A Real Opportunity Part 2: Real Goods Solar

Jan. 9.14 | About: RGS Energy, (RGSE)

Since I first published on this several weeks ago A Real Opportunity: Real Goods Solar Real Goods Solar is up greater than 50%. I believe a combination of several meaningful business developments, additional positive analyst coverage, and other bloggers writing about the tremendous opportunities for RSOL are responsible for this . I believe this is only the beginning of a potentially massive move that I will quantify further below.

In my last article I discussed the opportunity in the downstream space and highlighted Real Goods Solar (RSOL) as a company which has been overlooked by the market. The article went on to point to the varying approaches taken by RSOL vs. their main competitor SolarCity (NASDAQ:SCTY). It's often a good idea, much like when biotech/pharma stocks present their data in peer reviewed journals, to challenge yourself and your hypothesis in the light of day and let the chips fall where they may. It was both exciting and refreshing to see that the only push back came from an often short day trader based in Germany whose main contention was that RSOL would be unsuitable for a financial transaction due to their lack of size. Of course lack of size would not limit banks and underwritten investment vehicles (liquidity pools) from participating in offering potential consumers the ability to adopt solar by utilizing lease like arrangements offered by SCTY. These liquidity pools critically allow customers to avoid a large upfront capital outlay. I decided to circle back to RSOL and discuss the issue further.

My logic has been that many banks would line up to participate in the nascent secular boom of greener/cheaper solar adoption. Further, that the size of the company, particularly as we move out in time, will not be the dependent variable for solar companies looking to access these liquidity pools. For example, many banks will loan to the secondary and tertiary automakers, homebuilders, appliance makers, etc. The main consideration for the banks should and will be the creditworthiness of the borrower and the profitability of the loan. Extensive conversations with management and investor relations confirms my previous logic that RSOL's size will not preclude them from participating in strategic transactions. These transactions could provide the company with liquidity pools, like the ones SCTY routinely enjoys, which allow potential customers the ability to avoid a large upfront payment.

New management took over in 2012 and their strategy was to first stabilize the patient, after the Alteris integration issues, by cutting costs and streamlining operations (the bulk of the heavy lifting here has been done and the business will regain profitability shortly as management had indicated on their last quarterly conference call). Second, to clean up the balance sheet by eliminating their debt through a series of offerings which are now completed. Third, they chose to make some smaller acquisitions to gain a competitive advantage, from a cost perspective, over the fragmented downstream market which is comprised of mainly smaller players. As a bonus they were able to pick up a handsome chunk of cash while doing so ($9 million from Mercury alone). Fourth, only when all of the above conditions were satisfied, go out into the marketplace with a much stronger position of leverage and credibility and monetize the success of the SCTY approach. From what I gather, investors from all walks have been pressuring the company to unlock this value for over a year now. Understandably management had decided steps 1-3 were the necessary precursors to any SCTY like approach which could explode revenues. So where does that leave us? If RSOL can successfully migrate their business model to profitably and monetize these liquidity pools, like SCTY, then what is RSOL worth?

