A phenomenon in the stock market that continues to fascinate me is the way in which closing prices become “fact”. What I mean by this is that investors behave in a way that implies that yesterday’s closing price was the mythical intrinsic value and today’s news, whether positive or negative, should result in some sort of delta from yesterday’s close.
Let’s imagine that stock XYZ is trading exactly at its intrinsic value of $10 and then announces negative news which fundamentally lowers its intrinsic value by $1 however market forces (see: evil hedge fund short sellers, high frequency momentum traders) send the stock down $2 and it closes the day at $8 per share. Now let’s assume that another piece of negative news comes out the following day which again decreases the fundamental intrinsic value of XYZ by another $1 leaving the intrinsic value at $8 per share. Despite the stock already trading at its new appropriate intrinsic value I will guarantee you that the market will send the stock down further and will view the prior day’s closing price of $8 as the base for which to calculate the magnitude of the second day’s trading. The obvious problem with this type of trading mentality is that yesterday’s price was not necessarily accurate.
I dub this phenomenon the “compounding of irrationality” and I see its occurrence as a major source of the mispricings that develop in stock market over time. As a fundamental value investor I am grateful for the “compounding of irrationality”, despite how maddening it can be in the short term, because it creates investment opportunities. A stock that has recently been punished by this folly is Power-One Inc. (PWER) which currently offers investors an attractive entry point.
PWER sold off -23% in one day last month after issuing guidance for Q1/FY 2011 that was below Street expectations. While certainly dramatic, some sell-off was warranted as the company warned of inventory issues in the channel and expectations for further feed-in tariff reductions. However it is the price movement after the big sell-off that I find most interesting and more relevant to the “compounding of irrationality” idea.
Following the disappointing guidance, PWER has seen its share price decline further on news of rumored changes to subsidies in Italy and lackluster guidance from peers Energy Conversion Devices (ENER) and SatCon (SATC). The isconnect is that these items have all just been a re-hashing of the same news that PWER announced in early February. The various and unwarranted declines have resulted in a compelling mispricing for PWER. PWER sells into a growing market that is benefiting from a positive long term secular trend as solar power becomes a larger part of the world’s energy solution. PWER has a pristine balance sheet with $1.21 per share (17% of stock price) in net cash. Given the undemanding valuation, technological expertise, brand recognition, and attractively located manufacturing facilities I think PWER could be an acquisition target at some point in the future.
Power-One (PWER) designs and manufactures power conversion and power management solutions for alternative renewable energy, data storage servers, wireless communications, and other industrial markets. PWER derives over 70% of revenue and ~100% of operating income from the renewable energy segment which designs and manufacturers inverters for solar power systems. Inverters are used to convert Direct Current (DC) electricity which is produced by most alternative energy generation sources into Alternative Current (AC) which is needed for most applications including connection to the electric grid and powering homes.
PWER sells products under the Aurora name and is currently the 2nd largest inverter company in the industry behind SMA Technologies. The remaining 30% of revenue is derived from the Power segment which designs and manufacturers power conversion devices for computer server, storage, networking, industrial, and transportation markets. PWER has manufacturing centers in China, Italy, Ontario, and Phoenix. Private equity firm Silver Lake Partners has a large convertible stake that could be fully converted into 32% of common shares outstanding.
Stock is mispriced given industry growth
PWER has experienced phenomenal growth over the past year, FY 2010 revenue was up +140% vs. 2009, however the rapid growth now appears to be behind the company as Q1 revenue is expected to show the first sequential decline in about 8 quarters although yr/yr the top-line is still growing +68%. At the current valuation I see the stock as being mispriced on a DCF basis even if we assume the top-line never grows again so any growth will be incremental upside assuming margins do not collapse. Guidance for FY 2011, which was released a few weeks ago, calls for +14% revenue growth.
PWER sells into a growing end market as solar energy becomes more utilized and economical. The rapid decline in panel prices coupled with the increased efficiency has brought solar energy closer to grid parity. My contact in the solar industry believes that grid parity could be reached in certain areas (areas with lots of sun and high electricity costs) by 2013. The decline in the cost of solar is slowing (good for solar pricing) and from here the driver to grid parity will likely be the rise of electricity rates.
Currently solar relies on subsidies to make the project economics work. A widespread cut in subsidies is the largest risk to the solar industry however once grid parity is reached subsidies will no longer be required and the industry will be able to stand on its own. Currently the US generates less than 1% of all electricity from solar power which pales in comparison to Germany which generated 14% last summer, this highlights the vast amount of “runway” for industry growth. The transition to solar energy should provide PWER with a growth tailwind for many years.
Historical Solar PV Shipments by Region (click to enlarge):
There is concern among investors regarding solar’s heavy reliance on European countries and the viability of continued subsidies amidst the stresses on government budgets. 2010 was by all accounts a banner year for the solar industry as solar installations were up +110% yr/yr.
