• EFOI manufactures one of the most reliable tubular LED lamps in the industry, offering an incredible 10-Year warranty;
• The LED lighting market is expected to grow 45% per year, reaching sales of $63 billion by 2020;
• Nearly 40% of the stock price was in cash at year-end 2015

The Company

Energy Focus (NASDAQ:EFOI) is a Solon, Ohio, based manufacturer of LED lighting products.  EFOI is a microcap stock, with a market cap of only $85 million.  James Tu, founder of 5 Elements Global Advisors (a clean energy fund), became Executive Chairman and CEO in 2012 and began the company’s current emphasis on LED products.

Working with the US Navy, DOE and DARPA, Energy Focus has developed a superior tubular LED lamp.  Energy Focus’ unique selling proposition is that they are currently the only domestic manufacturer of LED lamps certified by the US Navy to provide replacements for the existing fluorescent lighting on its warships.

The Product

These military-grade LED tubes by Energy Focus are amazing devices, impervious to EMF pulse, physical shocks, very reliable, and durable. The Navy tested them on several ships in 2013 and 2014 and last year started buying them in mass.  The company currently has products in 30% of the Navy’s fleet, and last year added its first foreign navy, the Australian Navy, to its customer base.

In 2015, Energy Focus introduced a commercial tubular LED product (“Intellitube”) which they hope will replace the military sales when the complete US Naval fleet has been retrofitted (in 2 or 3 years). The margins are lower in the commercial market and it is an open question how EFOI will fare in this highly competitive market based largely on price.  But EFOI arguably has the most advanced and reliable product in the market thanks to their work with the Navy.

EFOI’s first commercial installation of tubular LEDs (“TLED”) reached a 5-year anniversary in 2015.   With a performance reliability rate of 99.8%, as a mere 2 out of 930 TLEDs burnt out during the first 5 years.  This performance virtually eliminated the need for labor costs of frequent lamp replacements associated with fluorescent lighting.  EFOI offers an incredible 10-year warranty on their tubular LED lamps, 5 years longer than industry standard.

The Competition

LED lighting products are coming to market rapidly.  Suppliers carry LED lamps from over 150 different manufacturers (many Chinese of questionable reliability) to fit the various needs of consumers and businesses.  Frequent product introductions have characterized the LED lighting industry. There is a highly competitive pricing environment.

The Market and its Potential

LEDs are quickly becoming the efficient lighting technology of choice, rapidly gaining on Fluorescent tubes and CFLs.  The market potential is huge, as linear fluorescent tubes (which haven’t changed much since the 1940’s) comprise about 70% of commercial lighting in the US.  Penetration is still very low, as LED’s occupy only 1% of the linear fixture lighting market (DOE 2014).

LED lamps offer energy savings (consume 50–85% less energy than fluorescents), labor savings (last 3-10x longer, extending time between bulb replacement) and generate 90% less heat than incandescent (saves on HVAC loading).  Switching to LED lighting is one of the simplest energy efficiency projects an organization can undertake, with an economic payback often less than a year.

The LED market is still in its infancy.  The LED lighting market is expected to grow 45% per year through 2020.   LED sales are anticipated to reach $63.1 billion by 2020.  LED manufacturers are leveraging economies of scale to achieve price points attractive to users.  Markets appear to be moving toward 100% LED replacement of existing technology including incandescent bulbs.

The Financials

Strong sales of EFOI’s proprietary tubular LED product to the US Navy has been the stock’s main catalyst. However, they are rapidly expanding into the commercial market.  The company’s long-term target is +50% organic sales growth.

Net sales for the full 2015 year was $64.4 million, an increase of 184% compared to 2014. Commercial product sales increased 148% as EFOI continued to penetrate markets of education, industrial manufacturers, national retailers and hospitals.  Military maritime product sales increased 196% as a result of continued high volume sales to distributors for the U.S. Navy.

I’m interested in EFOI due to their excellent return on capital and Gross Margin of 42%.  Energy Focus currently has no debt (debt was converted to equity last year).  The stock price spiked from $4 to $27 last year as sales to the US Navy ramped up, then fell hard and has settled around $7.20 recently.  EFOI has about $15M of remaining net operating loss carry-forwards to offset future taxable income.  Net income from continuing operations was $9.5 million in 2015.

In the 4th Quarter 2015 sales to the Navy fell sharply, reportedly due to a short-term delay of military funding, which is expected to be back on track in 2016.

EFOI has had several rounds of equity financing, most recently at $16.50 per share.

On March 16th a director purchased $24,000 of stock at $8.05 per share.

Key Variables and their Predictability

The product mix in 2015 was 80/20 military/commercial.  Energy Focus knows they must succeed in the commercial market as sales to the military will eventually reach a point of diminishing returns.

Sales to the US Navy fell to $10M in the 4th Quarter 2015, and are expected to stabilize around $10-15M per quarter.  Most notably, in the fourth quarter of 2015, EFOI saw accelerating growth momentum for the commercial lines business, which generated $6.9 million in sales, almost five times the sales a year ago, and 107% increase from third quarter 2015.

If military sales are $40M in 2016, and commercial sales simply remain at 4Q 2015 levels, 2016 revenue would be around $68M (compared to $64M for 2015).  This would be a no-growth scenario, and perhaps is a worst-case.

Commercial sales continue to impress, however.  “Our growth right now is pretty much limited by the ability for us to expand our staff” according to the CEO.  If commercial sales continue growing, sales to the US Navy stabilize and 2015 profit margins hold up, the stock price should resume its upward momentum.

Notable commercial sales made during 2015 include: a 2 million square foot factory of the largest tire manufacturer in the world that operates 140 factories worldwide; the first 17 malls of a Fortune 500 mall operator with 120 locations throughout the US; a large private university in New York City; and numerous school districts throughout the country.   They also made inroads into the VA Hospital system and the federal prison system. EFOI retrofitted a total of 41 school districts, entered into the largest healthcare retrofit contract ever in the country with the Cleveland Clinic, obtained initial sales with 10 national accounts with over 3,800 locations. They have also initiated an exclusive partnership with the US Green Building Council, the premier global leader in building sustainability standards to jointly promote LED lighting in the K-12 school space.