Before I start discussing my investment recommendations, I want to give my sincere apologies for being a little bit gloomy in my latest articles. However, the current investment environment doesn't offer much of a choice for value investors except being pessimistic about current market valuations. After Trump's victory, I turned bearish on most solar stocks (except for two companies). That's not only because he promised to abandon the Solar Investment Tax Credit (ITC), or due to his classification of global warming as a "Chinese conspiracy." It's because I believe that he will succeed in cutting the corporate tax rate; after all, his election was mostly based on that.
What a Corporate Tax Rate Cut Means for the ITC Program
I believe that the ITC program will automatically be changed as a result of a tax reform. That's because when the corporate tax rate becomes 15%, or a little bit higher, the 30% ITC will give corporations the ability to pay a very low effective tax rate.
To explain more, let's assume that corporation "Y" has earnings before taxes of $1 billion. With a 15% tax rate, corporation Y should pay $150 million in taxes. But due to the ITC, Y's management will say: "Why pay $150 million in taxes? Let's invest $150 million from our earnings in renewable tax equities."
In doing that, corporation Y will pay a $127.5 million tax on the $850 million ($1 billion - $150 million) taxed earnings, and will get a $45 million reduction from the $150 million investment in the tax equity. Thus, corporation Y will pay a net of $82.5 million in taxes (8.25% effective tax rate) instead of the pre-tax equity investment of $150 million.
But will Trump let that happen? No.
Trump's tax plan already has a very high cost. Add to that the ITC benefit, and the cost will be much higher. Thus, Trump will either remove the ITC all at once (I think there's a low probability for this scenario), or make the necessary adjustments for the ITC (the likely scenario). Even adjusting the ITC will create lower incentives for corporations to invest in tax equities.
The IRR of most tax equities is between 10% and 15% at the current 35% tax rate. When the corporate tax rate decreases to something close to the 15% level and the ITC decreases from 30% to 20%, for example, the IRR of tax equity project will naturally decrease, thus increasing the risk/reward ratio for investing in tax equities with it.
What Companies Will Take the Biggest Hits?
I'm still a big holder of both Sunrun (NASDAQ:RUN) and Vivint Solar (NYSE:VSLR). That's because I believe these two are the most undervalued and safest stocks in the solar industry. Both are trading lower than their net retained value, with good short-term coverage of their obligations. However, capital goods producers are the first to be affected from a decrease in consumer demand. That's because they have the highest fixed costs. (This is the reason why you see companies like Apple (NASDAQ:AAPL) avoid vertical integration by depending on other suppliers like Samsung (OTC:SSNLF), Sony (NYSE:SNE), and LG (OTC:LGEAF) to build its iPhones.)
As such, solar panels manufacturers will take the biggest hit from lower supply of tax equities. First Solar (NASDAQ:FSLR), one of the biggest solar panel manufacturers, will take a significant hit. The stock is trading at a 75 forward P/E with expected EPS next year decreasing tenfold from the current year (that number assumes that the ITC remains in its current form). In addition, its sales decreased ~50% from Q3 2015, while its cost of goods sold decreased 35% and its operating expenses increased 12.7%.
However, the company has a very strong balance sheet. That's the main reason the stock didn't fall like SunPower (NASDAQ:SPWR). But sometimes a strong balance sheet isn't enough. The company is burning cash at a high rate. This quarter alone, it burned $276 million. Thus, I recommend getting away from this company and investing your money in a safer place.
In conclusion, I believe that Trump will have no choice regarding the ITC program. He will make the necessary adjustments, which will push corporations to partially avoid investing in tax equities. As a result, being one the biggest American manufacturers of solar panels, First Solar will take a significant hit. On the other hand, I believe that companies like Sunrun and Vivint Solar are safe alternatives to FSLR and SPWR, even if the ITC program is adjusted. RUN and VSLR will definitely have lower growth rates since they will be pushed to find other alternatives to tax equity investments, which are few in number.
But don't forget that by buying the stocks of both companies, you are getting the growth part for free. That's because both stocks are trading lower than their conservative net retained value, which I believe is the most important metric in valuing residential solar stocks. To know more about RUN's conservative retained value, you can read my other article here. I will continue writing periodic updates on solar stocks in the future; you can follow me to get the latest ones.
Disclosure: I am/we are long RUN, VSLR.
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.