Burnes: "Many people confuse energy efficiency with conservation, leading them to believe that our products force a change in behavior..." Can a good idea become a great one? In the world of technology, change is always bubbling beneath the surface, revealing strengths and weaknesses that hadn't been apparent before. Netflix makes Blockbuster obsolete. Digital music sales soar while the record store down the road closes shop. IBM disrupted its own business by getting out of the PC market. What do these examples have in common? The constant is that the movement from physical to virtual delivery reduces friction and raises margins. If you know SmartCool (TSXV:SSC), it is for the company's good idea; its intelligent cycle optimization technology saves clients who have commercial refrigeration, air conditioning or HVAC units more than 15% in energy costs by improving the performance of inherently inefficient compressors. In January, Google acquired smart thermostat maker Nest for $3.2-billion Nest. This, says SmartCool CEO George Burnes, was his company's "Eureka" moment. Web enabled digital thermostats with wireless apps now give users more control of HVAC-R functionality, he explains. These new thermostats provide Smartcool an opportunity to embed its algorithms without any additional hardware or installation cost. In other words, home automation has just become virtual at scale. Cantech Letter talked to Burnes and SmartCool founder Ted Konyi about this opportunity and the company they are now describing as "SmartCool 2.0". Ted, you founded SmartCool more than a decade ago. Can you give us a brief overview of the company's history? The company was originally conceived as an energy efficiency company and became SmartCool Systems Inc. in July of 2004. Initially, Smartcool had the distribution rights for Canada and some US states for the proprietary Australian technology from Abbotly Technologies in Sydney, Australia. I first met Tony Murphy, CEO of Abbotly in the summer or 2004 at a grocery store install being done in Solvang, California. I was very excited by what I saw and recognized that Tony had not really been able to broaden the base for his technology. I immediately proposed the acquisition of the Technology into SmartCool and this was completed in June 2006. Unfortunately, in the intervening period, Tony Murphy had passed away and Smartcool acquired Abbotly from his estate. What happened then? Once Smartcool owned the technology, we embarked on a major initiative in the US market. We successfully passed rigorous testing at Oakridge National Laboratory, a U.S.Department of Energy test facility, as well as testing on behalf of Florida Power and Light, conducted by University of Miami. The economics of energy saving in the US proved challenging at the time due to the low cost of electricity, lengthening the ROI. This prompted the company to focus its efforts in high utility rate areas, such as the UK, Europe and the Middle East. The company acquired its most successful distributor, UK based TECC Services, in the summer of 2008 as part of its focus on more lucrative markets. The base of customers has been steadily growing in these areas since then and due to increasing utility costs in the North American market there has been renewed activity recently here. Further applications of the technology commenced in 2010 with the introduction of a simpler system that could be more easily installed in small commercial businesses and had certain residential applications. To date, this new unit, known as the ECO3, has been installed in over three thousand homes and many thousands of commercial installations. Konyi: "The ECO3 has been installed in over three thousand homes and many thousands of commercial installations." George, can you bring us up to speed on the technology? How does SmartCool save money vs. conventional cooling systems? In conventional control of HVAC-R equipment, temperature varies over the cooling cycle as load changes and the controls load and unload the system. This creates a control band. At the top of the band the system is working at its maximum efficiency. As the temperature in the controlled space is cooled the systems capacity to continue removing heat from the space drops dramatically. At the bottom of the band the system is using twice as much energy and time per degree of cooling. The Smartcool technology (ESM or ECO) is installed between the primary controller (thermostat) and the compressor in the customer HVAC-R equipment. Smartcool’s technology dynamically adjusts the length of each cooling cycle in order to help the compressor operate within the most efficient suction pressure band or modulate load for periods of time during the cooling cycle. Smartcool therefore,reduces the electrical usage by improving the performance of the compressors while maintaining temperature and humidity control. George, in talking to the both of you the phrase "Smartcool 2.0" comes up often. What has changed that leads you to believe a dramatic change shift has occurred or is about to occur in your business model? Smartcool's strategy has been to sell its ESM technology platforms directly or through distribution channels to end user customers, the majority of those being in the large Industrial/commercial space. With the introduction of the ECO, it has opened up opportunities with the smaller commercial clients and in certain jurisdictions the residential market. More recently smarter web enabled digital thermostats have been introduced with wireless apps that give users more control of HVAC-R functionality. These new thermostats provide Smartcool an opportunity to embed our algorithms without any additional hardware or installation cost. This provides the unique opportunity to dynamically provide savings when systems are operating