Shining Light On The Valuation Of SunEdison's Transformational 'PV' Retention Business Model

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Includes: SUNEQ
by: Hayden White

Summary

SunEdison recently expounded in a capital markets day presentation upon its shift towards a retained PV strategy, facilitated by its anticipated launch of a Yield Co. to finance solar projects.

By retaining projects on its balance sheet, SunEdison will benefit from a lower cost of capital, reduced frictional costs, and access to residual cash flows as owner of PV projects.

The implementation of SunEdison's new business model will generate lighter earnings in the near term but should cause earnings to accelerate over time.

Investors may be best served valuing SunEdison today on an adjusted earnings basis, similar to the one presented in this article.

For some time now, SunEdison has been extolling the virtues of a transformational shift that it is making to its business model. The strategic shift, however, is a bold one that the market may not yet fully appreciate, even though SunEdison has spent considerable time explaining it.

Starting in 2013, SunEdison began to tout the benefits of shifting away from its historic business model of developing and selling solar projects. CFO Brian Wuebbels described this transition as a move from a strictly "gross margin game," one in which SunEdison had previously sold solar projects to customers, recorded their sale, and allowed those revenues to flow through P&L, to what he calls a "retained value game." Under the retained value model, in addition to selling solar projects to customers outright, SunEdison plans to retain at least 50% of its solar projects on its balance sheet. By placing 400 to 500MW of projects into securitized investment vehicles as well as a Yield Co., SunEdison plans on taking advantage of a lower cost of capital and benefiting long term from the repeatable, annuity-like energy sale cash flows.

From a gross revenue and short-term P&L standpoint, SunEdison's decision to step away from its previous "gross-margin" strategy and more toward a more balance-sheet driven model might make some investors a bit uneasy. With SunEdison, however, that should not necessarily be the case. In fact, SunEdison's depressed near-term sales and earnings should be viewed as only a temporary accounting setback and symptom of the company's unfolding strategy. After SunEdison's most recent capital markets day, it is clear that management's decision, while at the expense of short-term earnings, is geared toward best realigning the company and its business model with long-term growth opportunities in the PV space.

Right when investors thought valuing players in the solar industry was difficult enough, SunEdison has introduced yet another uncertainty aside from the industry itself that makes assessing its value that much harder. Nonetheless, if SunEdison's management achieves what they have described in its capital markets day and the solar industry continues to grow consistent with their expectations, patient investors should be rewarded.

Strategy's Incremental Value Creation

During the fourth quarter, SunEdison completed a record development of 333MW of projects but sold just 206MW of those projects. By forsaking the sale of 127MW and the associated $100 million of short-term gross margin benefit, per its fourth quarter earnings call, SunEdison claims to have captured $250 million of economic value or $160 million of incremental cash flows above those generated from the sale of solar projects alone. The caveat to all of this is none of the $250 million of economic value generated from holding these projects could be reported as earnings during the quarter. Consequently, the new PV retention strategy caused reported earnings to be approximately 39 cents per share lighter than had the company not retained those megawatts.

Graph courtesy of SunEdison's 2014 Capital Markets presentation

CEO Ahmad Chatila has stated that reported 2014 and 2015 earnings will also suffer from the transition into the new strategy. However, management believes that it is growing shareholder value by retaining PV assets on its balance sheet and forsaking fixed reportable earnings of roughly 64 cents per watt from the sale of projects. SunEdison believes sacrificing near-term earnings is compelling because it enables the company in the future to generate, on a present value basis, about $1.92 per watt on projects that it retains. That is nearly three-times the company's current earnings per watt when it sells the solar projects.

During the capital markets day presentation, CFO Brian Wuebbels identified three economic benefits of its retention strategy: a lower cost of capital, reduced frictional costs, and access to residual cash flows. Perhaps the greatest benefit of the retained value strategy, which SunEdison values at 63 cents per watt on a net present value basis (or roughly half of the additional $1.28 per watt of value derived from retaining projects), comes from the favorable financing obtained by "dropping" projects into a Yield Co. (A Yield Co. is a separate vehicle that will hold the projects and pay out dividends to SunEdison and other investors.) At the moment, the company conservatively projects that the use of the Yield Co. will lower its effective cost of funds to roughly 6 percent. The second economic benefit SunEdison claims to keep from the strategy shift is an additional 23 cents per watt of value generated from reduced frictional costs. The company defines those costs as expenditures associated with the negotiations between buyer and seller over price, output, degradation, etc. The last identified benefit pertains to the incremental cash flows produced from the residual value of the PV assets that SunEdison will ultimately be entitled to as owner of its projects. By holding onto solar projects, SunEdison anticipates it will generate roughly 42 cents per watt of present value cash flow off a project after their initial PPAs, which typically last 15 to 20 years, expire.

