Pricing a company for an acquisition is never simple. Some valuation methods are an exercise in creative art while other methods are more structured. ABB Ltd (NYSE:ABB) completed the task recently by putting a value on the solar-inverter business of Power One (previously PWER). ABB is one of the most respected companies in grid energy control. If anyone knows that market, they do. When they made the decision to purchase Power One last year, it is likely that their analysis was quite thorough. This article will make the comparative case that Enphase Energy (NASDAQ:ENPH), a young company with few assets, has value comparable to the Renewables division (solar-inverters) of Power One based on superior revenue growth trends and future earnings potential.
The Power One acquisition by ABB appeared to make good sense since Power One was not only well established in solar power inverters, but also had a presence in power solutions. It looked like a good match, but was it a good deal? Power One investors were not so sure. Shareholders were understandably very upset that their shares of PWER, which had once IPO'd at $14 and were trading over $10 just a couple years prior, were now being put to rest at about half that number with a $6.35 per share buyout. Let's look at what ABB got for their money.
Looking at asset value, Power One was showing roughly the same $790 million at March 2013 as they were the year prior. That likely played a key role in the $1,028 million price tag, which was only a 25% premium over asset value. But using assets as a basis for value in this case would have been a mistake due to the declining potential of these assets to generate revenue. Inventories, property and equipment represented about a third of that asset number. And while Power One had just launched its first-generation micro-inverter, much of their asset value was based on string-inverter technology. This was a technology that was already losing sales to the micro-inverter market dominated by Enphase. And one year later, the emergence of the micro-inverter market is still only starting to become understood. I attempt to provide a summary of that competitive marketplace in the opening of a separate article.
As the eleventh hour approached, it was no secret that Power One was rapidly losing sales. The very last 10Q filed independently by Power One for Q1 2013 showed that their Power Solutions division comprised of $59 million (29%) and their Renewables division (solar-inverters) provided $146 million (71%) of the quarter's $205 million total revenues. The $146 million inverter revenue was the end of a four-quarter decline of 43% from the Q2 2012 number of $255 million. That 43% decline in solar-inverter sales was going to micro-inverters, primarily Enphase.
Recently, ABB sold off the Power Solutions portion of Power One for $117 million to Bell Fuse (NASDAQ:BELFB). Wait a minute, you may be thinking, isn't that the Network Power Systems and Industrial Product segment? Isn't that what a company like ABB should have been after? Perhaps, but not really. If those assets were considered redundant to ABB's own, then keeping only the solar-inverter portion made sense, as long as they could effectively monetize it. And by keeping only the solar-inverter side, it gives us a clean number to use as a comparator in the same industry.
The Final Price for the Final Act
For $1,028 million minus the $117 million, ABB paid a final $911 million in total equity value for just the Renewables division which is the solar-inverter side of Power One. They bought some cash and a shrinking solar-inverter revenue stream that was producing $146 million in quarterly sales at the time of the deal according to Power One's final filing as an independent company. They had also shown a net loss of over $7 million for that same quarter (Q1 2013). Power One was attributing much of that loss to litigation expenses from a patent infringement dispute. The problem with that claim is that litigation expenses were up only marginally from year-ago numbers. And remember those upset shareholders? More litigation expenses followed the acquisition as shareholders thought they deserved more and sued company directors for under-pricing the company. But in my opinion, Power One leadership saw the writing on the wall and timed that sale perfectly. They got the most that they ever would for a shrinking revenue stream that was already at a loss. Now let's look at the value of Enphase as a replacement to future earnings potential.
Enphase reached their first non-GAAP operating profit in Q4 2013 at a quarterly revenue level of $67 million. Then they recently surprised with a 26% increase in YOY sales for the following quarter (Q1 2014). They also increased guidance and do not expect to show less than 20% growth in YOY numbers for Q2 2014. Their asset value will not impress you and even the IPO was largely valued on their new technology and the promise of growth. And with only a quarter-billion in annual revenues, their current trailing annual sales still can't compare to Power One at time of acquisition. So we will have to look to the future for our valuation comparison. Let's focus on the future earnings potential for Enphase.
Buying a Brand Name
Enphase has over 50 patents in the industry and many more pending. That may sound impressive, but given the market growth predictions, their brand recognition is becoming their number one asset. Information learned from failure analysis combined with installer feedback on their early generation products led to a redesign that was the basis for their 3rd and 4th generation products. This redesign enabled easier installation, improved reliability and thus an extension of warranty from 15 to 25-years. The Enphase product had now become the most trusted micro-inverter in the industry. As a result, Enphase was recently titled as the number one brand of inverter in California. That is likely to translate globally. A crowded field of competition has had plenty of time to make an impact with little effect on Enphase share. It seems that installers have tried the competition and come back to the brand. What is the monetary value of that? It is unknown, that's why it's called intangible.