with no intervention by the users. The larger opportunity, we consider our "Eureka" moment, is the potential to move away from the hardware installation model and provide intelligent control from a cloud based app. With the new web enabled thermostats being installed in residential applications, data from an individual thermostat could be routed through our algorithm and report back to the thermostat the most efficient run parameters. The savings being generated by Smartcool can provide the return to fund the capital outlay in less than 12 months or if used in SaaS model provide an immediate net positive cash return. The market opportunity for this is already large and growing rapidly and provides, heretofore, rapid scalability. How would this new part of your business work? Is this a licensing model? This would be a licensing model where the algorithm is embedded in other form factors, Smartcool would receive a fee for every device sold, which would be a percentage of sales proceeds. This model is actually under contract with a Third party and product will be available for sale in 2nd quarter of 2014. As for the cloud based app, the possibility of working with a home automation provider or utility on a SaaS model would yield a recurring revenue source. In January, Google acquired smart thermostat maker Nest for $3.2-billion. SmartCool CEO George Burnes says the implications will be felt across the entire space. "The connected home is certainly something that plays to our strong suit," he says. "By eliminating the hardware and installation costs, ROI’s can be generated immediately." I imagine some utilities or alarm companies would want to white label this algorithm. What would a deal like that look like for you? We think that using a cloud based solution would allow Alarm, cable, utilities and telecommunication companies who are selling bundled services including home energy management the opportunity to see significant savings using our algorithm on a fee for use basis to provide customers real time energy cost reduction. In fact this new found cash flow can offset the monthly cost of the bundled services and be perceived as major value add. Just to be clear, you are not abandoning the physical business you have built over the past decade. Can you talk a bit about the margins you generate there and about some of the savings that current customers are seeing? Not at all. In fact, we continue to gain traction in both existing commercial customer deployments and new commercial opportunities. Commercial installations will be the back bone of our revenue stream for the next few years, covering all overheads and generating profitability. With the advent of higher utility costs and a keener awareness of green initiatives, our proven technology is finding new customers regularly. Many large retail chains are starting to consider cost savings and green initiatives very seriously and we have the track record to capture some of these new initiatives. The biggest news in the space recently is Google's acquisition of Nest. Does this have any implications for your model going forward? Yes, this has really opened many eyes to the opportunities that exist in this space. The connected home is certainly something that plays to our strong suit. By eliminating the hardware and installation costs, ROI's can be generated immediately. SmartCool's ECO3 has been a hit with enterprise customers, but Burnes believes residence derived revenue could represent as much as 90% of the company's topline within five years. With home automation in full swing, what portion of your revenues do you think will be derived from residences and opposed to businesses? Is the "smart home" market a significant opportunity? As we have mentioned, this is our "Eureka" moment. Residence derived revenue could easily become 80% to 90% of Smartcool's revenues within the next five years. The market is already large and according to research forecasts, web enabled thermostats will grow to an annual $1.4b market by 2017. This is truly a perfect storm for Smartcool 2.0. If you are enabling a large client to use SmartCool's algorithm what does the revenue model look like? Is this kind of a SaaS model in which people pay as they go? What kind of control do you have with regards to shutting off the service? Anytime you can do a deal with an existing well established intermediary, whether it be a utility, cable company or alarm monitoring company, their installed base represents an immediate opportunity. To be able to leverage their efforts for mutual benefit should be very attractive from a financial perspective. With a web enabled service, control is completely in our hands. Should the customer not pay their bills, savings will cease. What kind of margins do you think you will see from the "2.0" portion of your business? Without any hardware or installation costs, marketing and accounting expense will be the primary costs. As such, margins will be very attractive. We already achieve high margins in our traditional business, exceeding 60%. We would expect the margins in Smartcool 2.0 to exceed current margins. George, what are your plans for the next 12-18 months. What kinds of milestones should investors be looking for? We're going to be very busy. There are a large number of large commercial opportunities underway and we expect most of these to add to our traditional business. We have a new hardwired initiative underway in the refrigerated transportation vertical, another very large opportunity, that we are currently in discussion with some joint venture partners. Again, the cloud based opportunity, should see completion of the R&D within the next three to four months with possible partner discussion occurring concurrently. Disclosure: SmartCool is an annual sponsor of Cantech Letter.