Today's Development Drives Tomorrow's Earnings

SunEdison plans to apply its PV retention strategy going forward to a larger book of business and generally plans to keep increasing the percentage of completed projects that it retains, selling at least enough projects to cover operating expenses. In the capital markets day presentation, CFO Wuebbels set forth in slide 49 a limited view of its "value creation model." The slide below illustrates the dramatic value creation that the new strategy will help unleash, but close examination also reveals how SunEdison's true economic performance will be dramatically understated in the near term.

Graph courtesy of SunEdison's 2014 Capital Markets presentation

By way of illustration, the slide above compares the company's historic develop and sell model to the PV retention model assuming that SunEdison is able to complete 1.5GW of solar projects and then retain 50 percent of those developments in 2015. Under the company's traditional "gross margin" approach, SunEdison's sale of 1.5GW of projects would generate an estimated $830 million of gross margin compared to only $350 million of gross margin were SunEdison to retain 50 percent of those projects. That forgone $480 million of reportable gross margin ($1.80 per share before taxes) will not show up on the company's 2015 income statement. However, three times that value will be captured in reported earnings over many years after the project's development. Importantly, these are amounts that are "earned" from an economic perspective, but they will only be booked over the period which the power generated from the project is sold under PPAs.

SunEdison made it clear in its presentation that it will continue to ramp up the percentage of projects retained as developments completed per year grow. For 2016, SunEdison anticipates keeping 60 percent of projects completed if it is able to grow its business to 2GW by that time. Although not modeled out, the CFO suggested that reportable earnings will begin to mushroom rapidly for years into the future as SunEdison starts to be rewarded with cash flows from retained PV energy sales. Thus, over time, SunEdison expects reported earnings to begin to catch up with the value creation engine that it is aiming to establish.

Valuing SunEdison on an Adjusted Earnings Basis (For Future Value Created Today)

The question, however, is how does an investor value the new business model in the interim years where reported earnings will suffer. Currently, SunEdison's stock is trading at an approximate 50 price-to-earnings multiple over the consensus 2015 earnings estimate of 40 cents. That might seem like an overly generous forward multiple, even for a somewhat rapidly growing company. However, during this transition period, valuing SunEdison based on a conventional price to earnings or EBITDA method might not be appropriate. Another approach might be to value SunEdison based on reported earnings as adjusted for foregone gross margin from retained projects. For example, for the 2015 scenario described above, the earnings for valuation purposes might be more appropriately viewed as including at least the $480 million of gross margin that SunEdison would have generated from selling those projects. That $1.80 per share pre-tax earnings dwarfs the consensus earnings estimates for 2015 and is likely on top of current analyst consensus projected earnings of 40 cents. Thus, assuming a 35 percent effective tax rate, the adjusted earnings for SunEdison in 2015 would be reasonably expected to range from $1.17 per share to $1.57 per share (if added to the 40 cents share consensus estimate). On that basis, SunEdison shares (trading at about $20) might appear undervalued depending on expected growth rates.

CEO Chatila tried to drive home his belief in the new model by pointing out that he was willing to sign off on reporting a loss for the quarter even though he could have reported a gain by selling projects. From this alone, it seems certain that at least some additional value (beyond the foregone value) is being created. The question is how much of the $1.28 of "value capture" that SunEdison expects should be included in "adjusted" earnings for valuation purposes. The greatest contributor of incremental value comes from a reduced cost of capital associated with placing retained projects in the Yield Co. SunEdison believes that it will save between 1 to 1.5 percent in effective financing costs through the Yield Co. and possibly even more if the estimated expected yield of 6 percent sought by investors proves too high.

Under the 2015 scenario described above, SunEdison would be capturing $472 million of future savings on the retained 750 megawatts financed at 6 percent. That cost of capital savings translates into another $1.77 per share of pre-tax benefit ($1.15 per share after-tax) from the PV retention strategy. Assuming the Yield Co. provides a sustainable financing advantage, it is difficult to understand why an investor or analysts would not view the 63 cents per watt (pre-tax) of cost of capital savings as a favorable adjustment to projected 2015 earnings.

