SolarEdge Technologies (NASDAQ:SEDG) reported another impressive quarter, with solid growth across all geographies and products, gross margin expansion and operating leverage. The company reported:
- Revenues of $209.9 million, up 11% Q/Q and up 82% Y/Y.
- GAAP gross margin of 37.9%, up 40 bps Q/Q and 430 bps Y/Y.
- GAAP operating income of $40.8 million, with operating margin expansion of 116 bps Q/Q and 901 bps Y/Y, to 19.4%.
For Q2, SolarEdge guided to 65% YoY revenue growth and gross margins within the usual target range of 36% to 38%.
Moreover, the company announced an asset purchase agreement with Gamatronic Electronic Industries Ltd., an Israeli company that develops, manufactures, and sells Uninterruptible Power Supply (UPS) electrical devices that provide emergency power to appliances when the input power source fails.
It is very telling that since the start of the year, SolarEdge has started to describe itself as "a global leader in smart energy" rather than "a global leader in PV inverters, power optimizers, and module-level monitoring services", its traditional bread-and-butter business. In the press release announcing the purchase agreement, SolarEdge used the "smart energy" language again.
On what follows, we analyze Gamatronic financials, comment on the acquisition and other recent company moves to diversify away from the solar inverter business, and update on our views on valuation and market prices.
As a reminder: SolarEdge is a core holding of the IW Portfolio since August 2015. In February 2018, we presented the long case to the investment community. The stock has appreciated more than 30% in the 3 months since.
Before proceeding, we invite investors to familiarize themselves with our long thesis, since we will be later updating on valuation concepts and models introduced then.
Gamatronic UPS product line (source: FOX MIS Temple University)
Gamatronic Electronic Industries, another step towards "smart energy"
Based in the Har HaHotzvim Industrial Area of Jerusalem, Gamatronic was established in 1970 and began trading on the Tel Aviv stock exchange in 1994, under ticker GAMT.
Today, the company sells its products in the United States, China, Europe, South Africa, and Latin America, but seems to have spread its sales channels too thinly, with operating expenses exceeding gross profit in each of the last two years.
Gamatronic financials
In 2017, Gamatronic reported net income of -6.3 million NIS (-$1.8 million) on revenues of 65.7 million NIS ($18.4 million). 2017 revenue was down 13% YoY, but gross margin improved significantly, from 28.1% in 2016 to 36.2% in 2017, reducing the operating loss from 9.3 million NIS ($2.6 million) in 2016 to 4.5 million NIS ($1.3 million) in 2017, and bringing cash flow from operations close to break-even.
Gamatronic IFRS financials (source: TASE)
During the earnings conference call, SolarEdge CEO Guy Sella blamed Gamatronic's lack of profitability to sales and marketing (S&M) inefficiencies, a diagnostic confirmed by the financial statement. Gamatronic 2017 gross margin of 36.2% falls within SolarEdge's 36-38% target range for the solar inverter business, but operating expenses were a whooping 40% of revenues in 2016, and 43% in 2017.
The purchase agreement
SolarEdge is purchasing substantially all of Gamatronic’s assets, including its intellectual property, brand, and tangible assets, for $11.5 million, and a two-year earn out provision for 50% and 33% of the net income of that business in each year following the closing. We don't believe that the earn out provision will amount to much more than $500k, bringing the total acquisition price at some $12 million.
At $12 million, SolarEdge is paying 0.65x 2017 sales and 0.5x shareholders' equity, which is a very attractive price if SolarEdge manages to put OpEx under control and bring the business back to profitability, and an absolute bargain if SolarEdge eventually grows the new business unit to a meaningful share of the $7.7 billion worldwide UPS business.
Small, but meaningful acquisition
While at its current size Gamatronic is just a drop in the bucket for SolarEdge (initial contribution to total revenues below 3%), we view the announcement as proof of management's disciplined and value-conscious approach to capital allocation.
SolarEdge is acquiring another Israeli company in an adjacent field with sizable TAM for a discounted price, which limits the downside while providing ample room for appreciation. (At the core of a UPS system sits an inverter that converts DC power from a battery to AC power for the appliances)
Since its foundation, SolarEdge has proved capable of rapid value-accretive organic growth. Now the company has an opportunity to prove its ability to integrate and turn around an acquisition. If successful, the operation will serve as a blue print for future acquisitions that can help accelerate shareholder value creation.
The agreement is subject to customary closing conditions and is expected to close by the end of Q2 2018.
