity in the market where they can land and expand, where they can grow. What do you make of the opportunity today? Certainly aggressive. I think the 30 times trailing sales somewhere in that neighborhood. How do you compare valuation in the market against the opportunity for the business?

Jason Hall: I think it's one of those cases our good friend and colleague, Brian Feroldi, talks about. If you're ever going to pay a stupid expense evaluation, you want to do it in a very high-growth company with a massive market opportunity when it's still small. This is a $3.5 billion company at this point. It is growing at an enormous rate. You think about that sales multiple just reported earnings last week on the 9th. It's reported earnings exactly a week ago today as we're recording this, recorded revenues just under $40 million a year ago was nine million. That's 300 percent increase in revenue in the second quarter. Sequentially, revenues went from 19 million in the second quarter to 39 million in the third quarter. Part of that is timing because of those big deals. But this is the time to pay a premium. Again, $3.5 billion market cap is probably going to be further dilution, more shares that are going to be issued to help raise capital over time. But just almost inevitable at this point. You remember that big number between now and 2050? $1.2 trillion. This is an enormous market. It's a growing market and it's highly competitive. I think paying $3.5 billion for the company, it's only an overpay if they screw it up. It's an overpay if they don't execute. That's what [laughs] it boils down to. You're buying this company based on their proprietary technology, their ability to leverage it, executes and continue to gain deployments and gain traction with Athena. If they do that, the stock is going to look crazy cheap in 10 years. If they don't execute, it doesn't matter what you paid for.

Nick Sciple: For me, this is a stock that fits very neatly in the Rule Breaker basket. Rule Breaker trade is grossly overvalued according to traditional financial media after traditional financial metrics. The other five traits, top dog and first-mover in an important emerging industry. You believe that's sustainable competitive advantages driven by Athena. Past price appreciation is one of the double, since it's come out even after some of this back will come back to Earth, you mentioned. Good management and smart backing, the Kinder Morgan connection CEO has been on the job for 10 years, strong. Consumer appeal, we mentioned how there's been this really big pickup in customers in the past year. If you think it checks off those other five, then what the Rule Breaker approach would say is don't let that high-valuation keep you from buying the stock. That's really the story you have to tell to buy the stock today [inaudible 02:53:51].

Jason Hall: I agree 100 percent all of those things. To me, I would say it's almost a perfect Rule Breaker stock with the exception that I would want to see a founder. That's sector one. This one is a little bit squishy with that. Because I think in a lot of ways their CEO is about as close to a founders you can get because it has been there basically [laughs] since the beginning and he's built this business. There really has a lot to like. You've just got to be able to stomach the risks and let them execute.

Nick Sciple: We'll see where it goes from here. Jason, thank you so much for joining me on the podcast. Always love having you on.

Jason Hall: A lot of fun. Thanks too. I think we get this was a request. Did we have a listener ask us about this one?

Nick Sciple: Yes. They emailed us at [email protected] asking for us to talk about Stem, Inc. and I hope we did a good job for you. Same, if folks have any other companies they would like us to discuss, don't hesitate to send us an email and we'll do our best to get to it.

Jason Hall: Absolutely. One more thing that go dogs.

Nick Sciple: [inaudible 02:54:59] As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against the stocks discussed. Don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for mixing the show for Jason Hall. I'm Nick Sciple. Thanks for listening and Fool on!

Jason Hall has no position in any of the stocks mentioned. Nick Sciple has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Home Depot, Kinder Morgan, Stem, Inc., and Tesla. The Motley Fool has a disclosure policy.

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