What is Sunworks:
If you've not heard of Sunworks (NASDAQ:SUNW) , it's time you have. A small solar start up that began as a reverse merger into an OTC technology company several years ago has now grown into a NASDAQ listed and potentially formidable name in the solar industry. CEO Jim Nelson's "Solar3D" in 2014 entered into an agreement to purchase Sunworks solar, a small solar integrator in Roseville California. At the time, Nelson's company was a non-revenue generating entity, focusing on potentially breakthrough technology in the solar cell field. The thought of solar panel installation revenue brought investors en-masse hoping to cash in on a win/win scenario that married the new technology with the fast paced growth of the installation market. At the time, the technology promised record breaking efficiency and accompanied by the solar industry's white hot growth made this marriage sound like a real winner.
Nelson, a former private equity businessman cashed in on the explosive growth that the SLTD ticker experienced. Using solely equity, three acquisitions in the frame of three years took place. In early 2015, the company moved to the NASDAQ exchange and shortly after adopted the first acquisitions namesake, Sunworks while adopting the ticker SUNW.
With three acquisitions completed, Sunworks is a solar integrator, focusing on the underserved commercial/agricultural as well as residential solar markets. They have primarily focused on system sales as opposed to leasing, a move that appears to have anticipated the major markets direction years in advance. The majority of sales in the company come from California, however they have commercial sales occurring in Oregon and Nevada as well. Although the dreams of the once "breakthrough" cell technology have yet to materialize, the company has acquired intellectual property in the form of "RapidRack" commercial racking solutions that they outsource the production of, while use in house and sell to other integrators in non-compete markets.
The new ticker NASDAQ:SUNW followed the rest of the industry showing extreme volatility throughout 2015 and into 2016. However unlike the other major players, Sunworks has experienced growth year over year, and consistently increased their top and bottom lines. In a time when the SEC is cracking down on the use of non-standard metrics, fiscal year 2015 brought a small GAAP net profit for SUNW.
2016 seems to be on path to bring more of the same growth, on track to deliver on the CEO's promise of growth and recently raised guidance to 110-115 million revenue while maintaining its potential to bring more of the same GAAP net profits. When a company is maintaining a GAAP net profit quarter over quarter, and year over year, it's making money. Period. The company has proven their business model sustainable. Given such a solid balance sheet and income statement quarter after quarter and year over year, why does the ticker seem to be continuously introducing lower lows?
Dilution is, and is not, the problem:
The answer "is and is not" the one word that most people would lead you to believe. When one hears about acquisitions via equity, one thinks dilution, and people are terrified by dilution. Investors rightly fear dilution so much that they run from any mention of it, regardless of its context. On one hand the dilution is real, as evidenced by the financials. The other hand though seems to have been forgotten altogether. That second hand is holding a pen which is writing the word clearly and boldly, "accretion". Accretion is the goal and the reason behind making acquisitions. Accretion is the promise that with the use of cash or equity in making an addition to the company, the EPS will rise, eventually outweighing the purchase cost, the basis of a sound investment.
Why is there such a negative outlook here then? Until now there hasn't been anyone in the public installation sector doing what Nelson and the team have successfully executed, and that's make a GAAP net profit. Nelson has in the course of three short years put together a company that has surpassed a 25 mi/quarter revenue run rate, and is doing so profitably. Nelson has done this without tapping the debt markets a single time. In doing so, the ticker has seen measured dilution, however it has also seen increasing EPS. If Nelson stays disciplined in his approach to using equity for acquisitions, his goal, for them to be accretive, should be measurable and achievable.
The dilution direction however has been received with mixed reactions as evidenced in the charts, with the primary cause being the equity used to purchase the new companies, include grants to the acquired companies executives that many clearly view as excessive.
The tricky part of all this, and what I feel many are overlooking is that the strategy put forth by Nelson as he's stressed on the earnings call, is that this is "Not a Roll-up". Nelson is not simply buying anything and everything out there. He's been up to this point painstakingly selective in his targets, and only purchasing the best of the best,"profitable" companies. In doing so, the target company needs an incentive to be "bought out" as opposed to themselves continuing to expand on their own. This incentive comes in one form, and that's monetary compensation either through cash, equity or some combination of the two as seen in the previous acquisitions. The cash and equity "carrot" cost of acquisitions is real here.
To that end, as the company's market cap shrinks with the share price and increased share count, the equity ATM that is Nelson's preferred source of funds has dried up leaving the company without an acquisition since late 2015. If an acquisition is done at this price per share, they would likely face an unreasonable amount of dilution.
Current rate of growth cannot be sustained without further acquisitions:
The fast paced rate of growth is one of Sunworks main selling points. Although to date the strategy has included both growth via acquisition as well as organic expansion, both are needed to sustain the current rate. As Nelson announced the desire to be a 500 million dollar company within three years, maintaining that growth rate would seem to indicate the need for continued acquisitions.