During the earnings conference call, management provided guidance for marginal positive EPS contribution in full year 2018, as SolarEdge cuts redundant costs, including compliance costs associated with being a publicly traded company. One of the first priorities will be investment in sales & marketing to capitalize on what SolarEdge sees as a strong product offering, and bring the unit back to growth.
In 18 to 24 months, SolarEdge expects to introduce a new generation of UPS products with HD-wave topology, and CEO Guy Sella sees UPS revenues of a few hundred million dollars in about 3 years. Management made the point that the UPS market is not as competitive as the solar inverter market, and expects that the new topology, together with economies of scale and SolarEdge's operational excellence, will result in gross margins larger than in the core solar inverter unit, while OpEx as a fraction of revenues should converge to those of the rest of the business.
Transitioning from solar to smart energy
The acquisition of Gamatronic's assets, which will serve as the basis for a new business unit, can be seen as the third in a series of recent announcements to expand SolarEdge's activities beyond the solar power electronics market.
In July 2017, SolarEdge announced the first PV inverter-integrated electric vehicle charger.
And last week,
it announced a grid services and Virtual Power Plant ((VPP)) solution to differentiate the product offering and lay the first stone of what could become a high-margin recurrent business.Valuation
In our previous piece on SolarEdge, we valued the company on an Earnings Power Value (EPV) basis, and concluded:
At $45, the stock trades at a 27% premium over our conservatively calculated EPV.
But this is a business generating 30%+ returns on capital. Assuming a cost of capital of 8%, that means that this is a business that transforms a dollar of investment into $1.20, every year (1.30/1.08).
And with expected sales CAGR near 30% through 2020 within segments in which the company operates at a competitive advantage (hence the excess return on capital), there will be no lack of investment opportunities.
These two ingredients together, abnormal returns on capital and vast investment opportunities within an established franchise, result in wonderful shareholder value creation. And as of today, there is no competitor in sight likely to erode that competitive position.
Hence, in our opinion, the value of that growth is likely to exceed the current stock price premium over EPV by a large margin.
Following the Q1 2018 earnings report, the stock trades at $60/share, well above the $45 after Q4 2017 results.
At the same time, several factors have increased our estimation of EPV:
- Q1 2018 results and Q2 guidance have exceeded the assumptions in the valuation.
- The company has guided to an average tax rate of 14% going forward. In our previous EPV estimation, we used a 20% rate. We are now using a 17% rate, that still leaves enough margin of safety.
- The company generated $64 million of cash flow from operations in Q1.
Our revised estimate of earnings power is $2.83/share. Using a discount rate of 8%, that puts the value of earnings power at $35.4/share, before accounting for the $8/share of distributable cash.
The EPV to equity holders, including excess cash, is thus $43.4/share.
Therefore, at $60/share, the stock trades today at a 38% premium over a conservatively calculated EPV.
That makes the stock somewhat more pricey than in February (when the premium was 27%), but not expensive, since growth prospects are, if anything, accelerating.
Takeaways and future coverage
As our subscribers know, we have recently added Alphabet (GOOG) (GOOGL) to the IW Portfolio at about $1,000/share (initial long thesis here), and have estimated its forward earnings power yield, or the ratio of zero-growth 2018 earnings to market price, to be about 5.5%.
Given Google's growth prospects of mid to high teens at high ROC, we went further and advanced that 5.5% yield as the opportunity cost of tech investments, or the Google hurdle.
More specifically, we argued that for a tech investment with similar growth prospects as Google to be compelling in today's market should offer a minimum 5.5%+ earnings power yield.
At $60/share, SolarEdge trades at $52/share ex-cash. Our revised earnings power figure of $2.83/share is based on revenue rate and operating margin as of Q1 2018.
To compare it to the Google hurdle, we need to estimate a forward next twelve-month figure. Using a conservative multiple of 1.3x (30% growth) brings forward earnings power to $3.68/share, for a forward earnings power yield of 7% (3.68/52).
That figure is 250 bps above the Google hurdle. On the other hand, while sizable, SolarEdge's growth prospects are far less visible than Alphabet's. And its competitive position far more vulnerable.
All in all, the 250 bps margin seems about fair, and we reiterate our positive views on SolarEdge's stock, while acknowledging that the margin of safety is somewhat thinner than 3 months ago.
We recommend investors to maintain their long positions.
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We will update our thesis after the Q2 earnings conference call in June. In the meantime, we will keep publishing research on potential stock picks and other positions in our portfolio.
