Power One: A Very Crowded Short

| About: Power - (PWER)

I buy stocks for a living. I also periodically short them. Shorting stocks is a very different endeavor than being long; they are not the opposite.

Power One (NASDAQ:PWER) is one of the most crowded shorts I have ever encountered - 38 million of the 83 million shares floating are currently sold short. The short rebate has climbed from a negative 7% to a negative 9% during our checks at various prime brokers over the past few weeks. The stock is valued at a trailing 3.4x EBITDA right now. Power One's main segment involves manufacturing power inverters, which are used to convert and power generated by solar arrays and wind farms into usable electricity.

To be sure, there are myriad challenges faced by the company and good reason for the stock to currently be down 15% year to date. On February 3, Power One generally met or exceeded consensus expectations for its fiscal year ending January 2, 2011. However, its forecast for the first quarter was lower than consensus and the stock subsequently plunged over 20%. Additionally, Power One derived 51% of its inverter revenues last year from Italy and this is indeed a significant risk to the company. Italy is in the midst of reviewing its solar policy and it did appear a few weeks ago that the country was going to significantly decrease, if not eliminate, Feed in Tariffs. solar and other renewables. It is still a nascent industry that has yet to achieve grid parity and its implementation relies heavily on government assistance in most countries.

Power One does compete against a number of companies, including General Electric (NYSE:GE), which makes inverters. And there are credible concerns about inventory and over capacity in the industry. Lastly, Power One just built a facility in Arizona to manufacture inverters for the U.S. market and it is feared (or hoped by some) that the company will not win more share in the United States and this facility will add to a glut of power inverters.

These concerns, or criticisms, that industry over capacity will lead to lower margins and that Italy will cease all or significantly slow down all solar installations are valid.

However, Italy already appears to be backtracking on its plan to cut solar tariffs. Italy inconveniently relies on natural gas for much of its electricity generation, which is imported from Libya. Moreover, nuclear does not appear so attractive to the world after the Japan quake and ongoing the meltdown at Fukushma.

The solar and alternative energy industry is plagued by capacity issues. Large industrial solar projects demand bank financing that is predicated on forecast IRRs. But China recently announced plans to increase its investment in solar and another 2GW of projects have been announced in the United States since January. Moreover, in the United States, many corporate and residential solar installations are moving forward that, while not as meaningful to Power One in terms of revenue, are demanding ever more solar equipment.

Power One achieved $1.04B in revenue last year and had an operating margin of 27%, resulting in $290 mil of operating income. Adding $15 mil of depreciation adds to EBITDA of $305 mil. Interest expense was a nominal $6 mil and they are not a full tax payer and will not be for many years due to NOLs. Accounting for the $227 mil of cash they have, and an $8.69 closing stock price gives them an Enterprise Value of about $1B (using 144 mil fully diluted shares). Power One is currently trading an EV/EBITDA of 3.4x1. Mature electrical equipment manufacturers are trading at multiples of 8, 9 or 12x. Given the boom and bust nature of the alternative energy space over the past cycle and Power One's relatively limited history of profitability, I grant that Power One does not merit a very high multiple.

If we assume that for 2011 Power One's Power Systems segment revenues go to zero in Italy, the remaining $350 mil of inverter segment revenues declines by 10%, and the $331 mil of Power Solutions segment revenues declines by 10%, we get revenues of $616 mil for 2011. If we further assume that the operating margin declines from 27% for 2010 to 15% for 2011 and that D&A ticks up to include the new plant just built in Arizona we get EBITDA of $110 mil. The $227 mil of cash on the balance sheet is not likely to decline since the company hasn't burned cash in two years; for purposes of this exercise we will leave it constant.

Effectively, if the stock declines by 32% from here to $6 (an arbitrary level), and the company performs as stated in the paragraph above, Power One will trade at 5.8 EV/EBITDA. A decline to $5 a share would reflect a decrease of 40% and imply a multiple of 4.5 times.

These are very draconian assumptions, but not implausible. But the average short position2 will not make 40% from here if PWER declines to 5. Over the course of six months a short might pay 3.5%, 4.0% or more in negative rebate to remain short. Additionally, much of that short interest is not bank stock, it is broker stock; in many instances shorts will be called.

My question to those who are shorting the stock at these levels is the stock could go to 6 or 5 if bad things happen but what if it doesn't? Such a high short interest implies a tremendous squeeze. This is a very crowded trade. Italy doesn't appear to be imminently halting solar installations as was thought a month ago, and renewables are looking much better after the tragic events that started to unfold in Japan.

1. Bloomberg has a lower EV/EBITDA Multiple based on outstanding, not diluted shares.

2. Silver Lake partners has a convertible preferred and may be hedging their position with short stock.

Disclosure: I am long PWER.

Additional disclosure: Presently long a small stake in Power One, that position may increase or decline.

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