This post has something to do with roll-ups. Incidentally, there are no funny pictures on the internet about roll-ups. Better luck next week.
Two pieces of news broke last week that I thought were pretty significant. One is that Constellation Energy announced on Friday its intent to acquire demand response (DR) provider CPower. The other is that World Energy Solutions (NASDAQ: XWES; TSX: XWE), which runs DR capacity auctions for its clients, announced on Tuesday that it auctioned off a whopping 1.5 GW of DR on behalf of a single customer.
Together, these two announcements scream “commoditization.” What I mean when I say that DR is becoming a commodity is that two vendors selling a unit of DR in the marketplace have nothing by which they may differentiate their respective products, except for price. When that happens, it’s possible to sell that product through an auction, where price is by definition the only way vendors can compete with one and other.
So, what does this mean for broader demand-side management industry?
First off, commoditization should result in significantly lower margins for DR vendors. World Energy claims this to be the case, with an average of 80% of DR revenue in their auctions being retained by the customer. Interestingly, the poll on their homepage tells a different story:
Survey results from worldenergy.com
I assume these are the results of those who are merely those perusing the website and not yet customers. It’s more of a look into the past than the future, which is pretty dramatic if you think about that 42% mode of vendors moving from the 45-60% bucket to the 76-90% bucket.
Let’s look at the other side of the equation: 100% minus the vendor share is the gross margin of the DR vendor, the best comp for which is EnerNOC (NASDAQ: ENOC). I use a trailing twelve month (TTM) average gross margin in an attempt to remove the summer peaking seasonality below:
Source: CapitalIQ data
It’s interesting that the TTM average gross margin started to decline after the summer of 2009. Q1-2010′s number was as low as 34%.
So, what should we expect from an industry that’s commoditizing, with potential gross margins in the range of 20-30%, or maybe less? In a word, consolidation.
Consolidation allows companies to leverage synergies and economies of scale to remain profitable at lower gross margins. It’s particularly common in commodity industries, where price swings are cyclical and the best way to protect against their punitive effects is to be big. Rob Day had a nice post about roll-ups earlier this week (of the non-fruit variety), and I (and others) think that the CPower acquisition won’t be the first of these we’ll see in DR.
For others in the demand-side management industry, this consolidation could be a good thing or a bad thing, depending on your perspective. On one hand, commoditization should expand the market significantly and introduce a whole new set of customers to the notion of managing their demand actively. On the other hand, companies like EnerNOC will find it increasingly difficult to find customers who are profitable just on DR revenue. Fortunately for EnerNOC, it has anticipated this change well and has built a portfolio of other products to sell to its customers. This wholeistic approach will be the right way for vendors to approach the commoditization issue, but only the larger ones will be able to execute on it.
Overall, I see the maturation of DR as healthy indicator of progress in demand-side cleantech. New startups can specialize in solving hard problems around the granular management of behind-the-meter assets and will be able to use companies like EnerNOC as channels to market. At the same time, firms like EnerNOC will continue to outsource product innovation and focus on customer acquisition and retention. A healthy big company / small company ecosystem has begun to flourish in demand-side management, and it will certainly be interesting to see how the next five years play out.
Do you agree/disagree with my assessment? Feel free to comment below.
Filed under: Demand-side management
