SunEdison - How A Fragile Capital Structure Was Mistaken For A Large Margin Of Safety

| About: SunEdison, Inc. (SUNEQ)

Summary

Sum of the parts analysis on the intrinsic value of TERP and GLBL became irrelevant since the two captive Yield Cos can not retain a fair stock price.

While many blame Tepper for SunEdison's trouble, gaining a perceived view of independence for the captive Yield Cos is a good place to begin any hope of recovery for SunEdison.

The financial structure complexities of SunEdison ultimately lead management to take on vulnerabilities without recognizing their consequences.

This is a reflection upon the events that have taken place in the past few months with respect to SunEdison (NYSE:SUNE). Details will soon be revealed about the true situation of their financials. However, there is little doubt that what previously looked like an undervalued company for many is now on the brink of a liquidity disaster.

A superficial view

The problems on the surface level are numerous. Firstly, SunEdison is extremely capital intensive and takes on project risk itself due to actually having to own many of its assets and financing the projects itself through equity and debt. Hence, it's extremely dependent upon the capital markets which can be supremely fickle. Secondly, the company's top down message was essentially to grow as quickly as possible and as large as possible which caused it to take on the ill-fated acquisition of Vivint Solar (NYSE:VSLR). Management continued to focus on growth in a business with a capital structure that would be particularly susceptible to changes in the capital markets. Thirdly, management failed to take care for the simplest of liquidity needs. For brevity's sake, I'll leave it at that.

Valuation does not matter if your capital structure is flawed

Many investors, including David Einhorn, cited that SunEdison's ownership in Terraform Power (NASDAQ:TERP) and Terraform Global (NASDAQ:GLBL) made SunEdison a valuable company based on a sum of the parts analysis. They further claimed that the largely unproven project development business would earn a sizeable margin with or without the support of the Yield Cos (we may not see whether or not this is proven right or wrong). Regardless, neither TERP nor GLBL's intrinsic value mattered to an investment in SunEdison because the ownership in TERP and GLBL were used as collateral for SunEdison's debt obligations. Since the assets owned under TERP and GLBL were already used as collateral for debt on the YieldCo level, using the equity portion of TERP and GLBL for further leverage could only involve a margin loan of some kind and when you obtain a margin loan on a share price, intrinsic value goes out the window and your collateral's worth to creditors is only as good as what the market says it is.

From a peripheral view of the situation, SunEdison's dramatic downfall could have come from a variety of sources; lawsuits, mismanagement, a downturn in the energy sector, or its overleveraged balance sheet. However, all of these things were already quite well known when the company was selling at above $7 per share. Market participants on the long side argued that the assets that composed of the SunEdison entity were undervalued relative to the market price as a whole. These valuable long-term solar PPA assets would then supposedly provide a margin of safety for all of the negative aspects of the company as previously mentioned. Unfortunately, things did not turn out that way. The problem involved the complex financial structure of SunEdison and overconfidence in the value of their spun-off assets.

The problem with spinning off assets into a new company and retaining an equity ownership in the new company is that you generally don't have the same level of control over those assets as you did before because of the interests of a new set of shareholders or partners if you will. Hence, if you're in need of some cash for liquidity needs, you cannot depend on the new spun off company to sell its assets solely to fund your liquidity needs or for them to use their cash to purchase your goods at an inflated price even if you do have control of the company, because management has fiduciary duties to all shareholders. The only value the spun-off company has to its "parent" company is the value of the shares as determined by the public market and the cash payouts it can afford to all shareholders on a pro rata basis. In other words, when SunEdison created the TERP and GLBL Yield Co vehicles and used their equity stub as collateral for debt financing, SunEdison became dependent upon the judgment of the manic stock market for its credit financing rather than the long-term asset based lending market. Spin-offs tend to realize a lot of value for shareholders, but that's because they generally tend to become independent entities run by independent management and board members. SunEdison likely wanted to do the same, but their control over their Yield Cos and liquidity issues caused a dire lack of confidence in the independence and value of TERP and GLBL. Due to the large portion of value being assigned to TERP and GLBL relative to SunEdison as a whole, investors failed to realize the flaw of depending on an intrinsic value calculation of TERP and GLBL. TERP and GLBL may very well be worth roughly $25-$30 per share and $10-$12 per share, respectively. However, the precondition is that TERP and GLBL are perceived as independent from SunEdison's liquidity problems and to be acting in the best interests of all shareholders.

In comes David Tepper

While many blamed Tepper for SunEdison's problems, his solution of fighting for TERP's independence is, in my opinion, the only viable way forward for SunEdison. The reasoning is self-evident as given from the explanation from the previous paragraph. SunEdison's stake in TERP and GLBL needed to become buffers for liquidity, and the only way to do so would be to increase their market value; the easiest way being to get rid of the conflict of interest. Unfortunately, time is working against SunEdison, and the company may not survive to see full value of its equity stakes being recognized by the market.

Conclusion

When investing based on a sum of the parts analysis, it is vital to remember that once the assets are split off into another public entity, you tend to lose the flexibility to do certain things with those assets. SunEdison put itself in the unsavory position of financially depending on an entity it controlled while realizing it cannot fully control the company when it needed the financial support most. The conflict of interest between SunEdison and its captive Yield Cos compounded the financial troubles by devaluing TERP and GLBL's equity value which was supposed to act as a final buffer of liquidity for SunEdison. Had TERP and GLBL been recognized as fully independent and their shares reflected their assets' true intrinsic value, SunEdison may actually have had a fighting chance. But then again, you could say the same thing about a lot of the mishaps management put shareholders in over the past few months. Ultimately, SunEdison's capital structure became so complicated that even management could not fully comprehend the vulnerabilities they were setting themselves up with. The lesson in all of this could perhaps be to avoid complexity unless you understand the meaning behind the complexity.

Disclosure: I am/we are long TERP.

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.

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