Thus, assuming a development run rate of 1.5GW for 2015 and beyond, SunEdison should be viewed to have earned no less than an additional $1.27 per watt of profit (64 cents of foregone margin plus 63 cents of cost of capital savings) on the 750MW of panels it would retain, meaning that it should capture at least $952 million of value from those retained projects. On a per share basis, the $952 million of profit would produce $2.32 per share of value to shareholders assuming an overall 35 percent effective tax rate. That $2.32 would be on top of the net earnings that would arise from the remaining business (or on top of the currently projected 40 cents per share projected by analysts for 2015).

It is difficult to know whether an adjustment to the projected 2015 profit should be made for any of the frictional costs and pricing assumptions that SunEdison claims to avoid by retaining the projects. SunEdison claims that project purchasers now get this extra 23 cents per watt when projects are sold. It has described the value forgone from selling projects as attributable to negotiating friction by parties making conservative assumptions about future project performance. For instance, SunEdison claims that projects are sold assuming a greater panel degradation rate than is justified. Also, the company indicated that it will avoid legal and other fees associated with the individual negotiation of project sales. To be conservative, it might be sensible to exclude this additional value from the estimate of adjusted earnings, but an analyst more familiar with industry dealings might be able to validate whether these incremental benefits, if realized, are worth $112 million or another 42 cents per share on an after-tax basis.

The other more meaningful piece of the value creation that SunEdison claims to obtain by retaining projects is related to the residual cash flows generated after the company's 15 or 20-year power purchase agreements have expired. Per the capital markets day slides, the present value of those residual cash flows is worth 42 cents per watt. The assumptions used to arrive at the 42 cents per watt figure were not provided by management. However, the CFO did stress during the Q and A portion of the company's fourth quarter conference call that it currently realizes no value during the tail period for sold projects. The CFO later elaborated on the company's calculation of the incremental benefits from residual value cash flows, explaining that the 42 cents per watt is a present value estimate of the power SunEdison can sell at a substantial discount upon expiration of the initial PPA.

Even the most skeptical analyst would have to assume some value should be realizable during the residual period - at least during years 20 through 30 of the project. Given the rapid change that has occurred in the industry in the last 5 to 10 years, it might be next to impossible to reasonably predict how much SunEdison will be able to sell those watts for in the future. Indeed, it is possible that the substantial discount that SunEdison is assuming may prove imprudent due to increasing gas prices or curbs on carbon emissions. No matter the case, some significant positive future cash flows seem certain, so it might be fair to conservatively assume that half of the 42 cents of value that SunEdison projects will be captured. That estimated 21 cents per watt of additional value retained is worth an additional 38 cents per share after-tax.

As set forth in the table below, the estimated $3.10 per share of adjusted earnings or "economic profit" generated in 2015 under the company's projected 1.5GW of solar project developments would far exceed reported earnings. Assuming the adjusted earnings or economic value is a sound measure of SunEdison's per share value creation, the use of an adjusted earnings approach along the lines described above should be considered in valuing SunEdison at least during the initial phase of its strategy shift.

Projected 2015 EPS As Adjusted Under the 1.5GW of Production Scenario

Adjusted Mean EPS Estimate

$0.40

Forgone Gross Margin on Sale of 750MW

 

$1.17

 

Adjusted EPS (As if Sold)

$1.57

Additional "Unearned" NPV for Retained 750MW

   

Cost of Capital Adjustment

 

$1.15

Estimated Residual Value Adjustment

 

$0.38

 

Total Adjusted EPS

$3.10

Leap of Faith Should Prove Justified

During Ahmad Chatila's tenure, he has essentially reinvented the company (formerly MEMC) so as to be the third largest solar project developer in the industry. Given the financial team that he has put in place, the PV retention strategy has likely been well thought out. Indeed, as with other solar players like Solar City, SunEdison understands that the cost effective deployment of storage might be the final piece to the puzzle that makes solar into something more than just "alternative" energy. It is not inconceivable that SunEdison sees storage not only stimulating greater solar development projects but also enhancing the value of projects already owned. Any value created from storage is certainly not modeled in today, but it does give investors some additional comfort that SunEdison's PV retention strategy has even more upside than management is even suggesting.

Determining SunEdison's value today is not a straightforward exercise. A sum of the parts valuation method might be used as hinted at by Chief Strategist Stephen O'Rourke during SunEdison's capital markets day. That approach may actually underestimate the true earnings that SunEdison's strategy might generate. Projecting those cash flows is difficult and today, at least, the market seems unwilling to assign much weight to the hidden value that SunEdison believes its new strategy creates. Over time, however, those earnings will become more visible as SunEdison starts getting compensated with meaningful earnings for its past efforts.

Disclosure: I am long SUNE. 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.