Thanks to that intangible asset called Brand Name, Enphase currently enjoys a current market share of 50% for residential inverters and 42.2 for overall inverters according to IHS. But that is just their share of the overall inverter market. Enphase certainly has a much higher share of the micro-inverter market. Their micro-inverter market share is probably still greater than 70% but that number is hard to verify. Although it is looking highly unlikely, let's be pessimistic and assume that competition will succeed in significantly reducing Enphase micro-inverter share. In fact, let's just assume that the Enphase share of the micro-inverter market falls clean in half in the next three years.
Recent market surveys have shown the solar market as doubling in four years but micro-inverter sales are expected to quadruple in only three. So if Enphase only gets to enjoy half of their current share while the market quadruples, then sales for Enphase should at least double within three years.
Yahoo Finance shows five analysts providing revenue estimates through 2015. Projecting two additional years at their conservative rate also gives us nearly the same doubling of revenues by 2017 as mentioned above.
The Enphase Break-Even Point
Based on new guidelines for warranty obligations and the need to cover warranties on early generation product with somewhat higher fail rates, the GAAP profit point for Enphase has risen. Enphase has already posted an operating profit at a revenue of only $67 million for Q4 2013. They are currently operating with margins that should achieve GAAP profit at about the $78 million threshold for quarterly revenue. Enphase is already fast approaching that revenue number. Enphase gross margins are about 33 percent. For simple math and to remain conservative, we can round that down to 30 percent.
Power One's income was falling fast as the acquisition grew near. Quarterly income had fallen in half from Q3 2011 to Q3 2012 and by Q1 2013, Power One reported a loss of over $7 million for their final quarterly report. In spite of that overall loss, they claimed a quarterly inverter operating income (Renewable Division) of $5.8 million in their last independent filing as PWER. For the sake of comparison, let's accept that number. At a 30 percent margin, Enphase needs to show only about $97 million in quarterly sales to match that number for GAAP profit. With current trends, they should attain that in mid to late 2015.
An equivalent operating profit (non-GAAP) will come much sooner. In three years, as expansion expenses fall off, Enphase could conservatively be showing more than three-times that profit number. Assuming margins remain flat or even drop off slightly; then a doubling of current sales should yield just over $20 million profit per quarter or $80 million annual profit by 2017. And at that time, residential solar will still be only a small fraction of global production and growing fast.
Lifting the Lid on the Grid
Utility grids are increasingly wary of the increase in renewable energy sources because the power they produce fluctuates and forces the grids to divert power during periods of excess production. As a result, some markets face greater regulatory pressure than others. Most growth projections acknowledge this limitation. But grid storage technology is improving and will help absorb excess daytime solar production while filling the gap at night.
As energy storage and power control technologies continue to improve grid stability, renewable power sources like wind and solar will meet with fewer regulatory obstacles. As utility grids continue to accommodate renewable energies in the next few years, growth in grid-tie residential solar will make today's already aggressive trends look flat by comparison. With a dominant role in the grid-tie residential solar market and strong brand loyalty, Enphase is well positioned in that rapidly expanding market.
Cash Value vs Growth Value
If the Power One inverter business, with significant sales declines and net Q1 2013 losses, was worth $911 million, it is not unreasonable to assign at least a similar value to a fast-growing Enphase when 2015 profits will more than match Power One's closing act. With 42 million shares currently outstanding, that yields a share price of about $22. Adding 5,000 shares for dilution draws the price down to $19.40.
Enphase has been building its cash reserves fast, going from $30 to $40 million in 2 quarters. Our last peek at Power One's cash equivalents showed $255 million. That is more cash than Enphase is likely to have next year when their profit matches the $5.8 million quarterly operating profit that Power One claimed at the time of acquisition. Some might argue that the superior Enphase growth prospect combined with brand name recognition carry value that may exceed that of the additional Power One cash. But to remain conservative, we can discount for a projected cash difference leaving an $18 per share value for Enphase.
That number represents a conservative acquisition price for the near-term 12-month time frame. The current stock market valuation is another matter. Keeping it simple and staying with the Power One example, PWER was trading at $4 when the $6.35 acquisition was announced. If we use similar ratios to discount the current stock market trading value from estimated acquisition value, then $18 becomes $11.33.
Enphase stock currently trades at little more than the post-IPO price from 2-years ago indicating that the market has not yet responded to the growth potential of Enphase. But any formula for estimating what market value should be is pointless since one need only look at the current share price to know exactly how the market values a stock, right? If Enphase were worth $11.33, then wouldn't the market be reflecting that? Not if we consider the effect of short interest.
The Short Effect
Continuous short selling has helped to hold down the share price of Enphase to current levels. As of this writing, the short ratio (days to cover) for Enphase sits at 25 with 4.8 million shares of short interest. That is enough to get it on the Wall Street Journal's list of companies with the highest number of days-to-cover. Does that level of short interest make sense given the recent performance and future growth prospects for Enphase? Obviously not, but the picture didn't always look this rosy for Enphase.
