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Sunrun: Stuck In Earth's Gravity

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About: Sunrun Inc. (RUN), Includes: NOVA, SPWR, VSLR
by: Joseph Kowaleski
Joseph Kowaleski
Growth at reasonable price
Summary

My valuation-based bearish thesis is playing out.

Given long-term uncertainty shares are not worth much more than net earning assets; dilution has decreased shareholder value since June.

Sunrun is the leader in solar installations in the United States, but the competitive nature of the business makes competitive advantage difficult to establish.

The solar industry faces numerous headwinds and challenges; the picture is too murky for long term investors.

Should shares decline towards $9.36, a 20% discount on net earning assets, consider Sunrun as a value trade.

Thesis

Sunrun Inc. (RUN) was a position I held for a brief period of time in mid-2018, as chronicled. Sunrun is no longer in deep value territory, net earning assets have slowly increased, but dilution has decreased value per share.

Sunrun's convoluted financials, lack of sustainable competitive advantage, and massive cash burn are all red flags. But, on occasion, even such risky assets can be unfairly discounted as was the case in early 2018. But, the wave of euphoria that Sunrun rode to a stretched valuation close to $20 per share was unwarranted. The transformation to alternative energy is still in its infancy, this makes the solar industry speculative to a degree. For this reason, investors must be extra cautious in determining what is a fair value for to pay for these businesses.

Complex Financials

Sunrun's financials are complicated by the nature of the company's model. The company incurs high up front costs for solar systems in which it receives the benefit over a period of 20 years.

High up front costs, and non-existent cash flow is a poor way to run a business. This is a stark contrast from quality businesses like Amazon (AMZN) and Starbucks (SBUX). In Amazon's case, the company is able to collect payments from customers well before it has to pay suppliers. This increases cash flow metrics. Starbucks does something similar, the company benefits from prepayments, it receives cash before it supplies customers with product.

Sunrun, on the other hand, incurs high upfront expenses for money to be received over a long period of time. Amazon's early losses, and Sunrun's GAAP profitability is a perfect representation of the brokenness of reported earnings. One business is generating enormous sums of cash to which it can put to work, while the other is piling on debt.

ChartData by YCharts

While the businesses provide polar opposite goods and services, the structural challenge that Sunrun has should make investors weary, and requires a large margin of safety compared to a business like Amazon, where investors understand the multiple they are paying for cash entering the business.

Sunrun's GAAP profits are a result of investment tax credits that the company bundles and sells to investors. As the tax credits run out over the next several years, this will be yet another headwind the company faces. Tariffs on solar equipment is another challenge faced by the industry.

For that reason, Sunrun's value is almost entirely wrapped up in its assets, which should produce cash flow for the business over a period of 20 years. Metrics such as net earning assets and book value are most important in determining a fair value to pay for the stock. The rate by which this value should be discounted is up to investor discretion, but given the complex and uncertain nature of these future cash flows, I believe a hefty discount is warranted to ensure a large margin of safety.

When I purchased shares in Q1 of 2018, the company had roughly 1.1 billion of net earning assets, and had a market capitalization of 900 million or so. This is nearly a 20% discount on the fair value the company computed for its net earning assets.

Source

Net earning assets have increased to $1.438 billion, and shareholders have been diluted, with now 122.8 million diluted shares. If we require the same 20% asset discount, that gives us a market cap of $1.15 billion, or $9.36 per share. Given the capital intensive nature, we can expect further dilution, so my calculations would be the absolute maximum entry point.

My calculations above are reliant that Sunrun's assumptions for its assets values are correct. Net earning assets requires a number of assumptions made by the company.

ChartData by YCharts

I would consider price to book value to be a rather outdated metric in business valuation. In instances of businesses with tangible assets that have value, it is a useful metric. Under 1 is value territory, while the stock rallied to nearly 2.5x book.

Competitive Advantage

Sunrun's services are commoditized. There are a number of solar providers that will provide similar leasing services to Sunrun. Sunrun does not provide any proprietary technology that gives the business a semblance of a moat. Sunrun's recent deal with Enphase Energy (ENPH) is an example of other suppliers extracting value through Sunrun's supply chain. Sunrun relies on suppliers developing the technology to sustain operations. Enphase and other suppliers like SolarEdge (SEDG) will gladly supply inverters to Sunrun's competition. Sunrun's lack of proprietary equipment means success in the solar industry boils down to more arbitrary tactics like customer service and marketing to differentiate commoditized services. This creates a spending war that pressures margins.

Source

Sunrun has executed better than competitors Tesla (TSLA) and Vivint (VSLR) by taking market share over the past several years. While this is a net positive for Sunrun, its leading competitive position is not secure given the challenging underlying economics of the model.

Sunrun and other solar installers' sales & marketing expenses exceed gross profit. Marketing expenses can be a telling indicator on whether if the company's brand is superior to competitors, and overall product demand. Sunrun reviews are generally good, near the top of the bunch in the highly competitive industry. Sunrun ranks second to Sungevity, with other public installers Sunnova (NOVA) and SunPower (SPWR). Sunrun's Glassdoor rankings lag its closest competitors as the company has reported a labor shortage dampening its growth outlook.

Sunrun has a strong position amongst other solar providers, but the underlying economics of the business are of concern. Despite Sunrun's high operating cost, the company still needs additional labor spend to support growth.

Sunrun's management has positioned the business for success, but the changing nature of the business could tilt the advantage towards a competitor. New mandates requiring solar panels on all new homes would benefit the businesses best connected to the homebuilders. Most of the solar providers offer similar solutions, even Sunrun's BrightBox storage solution which is manufactured by LG Chem, can be copied by the competition. Looking forward, investor's should keep their eyes open for solar businesses that are able to differentiate their offerings from competitors.

Too Speculative for the Long-Term

Solar's promise of a future closer to carbon neutral than further is a compelling idea for dreamers. Valuation matters and investors should be cognizant of the challenges that a business like Sunrun faces in generating future cash flows. The shifting nature towards cleaner energy highlighted by California's 2020 solar mandate has investors digging for a winner amongst the space.

Overall, this makes the biggest concern with Sunrun is separating the difference between demand and profitable demand. Societies' shifting focus to renewables will increase demand for solar systems, but cash flows are unpredictable given the poor economics. Sunrun's leadership position in solar installations gives investors some hope, but the underlying business model is still too risky for long term investors. If Sunrun were to creep down towards my $9.36 entry point, Sunrun becomes a potential value trade. Given the nature of the business, there is far too much uncertainty over a long term time horizon, but given the company's physical assets the stock could be an interesting trade given no deterioration in fundamentals.

Sunrun is still slightly overvalued, given net earning assets has declined to $11.50 per share as opposed to $13 in June, mostly because of dilution. Fundamental investors would be best staying on the sidelines for now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.