We believe solar is the energy technology of the future. We like the solar space and our favorite company in the space is First Solar (NASDAQ:FSLR). You can read about First Solar thesis here. The company that is closest to First Solar in terms of strong solar technology is SunPower (NASDAQ:SPWR). You can read our opinion about SPWR here.
There are three other US public companies that are primarily focused in the solar panel installation business. They are: SolarCity (NASDAQ:SCTY) (see our thesis here and here), RGS Energy (NASDAQ:RGSE) (see our thesis here) and SunEdison (SUNE). Of these three, SolarCity gets the most press but we believe SunEdison may have the most compelling story. Unlike SolarCity, which is focused primarily on the kilowatt residential market, SunEdison is primarily focused on the megawatt commercial and utility scale markets. In the long term, we believe that the megawatt markets are likely to be much more sustainable and profitable for a public company. The smaller kilowatt systems are likely to see substantial margin compression and are more likely to be dominated by low overhead local and regional contractors than by high overhead public companies.
In the large commercial and utility sector, SunEdison competes directly with First Solar and SunPower. SunEdison, unlike First Solar and SunPower, is technology agnostic and instead of developing solar cell technology, it has bet on the commodity silicon solutions. While "commodity solar" has certain negative connotations, SunEdison management is well aware that First Solar and SunPower proprietary solutions are significantly handicapped in certain product attributes. Over the past couple of years, SunEdison exploited this dynamic to its benefit. SunEdison has seized on the market opportunity early and has done admirably well in the past few years at growth rates far exceeding that of First Solar or SunPower. SunEdison has developed reputation for excellent project completion and is seen as a reliable, top notch project developer in commercial and utility scale markets. And consequently, SunEdison scale is rapidly approaching that of First Solar.
However, competition in the commodity solar module developer segment is likely to get intense over time. Every Chinese solar module manufacturer of note (for example JinkoSolar (NYSE:JKS) see thesis here ) has entered the project business. While the Chinese competitors have not been of much threat in the past due to their poor balance sheets and bankability issues, the situation has changed dramatically in 2014. We expect competition in this segment to get intense going forward and we do not view any of the commodity solar panel companies gaining sustainable long-term barriers that enable high profit margins. However, over time, the dominant players in the industry can develop a significant amount of brand equity and deliver reasonable return on investment. And, we believe SunEdison is well positioned for leadership in this segment.
The execution history of SunEdison makes it a strong investment candidate but understanding the valuation of the company is rather difficult. The reason for this is twofold:
1. SunEdison currently has two distinct operating units - a semiconductor unit and a solar energy systems unit. The semiconductor unit has been underperforming for several years and is set to be split from SunEdison imminently. The implications of the semiconductor unit's split on SunEdison's cash flow and future operating metrics are somewhat uncertain at this point and will not be known until split is completed.
2. SunEdison, like SolarCity, is starting to retain projects for itself (instead of selling them) in the hopes of capturing large future retained value. We have already written about the risks of this dynamic in an earlier article. We believe that SunEdison management needs to develop the models for long term energy prices, customer default rates, and share the risks of its long-term contracts to enable investors to develop a reasonable value of the retained value.
Unfortunately, the above issues largely handicap investors' ability to come up with a reasonable valuation for SunEdison. In the absence of proper information, markets can reach inappropriate conclusions on the value of SunEdison's business.
In the recent past Wall Street analysts have started valuing SunEdison and similar companies based on a multiple of retained value without so much as even understanding what this really means. We believe there are far better ways to modeling the impact of retained value on company valuations. And, we believe that a reasonable valuation method will not involve approximating retained value to earnings and giving the company a multiple based on retained value. Before we get too far on the path of meaningful valuation methods, we believe the onus is on the company management to do appropriate modeling and share the assumptions behind their retained value calculations.
When it comes to a project developer like SunEdison, company management and investors need to be careful about estimating a company's market value. A bad valuation methodology not only harms the investors and employee when it unravels but it also incentivizes management to make bad companywide decisions. For example, a company valued on the basis of a multiple of retained value may lean towards project development models where it increasingly takes low margin businesses in the hope of future retained value. This kind of valuation may also incentivize managements to make unrealistic assumptions in their 20 year revenue stream calculations. And unscrupulous managements may resort to other shenanigans to increase the nebulous retained value (this is a commentary on incentive structures and we do not mean to disrespect or impugn SunEdison management here). After all, the current management teams of most public companies are unlikely to be around years from now when the earnings streams do not pan out.
While we like SunEdison's business model and its performance to date, we are reticent to consider it as an investment at this time. Long-term investors need to be aware of these dynamics and consider them carefully before investing into SunEdison or any of the other solar project companies.
Disclosure: I am long FSLR, JKS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.