At IPO, Enphase looked like a short-sellers dream. The bearish expectation was that the technology would never catch on, cash reserves would deplete, debt would skyrocket and the music would stop. This was compounded when warranty obligations were increased to cover early generation products. But instead of plunging into bankruptcy, the company eventually delivered growth as outlined above. Brand-recognition is helping to fuel a global expansion and the market has only recently begun to respond.
Short selling is effective in holding down share price because it is no different than any other selling in that every share sold counters the effect of a share purchased. In other words, the effect on share price of a demand for 100,000 shares can be countered with the short sale of 100,000 shares. With Enphase, current short interest has countered the effect of 4.8 million shares of demand.
Accumulating short interest is fine when you can reasonably expect some level of capitulation in the near future. But holding a very large short position can be a dangerous game. As the investment market begins responding to the Enphase growth prospects, and available shares to short are exhausted, a large short position may become difficult to manage.
Nearly all stocks have some level of short interest. One metric used for comparison is the short ratio, or days-to-cover. Based on average daily trading volume, this is the number of days it would take to buy back (cover) a given amount of short interest. To illustrate the relatively high accumulation of short interest in Enphase, let's compare its short ratio to those of SolarCity (SCTY) and ReneSola (NYSE:SOL).
Just as short selling can hold a price down, short covering follows the same principle except that every share purchased to cover the short sell, counters a share sold and adds to demand. If price acceleration begins to trigger short covering while the market is trying to accumulate, then share price may climb to appropriate valuation levels much sooner.
Projected micro-inverter market growth does make corporate consolidation a definite possibility for Enphase within the next 12-months. Potential buyers may see the advantage of a near-term acquisition move. Share price is still near IPO level, and acting now rather than several years from now would give them a better ground-level entry on growth benefits and more time to recover the cost premiums of an acquisition.
With a powerful foothold on the global micro-inverter market, Enphase has likely already faced M&A prospects that we won't know about. They have extremely low debt, high growth performance and assets that are undervalued based on current revenue and future earnings potential. Their impressive expanding portfolio of intellectual property certainly has value, but their brand loyalty may carry the greatest value going forward.
Who might be suitors with an interest in acquiring Enphase? Predicting likely buyers is not the focus of this article but there are plenty of healthy wallets out there that might see the benefits of such a move. Large industrial players like GE (NYSE:GE) quickly come to mind and certainly have the capital but there are other good matches that might also benefit. ABB bought Power One based on perceived strategic value.
Warren Buffet's energy empire just paid $2.9 billion for an energy transmission line company that reported only $487 million in revenue last year. The Buffet strategy for acquiring growth potential easily applies to the global market prospects for Enphase Energy.
Tesla Motors, Inc. (NASDAQ:TSLA) has the means and could also see a strategic value with owning a well-branded micro-inverter. They have already established a significant presence in residential solar with the home battery storage systems that they are selling through SolarCity. And speaking of SolarCity, they have not yet adopted the micro-inverter technology. But how long can they wait before getting on board?
-This is an alternative energy play. Anything can happen. Grids can move against renewable energies rather than adapt.
-Global incentives and tariffs can ebb and flow causing localized changes in government incentives for renewable energy. This will affect some markets more than others and continued drops in system prices will help to offset this risk.
-Enphase recently filed a shelf registration on behalf of unnamed original investors who want to be ready to offer 5 million of their Enphase shares to the public 'from time to time'. The CEO and CFO will likely find institutional homes for most of these shares with their upcoming investor conference presentations, but the rest of us may not know when that happens until it's over.
-This comparative valuation loosely fits the replacement cost method of acquisition valuation in that it argues that the value of Enphase represents at least a fair replacement for Power One's final act for earnings. Looked at another way, it implies that a potential suitor could simply create another Enphase for the same amount. Considerable competitive efforts to that end have not succeeded and the expense of trying may be represented in Power One's last reported numbers.
-The inability of competition to get a foothold in a 2-year timeframe makes a 50% loss of market share in the next three years a very unlikely assumption thus leaving this valuation potentially low.
-Assuming that Enphase will only reap the benefit of a quadrupling micro-inverter market in the next three years may be underestimating their growth potential. They are in an aggressive global expansion within a quadrupling market. This may compound the growth curve thus leaving this valuation understated.
-Short interest in Enphase is staggering and the effect of buying shares to cover large short positions could accelerate upward price movement.
Enphase Energy represents a value that is at least an equivalent replacement for Power One's closing act when it was acquired by ABB. For Enphase, this translates to a share value between $11 and $18 in the next 12-months. Enphase is likely to produce quarterly profit numbers next year that are better than those last provided by Power One while better capturing future market growth.
Given how little success the competition has had in the last two years, basing this valuation on the assumption that Enphase will lose 50% of its micro-inverter market-share in three years is an unlikely worst-case scenario. Gross margins will also likely erode somewhat, which is also built in to these numbers. However, since market predictions for solar are better than linear, growth should be even more robust going into 2020 from 2017.
Disclosure: The author is long ENPH. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.