Acquisitions have more upfront cost than organic growth but they also bring benefits like seasoned employees, immediate sales growth and sometimes intellectual property and other resources as seen with the previous acquisitions which included "RapidRack", another revenue stream and vertical cost reduction.
With that said, acquisition is a integral part of the strategy here to keep the rate of growth "optimal", and it's for this reason I think Sunworks investors are going to see another acquisition sooner than later. The pain at the equity pump will be real though if solely utilized, remember the carrot must be large enough to get the high quality company to submit to being acquired.
The question then becomes how to pay for the next acquisition? Similar amounts of equity than in the past? Risking potentially catastrophic dilution and market rejection? Or throw some debt into the mix this time? When researching the use of equity vs. debt one finds a myriad of factors involved in the decision as to which and what ratio is best. There are a lot of reasons to use debt, the primary being it is usually cheaper than equity, as well as the fact that debt is repaid within a limited time frame however equity is forever. However there are also risks associated with debt use. With debt comes covenants, that for a young company in a volatile sector like solar, have a greater risk of being breached which could in turn be just as catastrophic.
Until recently the cost of debt for a fledgling company with little revenue was likely prohibitively high when accompanied by the risks associated with its covenants. However as time has been good to both the top and bottom line, that cost of debt should now be lower and likely more acceptable, even with the additional risks associated with covenants. Covenants must not be under estimated here, as long term investors have seen how good news and no news affects this ticker, what happens if and when the eventual stumble happens and the company had to convey actual "bad news" in the form of an earnings miss or some other industry growing pains.
Seeing equity get tapped repeatedly here is no surprise as the CEO's strategy has been to use certain cash/equity ratios. However with the current low share price any significant use of equity could be extremely detrimental to the already weakened share price. So where does this leave us?
The solution to dilution is... debt.
The CEO had a very interesting statement in the last CC. When asked about having his ducks lined up to do a much larger acquisition his response was, "That's a complicated question and I guess by saying that I would say not really at this point and frankly part of what we would like to be able to do is use our stock as currency, our stock price does not - doesn't really justify using a lot of stock to do a major transaction right now so the result is we continue to grow rapidly on a organic basis and do smaller acquisition as we continue to build but I think that by doing that we are still going to end up doing extremely well and get some traction so that we will be able to do a much bigger transaction. Also, we are talking to a number of people about the substantial debt facility that will allow us to do and of course when we talk about a substantial transaction, I'm thinking in terms of buying somebody as big as us, but in terms of buying somebody at 50 million in our target of 15 to 50, yes, we could do that.".
The first part of the response basically says no. As stated repeatedly in this piece, that due to the PPS they will continue to do smaller acquisitions and expand organically for now until they "get some traction". As the business model is still being evaluated by the street, and could eventually be seen as a winner pending repeated increases in diluted EPS and operational profits this method is the safer path, although the less interesting one for investors, traders and people looking for short term big gains. However it appears at present it's still a sustainable and safe bet business model.
In evaluating the second half of the statement however, there's something much more interesting, the carrot if you will for investors. In closing his statement he reveals they are in talks with a number of people regarding a "substantial" debt facility to buy somebody "As big as us", in the 15-50 million range ending with "yes, we could do that". I've got mixed emotions on this. On one hand, this term has been used before "in talks". The CEO has used that phrase regarding acquisitions as well as cell manufacturing over the years(which has yet to pan out) so much that it makes one wonder if it's merely lip service to the long investors looking for reasons to average down.
On the other hand however, since the statement was made there's been a replacement of the CFO as well as the replacement of another independent director with CEO and solid CFO experience. These changes and additions could be seen as preparatory moves in order to expeditiously facilitate a substantial debt offering before the rate of growth stalls. The business is now net profitable and with net profits come taxes. As the CEO has also stated that the net operating losses will run out this year. Interest expense on debt would reduce that taxable income lending further evidence that now is an opportune time to take a reasonable debt load.
Should Sunworks make the leap and take on a "right sized" amount of debt, (currently they have no debt on the books) to potentially double the size of the company, while bringing on as the CEO has stated "something they don't already have", in terms of a geographic footprint, or potentially some sort of storage solution that has repeatedly been mentioned, it could be viewed very positively by the markets.
Sunworks is doing things investors clearly haven't agreed with to date. Although using all equity transactions for growth has served the company's balance sheet and income statement well, it has yet to yield a return for long term investors since the inception of the strategy. Rome wasn't built in a day though. If the company simply needed a solid track record, it has that now. However the long term downtrend of the chart has left the CEO's ATM out of order for the time being leaving only the debt markets available for the continuation of the current strategy.
Recent changes in leadership were potentially prompted by the necessity for the for the company to begin shifting away from all equity deals. That in turn could be a impetus for the market beginning to see this increasingly as a potential ground level investment opportunity.
Disclosure: I am/we are long SUNW, SUNWW.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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