If we look at the different solar markets over time we see that different countries have taken the lead role in solar deployments at different times. Currently Germany and Italy are the major players in solar deployment whereas Spain which was the largest solar country in 2008 is now one of the smallest players. While the players at the top shift around I think it’s crucial to note that overall “pie” is projected to remain relatively firm which is inconsistent with how some of the solar stocks are being priced (PWER is trading at 3.5x EBITDA with zero debt). In 2011 overall solar deployments are expected to be flat yr/yr, deployments in the markets most relevant to PWER are expected to decline by ~4% yr/yr and then grow again +9% the following year (click on each chart to enlarge).
Germany is expected to remain a mainstay in the solar arena and has a healthy economy to support subsidies. Of the European countries that are facing sovereign debt concerns and budgetary stresses, Italy is the largest player.
While it makes intuitive sense that countries with budget concerns would look to solar subsidies as a way to cut government spending the reality is that solar subsidies are quite small in the scheme of things. For both Italy and Germany solar subsidies amount to only about 0.16% of GDP ($3.5b and $5.3b respectively) in 2010. This amount is inconsequential relative to the larger budgetary issues such as entitlement spending and public employee costs. As such I do not see budgetary stresses as being the driver behind subsidy cuts but rather I see grid parity and excessive investment returns on solar projects as being the catalyst.
Valuation compelling on absolute and relative basis as well as sum of the parts
PWER is trading at a compelling valuation on virtually every metric, it trades at a significant discount to the peer group (peer group EV/EBITDA: 8.7x, PE: 11x ) and looks undervalued on a sum of the parts basis. Currently 30% of PWER revenue is derived from the Power sales business which is a very low margin business. In Q4 the Power segment posted positive operating income which was the first time they had achieved that in awhile.
The future of PWER is clearly the Renewable energy inverter business so I would not be surprised to see PWER divest the Power business at some point. If we assume the Power segment is able to fetch a price/sales multiple that is given to the most commoditized electronics manufacturers (P/S: 0.32x) that segment is worth $.67 per share, add in the $1.21 of net cash, and the $10+ that I think the Renewable energy business is worth ($10 on a PE basis, $10.50 on a DCF basis) and PWER should be trading above $12. Given the low valuation, excellent balance sheet, and industry dynamics I think it is likely PWER gets acquired at some point.
Inverter space is more attractive and defendable than panels
The bear case for solar companies, which I see as the current consensus view given that the group has a very high short interest, is that there has been and will continue to be fierce price competition which will dramatically erode margins. It is likely that solar panels will face a supply/demand imbalance in FY 2011 resulting from a ramp up in manufacturing capacity.
According to IMS Research capacity increased +70% over the course of 2010. The expected oversupply should continue to pressure panel prices and lower the overall costs of solar which should drive demand for solar projects as it becomes a more economically attractive way to generate electricity.
The potential for this negative view to play out is possible although it is more applicable to the panel manufacturers such as First Solar (FSLR) because solar panels are becoming more commoditized. Invertors however are becoming more complex and are essentially the “brains” of a solar project. The increased complexity and varied performance capabilities lead to differentiation and competitive advantages for inverter companies which solar panels do not enjoy. Inverters compete on performance as opposed to price. An inverter is only about 10% of an overall solar project whereas the panels comprise 40% of the project cost. Evidence of this dynamic can be seen over the past several years as inverter prices have declined by much less than panel prices. Pricing for PWER on a per Mw basis was firm in FY 2010.
Huge short interest
PWER has a huge short interest with 45% of the float currently short. I estimate roughly 20-25% of this short interest is due to the convert outstanding but adjusting for that we are still at 15-20% short interest which seems like a dicey situation for shorts given the stock is at 3.5x EBITDA with $1.21 in net cash per share. The short call worked as evidenced by the -23% decline last month however it looks like many of these investors have kept the trade on. Any improving sentiment could result in a short squeeze with the short trade that crowded.
- Government subsidies for solar power disappear as a result of budget tightening. This is the largest risk to the solar industry and inverter volumes which are dependent on solar project volumes.
- Price competition grows within the inverter space.
- Growing solar inverter market attracts new entrants. PWER is insulated by incumbent status and #2 market share.
- Electricity prices fall worldwide making grid parity less likely. I see this risk as remote in our commodity inflationary world.
- Interest rates rise which makes project financing more expensive and the economics of solar projects less appealing.
- Technical obsolescence for Aurora inverters including the potential for future adoption towards micro inverters. I see no reason to expect PWER technology and products to be rendered obsolete, spending on R&D has grown over the past two years.
Furthermore there are fewer competitors in the inverter space. There are over 200 suppliers of solar panels versus fewer than 20 for inverters. Currently PWER has the #2 market share and offers some of the highest yielding inverters relative to competitors.
The inverter market is somewhat insulated from new competition as inverters also compete on service capabilities and warranty credibility which new upstarts have trouble competing with the name recognition, proven field hours of reliability, and balance sheet to match incumbents like PWER. The market is wrongfully extrapolating the intense price competition that has been seen in the solar panel space onto the inverter space which is unwarranted because the inverter industry is less competitive, less commoditized, and requires more technological and design expertise. At 3.5x EBITDA I think PWER offers plenty margin of safety should some price competition emerge.
Disclosure: I am long PWER.