In December 2015, the conference in Paris created a historic moment when 195 countries came to an agreement on climate change. All of the countries agreed to lower their planet-warming greenhouse gas emissions to help stave off the most drastic effects of climate change. Then, in the middle of December 2015, Congress extended the ITC and solar stocks soared. Now US solar customers are not in a hurry to take advantage of the ITC. Especially Chinese solar companies that seem to have forgotten about the 2012 oversupply and have aggressively expanded their production capacity, thus creating another oversupply. So now investor enthusiasm about the ITC extension has waned, and investors are concerned about the industry challenges. So, most solar stocks are down more than 50% compared to last December and SunPower Corporation's (NASDAQ:SPWR) stock is leading the decline and is down almost 75%. SunPower's power plant business is facing challenges and recently the company has lowered its full-year guidance.
There are some short-term industry concerns, but solar is here to stay and the long-term global solar demand is strong. SunPower is a well-managed company. So, we believe it is worth considering for the long term.
In the last few years, Chinese players have been aggressively expanding their production capacity. So, there are concerns about a supply glut forming and right now that is the biggest concern facing the industry. If there is an oversupply, the price will fall further and margins will decline. Many Chinese players are also expecting lower ASP in the second half of 2016. During the price decline, customers might be delaying the purchase to take advantage of the falling prices. Declining module prices will also have an impact on the project pricing. Recently, SunPower has sold power plant projects without any profit. Although the company has blamed that on other challenges facing the power plant project business, the declining module prices might have also contributed to it. A few years ago, the industry faced a very brutal oversupply situation. However, this time the demand is much stronger and the lower prices will likely increase the demand further. In addition, recently some of the Chinese players such as Canadian Solar (NASDAQ:CSIQ) and JA Solar (NASDAQ:JASO) have mentioned that they are putting a break on their production capacity. Even First Solar (NASDAQ:FSLR) has decided to cut the production and improve its profitability. Eventually, the oversupply situation will force out some of the weaker players, lead to industry consolidation, and will create a better environment for the stronger players. SunPower is one of the stronger companies in the industry.
Due to the ITC extension, US solar customers are not in a hurry to take advantage of the tax incentives. So, the ITC extension has reduced 2016 solar demand in the US. As I mentioned earlier, SunPower has blamed its power plant project business challenges on this. However, according to the GTM research, the ITC extension is creating an additional 22 GW in solar demand in the US between 2016 and 2022.
In April SunEdison, the fast growing global alternative energy developer, applied for bankruptcy. SunEdison's bankruptcy is due to its own mistakes, not a reflection on the sector. However, due to its bankruptcy, tax equity investors are concerned about the health of the companies that construct and maintain solar projects and are expecting a higher IRR for solar projects. So even though SunEdison didn't apply for bankruptcy due to industry challenges, its bankruptcy is enhancing those challenges.
Recent regulatory issues regarding net metering in Hawaii and Nevada have created a bit of uncertainty in the US residential solar market. In April, SolarCity (SCTY), largest residential solar builder, lowered its full-year guidance. However, according to SolarCity's CEO, regulations are now clear and in a long time it has a good visibility into the future.
In emerging markets, solar demand is growing, but the cost of capital is high, competition for the power plant project development is increasing, and margins are declining.
There are uncertainties over the Chinese Feed-in Tariff (FIT) and some of the Chinese players have lowered their downstream project guidance for the year. China's solar demand will be lower in the second half due to its June 30th FIT deadline. Many Chinese players are expecting a lower ASP, which will impact the margins. Apart from China, Japan and the UK also are scaling back on FIT. However, as I mentioned earlier, the US will experience strong growth over the next few years and there will be strong demand growth in India. But, the US and India demand will not be able to offset the pullback from China, Japan and UK. According to GTM industry research, starting in 2017, global solar demand will experience a multi-year slowdown. However, as you can see from the figure below, the demand is more than in the past.
SunPower Corporation is a vertically integrated solar company which serves all three segments - utility, commercial and residential. It builds large scale utility and commercial solar systems as well as residential rooftop projects. It generates revenue by providing energy solutions and services to different segments and selling components to third-party developers. Like most solar players, it has a global presence. Due to its strength in the rooftop business, it has a very strong presence in Japan. It builds reliable, high quality products and has the highest efficiency panels in the industry. Every solar player is focused on improving efficiency and reducing costs. However, technological innovation is an integral part of this company. So it maintains its leadership in quality and panel efficiency.
