Orion Energy Systems needs to improve its SG&A spending
Orion Energy Systems (NASDAQ: OESX) is an American manufacturer of LED systems that offers complete LED retrofit solutions for B2B customers seeking to improve their energy efficiency.
The business has been operationally unprofitable for most of the last decade, including start-up and abandonment of a solar equipment rental segment. Between 2019 and 2022, she landed huge contracts with a single client that allowed her to reach between $6 million and $10 million in net revenue. While those contracts are slowing down because the company is back in unprofitable territory.
In my opinion, the continued unprofitability of OESX is caused by fixed SG&A expenses that cannot be justified in a business that is constantly losing money. In turn, I assume that SG&A spending is not improved because there is no strong shareholder to lead this change.
On the positive side, OESX has used recent earnings to pay off all of its financial debt. He now has no debt and $10 million in cash, as of 1Q23 (June 2022).
Note: Unless otherwise stated, all information was obtained from OESX filings with the SEC.
OESX deals with the manufacture, design, installation and maintenance of LED systems. It mainly does this in retail, office, industrial or outdoor settings for B2B customers directly. It also sells indirectly through commercial agents and ESCO.
The company offers a complete solution, while it assesses the customer’s facilities and designs an improvement plan to reduce energy costs. He can then implement this plan in a short period of time, with minimal inconvenience to the client, in multiple establishments.
Although OESX also offers specialty LED equipment as separate products and product revenue accounts for nearly 80% of revenue, it is difficult to separate service and product revenue. Since OESX sells a significant portion directly to customers and equipment is used in facility improvement projects, it is likely the service side that is driving product demand.
Let’s analyze the competitive dynamics of this market.
First, on the manufacturing operation alone. LED equipment is a relatively commoditized product and an industry with much larger players than OESX. The company has a relatively small manufacturing facility in Wisconsin, which likely makes it less competitive than larger players operating in cheaper manufacturing markets. From a Porter’s point of view, it’s not a big market.
The design and implementation of LED systems is somewhat more protected from cheaper overseas competitors as it is a non-negotiable service, meaning it must be done locally. On the negative side, design and implementation is also not a very attractive market.
D&I is a relatively undifferentiated service, which many companies can provide with insignificant differences. OESX argues that not all companies are capable of providing large enterprises with implementation in multiple installations, but I doubt there aren’t other competitors with these capabilities.
The service is also capped by the gains generated by energy efficiency. Customers compare the cost of implementing a new system with the savings generated over several months/years. Having a price cap is terrible for the competition. Along the same lines, OESX sells to businesses, which is always worse than selling to consumers, because businesses compare alternatives better.
In terms of sourcing, OESX benefits from having a standardized LED market to source from. The fact that he mostly uses his own manufactures is interesting, although we’ll get to that later. Employees participating in the D&I component are qualified electricians and engineers or energy efficiency analysts. These can be difficult and expensive to find.
OESX faces competition from other companies providing the same service, but also from energy service companies, or ESCOs, which combine design and implementation with financing or performance payments. ESCOs sometimes fund energy efficiency improvements (including lighting) and are reimbursed on energy savings. In other situations, their remuneration is linked to energy savings.
In terms of channels, OESX primarily sells directly to end customers. Its services segment, which represents the direct sale of solutions, accounts for 75% of revenue. The rest comes from independent sales agents or ESCO who compete with OESX in the system design segment but purchase OESX’s LED equipment.
The result of this dynamic? OESX revenues have been stagnant or declining at best for most of the past decade. According to company’s FY22 10-K report.
Going down the income statement, two things are interesting. First, gross margins are relatively stable, despite declining and then rapidly increasing revenues. Second, operating margins are consistently negative.
The second point is a key aspect of OESX’s underperformance over the past decade. SG&A expenses have been pegged at near or above $20 million per year for more than 15 years, despite the company not being profitable and gross profits declining with declining revenues.
This signals a problem because it shows that OESX was unable or unwilling to implement an efficiency program that reduced SG&A expenses to a level consistent with the gross profits it was able to generate. generate. In my opinion, a business not being able to grow is not a problem, as long as it can make a profit in any market it has. OESX has had almost twelve years of operating losses, but has never been able to sufficiently reduce SG&A expenses.
Another interesting aspect of the company’s accounting is that it has always spent less on capital renovations than it spends on depreciation. It also has relatively low fixed assets for a heavy manufacturing company, with just $35 million gross and $11 million net.
Recent Developments and Financial Strength
Due to the significant SG&A leverage of OESX, the significant increase in revenue in fiscal years 20, 21 and 22, combined with consistent gross margins, resulted in a significant increase in profits.
Earnings were also boosted by losses carried forward from OESX and a reversal of tax allowances. On a normal tax basis, considering the US income tax rate of 21% plus Wisconsin’s state income tax rate of 5%, OESX would have generated approximately $10, $5, and $6 million dollars of net income in fiscal years 20, 21 and 22 respectively.
OESX used $10 million of these profits to pay off its financial debts and also accumulated cash. This is positive for the company, which now has no financial debt, an unused credit facility of $25 million and $10 million in cash. at 1Q23.
OESX also acquired a lighting installation and maintenance company called Stay-Lite Lighting. SLL has its operations concentrated in the Northeast and Midwest of the United States. OESX provided very little separate information for SLL, only that between January and March 2022 the company generated $2.7 million in sales and $0.2 million in operating profit. This is very little information, but the price of 4 million dollars paid for SLL does not seem exaggerated. OESX only recorded $600,000 of goodwill for this acquisition.
The problem is that large OESX contracts, with a single client, which accounted for 74%, 56% and 49% of revenues in FY20, 21 and 22, are slowing down. As you can see in the chart below, OESX’s revenue has steadily declined over the past three quarters. The company was unable to obtain new contracts, and on its Announcement of 1Q23 resultsshe mentions that her clients are slowing down their investments due to the more complicated economic context.
OESX needs to improve its SG&A
The results for the last quarter relate to the situation observed for most of the last decade. The main problem with OESX is that it cannot operate under a certain income level because its SG&A expenses are too high.
If the business can only be profitable at an extraordinary level of income for a decade, it is not a good investment.
I guess OESX hasn’t been able to improve its SG&A spend because it doesn’t have a major shareholder. As of 2022, according to the company’s latest proxy statement, it has only two significant shareholders, one with an 11% stake and the other with 6%. If we go back to Proxy Statement 2016, the situation is not very different, the first shareholder holding 15% of the capital. back to proxy statement 2011 and the largest shareholder was the company’s founder with 9.5%.
A strong shareholder is necessary to carry out a strategy of improving efficiency, which is probably difficult and may harm people’s interests. OESX operates in a small town of 30,000 people in Wisconsin.
Of course, this is speculation, it may very well be that OESX cannot generate revenue with lower levels of SG&A. In this case, the company is simply not profitable unless it receives an exceptional contract.
Either way, I don’t consider OESX a buy for an individual investor. This can be interesting for an activist fund, of course by doing much more in-depth due diligence.
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