Valuation

I believe when trying to value RSOL there are two ways to do it. The core integration business that the company has grown from $39 million in 2008 to what is predicted to be between $128-161 million for 2014 (according to wall street estimates and inclusive of the close of Mercury slated for January 14th). When I look at the models of the 3 analysts that cover RSOL I'm struck by one consistent theme: Conservatism. None of these analyses give much attention to the notion of what will happen if and when RSOL transitions to more of an SCTY like approach. The inclusion of liquidity pools could change the game by solving the largest hurdle for adoption (large upfront capital outlays by the consumer). Further, they look at the current book of business and give current management team little credit for having successfully cleaned up the business. In 2010, on just 77 million in revenue, RSOL generated 7 cents of adjusted eps profits. A return to those non scaled economics (their is leverage to growth and scale in this business) would yield 21 cents of adjusted eps at $210 million in revenue. I think this could be possible in a year. For a stock growing this quickly, in a space as hot as this, (not to mention the scarcity value of ways to play the downstream space) a 30x p/e would yield a $6.3 fair value. Add the roughly 25 million the company will have in cash (roughly 70 cents and closer to 50 cents when you adjust for warrants and additional shares from Mercury) you can easily get close to a 7$ price target for the core integration business using a p/e type valuation. On the other hand if we look at the standalone business on a revenue multiple (like many are doing for SCTY) the numbers get much larger. Goldman recently added SCTY to their conviction buy list with an $80 target but acknowledged how it could easily get to $100 should growth accelerate. They assign half of the $5.7 billion enterprise value for SCTY (at current levels not their price target) to the core integration business (the identical business to RSOL) and the other half to the leasing business. That means they think the standalone RSOL like business is worth $2.85 billion (again with current market price not their target price). Lets be generous and look out to 2015 for SCTY(instead of using 2014 consensus of $259 million) and use the $488 million in sales the street consensus currently expects. We get a 11.68 revenue multiple. If we use the same 11.68 revenue multiple for the core standalone integration business, on the $173 million street consensus for RSOL 2015 revenue estimate, and divide it by the roughly 50 million shares out (on a fully diluted basis) we can get to $40.41. Again it is important to note, Goldman has an $80 target and speaks to how it could easily move to $100 should growth accelerate. I'm using today's SCTY valuation not their price target assumptions which are much higher. So the standalone integration business for RSOL can be $7-40 (more if you believe the bullish SCTY targets) based on a p/e analysis or the more aggressive deconstructed SCTY valuation. If Goldman and the other SCTY bulls are correct, and half of SCTY's valuation is comprised of an identical RSOL integration business, why the discrepancy in valuation? After all the only two differences are the leasing business/liquidity pools SCTY has and Elon Musk. Perhaps SCTY pioneering liquidity pools in this country (already been done in Germany) allows investors to think more broadly in the massive greener solar opportunity. Perhaps the largest shareholder/visionary Elon Musk has given investors confidence in the bigger picture. The integration business is the same. SCTY has Musk and liquidity pools. To the extent RSOL obtains a liquidity pool, what multiple of their projected revenue should their business trade at? Sub 1x 2015 like they do now or over 11x like SCTY does? People might say wait a second, Musk is part of the reason for the premium. Ok, well what if RSOL obtains their liquidity pools from SCTY. Or better yet, what if SCTY realizes the valuation discrepancy and buys RSOL?

Goldman argued the downstream space is the best way to play the solar market given the superior growth rate of the rooftop market and because there less risk to policy in this part of the value chain. What they left out and what I think is the most important advantage of the downstream space is that it is technology agnostic. As pointed out in the previous article, the panel makers are at constant risk to better technology with lower cost and higher efficiencies from a competitor. In the downstream space you have the luxury to source from the highest efficiency/lowest cost producer at a particular moment in time. This should inherently lend to premium valuations of the downstream players vs. the upstream players.

If RSOL were to take the liquidity pool business model into their approach how should we then value it? We see as a standalone how we can get to $7/share in the more conservative p/e valuation methodology and to the extent they don't incorporate the SCTY approach but execute on their core business as a base case from the analysis above. This leaves the company trading at an extremely depressed (at 7$) 1x 2016 revenue and 30x p/e basis (which Cowen who has the lowest target acknowledges is extremely depressed multiple relative to peers and to the extent they execute will yield large upside). To the extent RSOL attracts a partner and obtains a liquidity pool can we put an 11x revenue multiple on street consensus? My guess is that if RSOL obtains a liquidity pool their revenues, much like SCTY's has done, will explode. But even if they didn't, RSOL would need to be massively re-priced.

Conclusion

Words are cheap and actions are not. Clearly the market understands the value of the SCTY approach as evidenced by the valuation differential of SCTY and the random explosions in RSOL as the market has toyed with the idea of an RSOL conversion. Management understands the markets desire to see them make the transition to the SCTY approach and I'm sure investors have salivated at the calculations done above. The analyst community and the market have taken a wait and see or show me approach to pricing in the possibility of SCTY like liquidity pools for RSOL. The introduction of this change makes RSOL somewhat of a binary biotech like price movement to come (to the extent they do it of course). I believe the power of the opportunity is not lost on management and continue to believe this is not a question of if but when.

Let's take the average of the $7-40 discussed above and we get a $23.5 target. Let's say there is a 50% chance of this happening (I think it is much greater than this but let's be conservative) over the course of the coming 2 quarters. RSOL should be $11.75 right now and if they were to announce liquidity pools tomorrow it should be $23.5 in short order. If they were to announce liquidity pools with SCTY the stock could go to $40.

Again I would encourage everyone to do their own due diligence but this is my thought process and I believe in it firmly. I am long the stock and will trade it as price dictates as I'm an active trader/manager. I know I'm not the only one with these thoughts but given the stock price I'm clearly in the minority. If there were even just a small chance for RSOL to adopt the SCTY approach an efficient discounting would have the stock price materially higher right now.

Disclosure: I am long RSOL, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long it and plan to trade it actively based on price