In 2011 Total (NYSE:TOT) took a 60% stake in the company and now Total is its majority shareholder.
The company is geographically diverse but it generates the majority of its revenue from the US. It has a very strong presence in Japan due to its high-efficiency products for the residential segment. However, that market is slowing down. It has entered China through a joint venture. It is expanding its presence in emerging markets such as Chile and Mexico. Even though the Indian market is growing, it has no presence there and until recently it didn't plan upon entering that market. Now the company has come up with a new product called the Performance Series (P Series), which is a low-cost, high-quality product to compete against Chinese products in emerging markets such as India. The global PPA pricing is under pressure and power plant project development has become extremely competitive, so the projects in emerging markets yield a much lower margin. The company has decided to focus power plant project development in its core markets, which are the US, South America, and France. In the past, the company emphasized Total's global presence to build projects globally. But now, as the company is focusing project development to its core markets, it will leverage Total's global presence to sell components to third-party developers in other parts of the globe.
A few years ago, Spain and Germany were the largest solar markets. Today it is the US and China. Geographical expansion is essential for the survival of solar companies. However, companies need to focus on profitable growth, not growing for the sake of growing or expanding for the sake of expanding. The companies need to determine whether a particular region or a country is suitable for their long-term strategy and also whether they can be successful in that market. The success depends on whether a company's products are suitable for a region, its supply chain capabilities, its ability to form partners, the cost of capital and access to the capital market, etc. As I mentioned earlier, even though the Indian solar market was growing, SunPower didn't enter that market. However, now it is planning to enter that market with its new P series product. The Japanese solar market is extensively rooftop, so First Solar products are not suitable for that market and First Solar didn't enter.
When it comes to geographic expansion, it is not the idea that makes it successful, but it's the execution. Now, let us consider what it takes to go after a new market. A company needs to understand the regulations of that region, it needs to build a supply chain and acquire customers. To build a solar project, a company needs to understand the terrain, identify the site, work with the local authorities to lease or buy land, arrange finance, obtain a permit and a power purchase agreement, etc. So having a partner who understands the region and has a presence there will be an advantage. Total has a presence in 130 countries which will pave the road for SunPower to go after a new market much more easily. Even though right now SunPower is focusing on power plant project development in its core markets, in the future a new region will experience strong growth and a favorable condition for SunPower. When that time arrives, the company will leverage Total's global presence and go after that market.
Recently, the company has lowered its EBITDA guidance for the year and predicted a loss for this year as well as for the next year. The company has mentioned that it is facing challenges in its power plant project business and blamed that on the industry challenges caused by the ITC extension, increased IRR expectation, increased competition, and increased global PPA pricing pressure. As I mentioned earlier, the emerging markets solar projects yield much lower margins. However, in the past SunPower mentioned that it has an advantage over its competitors because it can access capital at a much lower rate. As the market evolves, competitive landscape changes, and companies need to adopt. Recently the company has decided to focus power plant project development in its core markets. In the second quarter, it has written down 16.5M impairment related to certain solar projects development. It is consolidating its module fab to reduce costs and working capital requirements. However, everything is not that bleak. Its residential and commercial segments are performing well and it is gaining market share in its residential segment. It is increasing its production capacity for its X series panels which are used in its residential solutions. It is focusing on providing complete solutions to differentiate itself.
Despite recent short-term challenges the company is upbeat about long growth. When the time comes, it is planning to increase its low-cost panel production capacity to participate in emerging markets growth. Recently it took full control of a solar cell manufacturing facility in Malaysia that the company currently co-owns with AU Optronics (NYSE:AUO). This will enable the company to reduce its manufacturing cost, support expansion and efficient operations.
As you can see, its power plant business gross margin is much lower this year and the company has mentioned that it is seeing pricing pressure. Recently the company sold projects without any profits. Power plant project development takes a long time. Depending upon the project, it might take three to 12 months or even 18 to 36 months to develop a project. When the module prices decline, project prices also decline. However, recently Canadian Solar has mentioned that it is seeing good demand and decent bidding for its projects. So, some of the problems might be unique to SunPower due to its cost structure. The company is consolidating its module fab and that will reduce its inventory in the transit and improve its working capital requirements. It is also working on reducing its cost structure. Well before the ITC got extended, the company was preparing for the post ITC market in the US. During the last analyst day, the company mentioned that it is in the process of reducing around 30% of its costs in all segments. During the recent call, the company didn't mention anything, but I am sure that the cost reduction is on top of management's mind.
It is planning to reduce costs by taking vertical integration to the next level. Apart from manufacturing the panels and developing projects, it is planning to provide all the components required to install solar systems and becoming a one-stop shop for all three segments' solar systems. It is focused on reducing the cost by improving manufacturing and installation efficiency, reducing residential customer acquisition cost by changing sales channel to digital and using economy of scale. By focusing on providing complete solutions, it is differentiating itself as well as reducing costs.
SunPower does need to reduce its cost structure. However, the power plant is a lumpy business and in 2015 it generated lower revenue from its power plant business and that has impacted its 2015 margin. Apart from that, the company wants to own some of the projects, so it has partnered with First Solar and created a YieldCO, 8point3 Energy (NASDAQ:CAFD). When the company drops down a project to 8point3, it defers profits. In other words, when SunPower sells a project to 8point3, it periodically receives profit distribution from 8point3.
SunPower's strength has always been its focus on the quality of its products and innovation. It has the highest efficiency solar panels in the industry while still maintaining its leadership in product quality and efficiency. It is focusing on providing complete solutions to all three segments. It is strengthening its complete solutions through acquisitions and partnerships. For example it has partnered with Enernoc to provide energy management software to its commercial customers and acquired Cogenra, which is the basis for its new P Series. However, most acquisitions increase goodwill in the balance sheet and during a downturn the companies need to write-down goodwill impairment. Even though SunPower had accumulated substantial goodwill during its past acquisitions and was forced to write-down goodwill impairment, it didn't accumulate much goodwill during its recent acquisitions.
In the residential segment, it is offering energy production and management. It has also partnered with AT&T (NYSE:T) to provide IOT to residential customers. The days when consumers received one electricity bill are long gone. Nowadays consumers want to monitor their energy consumption and solar energy production, think of ways to reduce their energy consumption, etc. In that regard, SunPower is on the right track with these offerings. Being a blue-chip company, it doesn't want to use the door-to-door sales strategy for its residential segment. So, it is focusing on the digital sales model. Similarly in the commercial segment, along with energy solutions it is offering analytics software, which provides its customers with detailed information about their energy consumption and production, enabling them to further reduce their energy costs.
It is automating its power plant project designs using drones and proprietary software. It will fly the drone above a site and using its proprietary software it will generate many potential power plant designs, considering everything from elevation changes to different solar panel options. In a relatively short amount of time, SunPower can determine what a project costs and what its return on investment would be for a given site and what it may have to charge for energy. This will speed up its project development process and reduce costs. Focusing on technology is not a new thing for this company, but rather it is in its DNA.
Going after digital sales channel
As I mentioned earlier, the company is trying to build a digital sales channel for its residential segment to reduce customer acquisition cost. It has hired the person who was responsible for successfully building the online sales channel for Dell. The strategy will not be successful just because it worked many years ago for Dell. During its recent analyst day, SunPower's CFO mentioned that nowadays no one goes to a store to buy a computer, except to Apple Stores. The success of a sales channel depends on many factors including product, target market, etc. A few years ago, a sales representative from Vivint knocked on our door. During the conversation he mentioned that Vivint founders were from Utah, so, they adopted a Mormon door-to-door sales strategy. Door-to-door sales strategies can be beneficial when the target audiences are not aware of the brand or the benefits of solar energy. For the digital strategy to be successful, the target customers should be aware of the advantages of solar energy. Due to its quality, SunPower targets high-end, sophisticated consumers. If "we won't knock on your door and disturb you dinner time, but take a look at us at your convenience" message works for anyone in the solar industry, it will be for SunPower. However, time will tell.
More than 50% of its debt is convertible debt. So shareholder value might get diluted. But the conversion price is 30.53/share and 48.46/share, so at current stock price, investors need not worry about the dilution.
The biggest risk I see is its ability to generate positive FCF. The company generated positive FCF only two years out of the last 10 years.
SunPower's residential segment is performing well. An uptick in the US residential segment can act as a catalyst for this company.
In the wake of supply glut formation, some of the Chinese players such as JA Solar and Canadian Solar are cutting their production. So if the threat of oversupply is not that imminent, investors' fear of 2012 repeating itself will disperse and that can act as a catalyst to the industry.
The company's progress towards its cost reduction effort and P Series gaining traction in the emerging markets can act as catalysts.
The sustainable raise in its stock price can only happen when the company delivers a strong performance and achieves its long-term goals. During the last Analyst Day, the company provided an aggressive plan to triple its volume and double its revenue and EBITDA by 2020.
In the best case scenario, during the second half of this year, SunPower will make progress in its cost reduction efforts and investors will feel that the threat of oversupply is not that imminent and feel optimistic about the company and industry.
In the worst-case scenario, the threat of oversupply persists for a long time and ASP continues to decline. In such a scenario, weaker players will eventually exit the market and there will be stability. Even in the worst-case scenario, SunPower is still one of the stronger players and will emerge as one of the winners.
The more realistic scenario is around middle of next year when US solar demand will pick up. By then, there is a high likelihood of the company reducing its costs and working capital requirements, increasing its manufacturing efficiency, and gaining traction for its new products its in emerging markets.
According to my DCF model, the company's valuation is 17/share. I am upbeat about the industry growth, SunPower's ability to reduce costs, offer quality products, and management's ability to operate in a disciplined manner. I derived my moderate assumptions based on these and didn't consider the company's aggressive plan of doubling revenue and EBITDA by 2020. However, any assumption is subjective, so is the valuation.
According to my ratio analysis, I value the company at 18/share. When investors were extremely optimistic about the solar industry, the company's market cap was more than 10B. During the last oversupply period, when investors were pessimistic the about the industry, the company's market cap was less than 400M. By considering the global demand, the company's ability to execute, I have taken a more realistic approach and calculated the median estimate.
In my comparative analysis, I have included SolarCity, First Solar and different Chinese players such as Canadian Solar, Jinko Solar, Trina Solar and JA Solar. SolarCity is not profitable and has a huge debt. Even when investors are pessimistic, its valuation is high. JA Solar is conservatively managed, but management is less transparent and even though it is trying to diversify, it has much a higher exposure in China. So, I consider the ratios of these two companies to be outliers. Canadian Solar's management is transparent and it is a well managed company. Jinko Solar has strong products and brand name. I believe First Solar is a very well managed company and has strong products. Apart from that, it is the market leader in thin film modules. The previous CEO of First Solar had successfully turned the company around and his departure created a bit of uncertainty. By considering all these factors, I value SunPower at 20/share. According to my ratio analysis, I value the company at 18/share. When investors were extremely optimistic about the solar industry, the company's market cap was more than 10B. During the last oversupply period, when investors were pessimistic about the industry, the company's market cap was less than 400M. I have calculated the median estimate.
SunPower is a well managed company with a strong balance sheet. It has a good, prudent management and reliable, quality products. The company's motto is profitable growth and not growing for the sake of growing. It enters a market only if it's right for its long-term strategy and if the company has suitable products for that market. Just because the Indian Solar market was growing, the company didn't enter that market. However, now it has come up with a low-cost, high-quality product to compete against Chinese players. There are short-term challenges facing the industry and the company. But that is part of being in a cyclical industry. Recently, Diamond Offshore's CEO mentioned that offshore drilling will continue to be part of oil drilling in the foreseeable future but, due to supply /demand imbalance, the day rates are still declining and sometime in 2020 the industry will bounce back. The solar industry is not facing such challenges. There's strong demand due to the ITC extension, emerging markets and almost 200 countries have committed to reducing carbon emissions. The solar industry is in its infancy stage and long-term growth is ahead. SunPower is a strong company. So, if you are not worried about the short-term volatilities, it is worth considering for the long-term payoff.
Disclosure: I am/we are long SPWR.
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.