TAN: Current Valuation Makes This A Dangerous Play
Summary
- The ETF's nine largest holdings have appreciated an average of 418% YoY despite many struggling with revenue growth or profitability.
- Valuations measured on P/E and P/S are extreme and require a long-lasting positive development for ETF holdings.
- Some top ETF holdings have struggled with revenue growth for an entire decade despite massive marketplace expansion taking place.
- Comparing risk and current valuations are asking investors to take a leap of faith for many years despite limited visibility.
- I consider establishing a position at current valuation carrying significant risk with underlying holdings being very overvalued.
Investment Thesis
Renewables make for an interesting investment potential as its growth is anchored via a global commitment from our political leaders. I think investors do well for themselves in finding exposure if the valuation allows it. I've looked at Invesco Solar Portfolio ETF (NYSEARCA:TAN) and its holdings in order to determine if the recent pullback allows for an interesting entry point. Within this article, I will consider its top holdings from a fundamental standpoint and consider the current valuation. I find that an entry at this point carries risk of capital destruction as valuations are much too high. Underlying holdings have appreciated greatly over the most recent year with an average of 418% despite some of the companies struggling with either revenue or profitability. Issues with elevating revenue is particularly interesting as the market is expanding massively, but also facing continuous downwards cost pressure and reliance on subsidies. Current valuation requires a very long runway for companies to grow into their valuations while an immature market also entails limited visibility as to how the situation will develop. Basically, current valuation is asking investors to hope for a very positive development for a very long time.
Introduction
I recently wrote an article covering iShares S&P Global Clean Energy Index ETF (ICLN) which is an ETF with exposure to a wide range of sectors within clean energy such as wind, solar, hydrogen, sub-suppliers and more. I concluded "you will be buying into extreme valuations across the board" with the "risk-reward trade-off much too risky at ICLN's current price". Reaching that conclusion, I went scouting for another opportunity as I genuinely want to obtain exposure to the clean energy transformation. In the previous article I described the clean energy transformation as an unstoppable train and one I would like to board.
Invesco Solar Portfolio ETF is both similar and widely different from ICLN. Where ICLN ensured wide exposure, TAN has a much narrower focus via a concentrated portfolio of companies within the solar energy industry, therefore not considering the much broader renewables market. It covers the entire value chain with companies covering raw materials, equipment or parts production as well as final product manufacturers. Both pure plays, who consider solar energy as their primary focus and medium-players who obtain at least one third of their revenue from solar related business.
The Solar Market Potential In Brief
The global solar market has been expanding massively in recent years with solar dominating annual new power generation capacity. In 2019 solar's share of new additions totalled a staggering 48%, almost twice that of wind energy and more than all other renewables combined. That development is depicted in the figures below, which showcases the ratio between new additions from solar and otherwise, more interestingly is the runway for renewables considering the other figure. Since 2015, Solar power has increased its ratio of total new additions from 21% to 48% in 2019. Further, that renewables total share of the cake still leaves plenty of space for massive continued growth looking forward. Looking at that equation we can't forget the fact that all our world leaders have committed our economies towards this transition.
Solar Power Europe.org Global Market Outlook, Solar Power 2020-2024, p. 7-8
Considering the transformation from the standpoint of revolutionising our energy base, solar energy has one strong fact speaking on its behalf. The cost of generating solar power has decreased drastically within the last decade, from being massively outcompeted by other sources when measured on costs, as opposed to now where it has become the cost leader within renewables. While that constant downwards pressure on prices is a source for increasing amounts of new solar installations it is also a pressure on the industry companies as they consistently must squeeze out more efficiencies to ensure positive net income. This pressure may very well show itself in company margins.
Solar Power Europe.org Global Market Outlook, Solar Power 2020-2024, p. 9
Back in 2010 only seven countries had more than 1GW of installed capacity with most from Europe but by the end of 2020, more than 40 countries will have reached this threshold. However, during the last decade there has been an overreliance on China for new installations, with China taking up more than 40% of new installations back in 2018, which since then has been reduced to just below 30% for 2019 and 2020.
REN21: Renewables 2020 Global Status Report, p. 107
Back in 2017, China's amount of new installations topped at around 53GW which has since dropped due to solar power becoming a less subsidised energy source. In 2017, the second largest installer besides China, was the US at 10.6GW. Europe was early to adapt solar power via subsidizing and is currently growing at a long-term average of roughly 5-10% annually while the US grow at a slightly higher pace. As such, there is still a high reliance on the existing top markets, but also the emergence of new markets in South America, Asia and the Middle East who will have to cover the gap of China's dwindling installation capacity coming down significantly despite still being the largest effectively outgrowing number two by at least twice as much depending on what forecast we put out. The previous decade was characterised by innovation, subsidies and cost reduction while the new decade will be characterised by global expansion.
IEA, Solar PV net capacity additions by country and region, 2015-2022, IEA, Paris
Extending the forecast timeline into 2024 we see a consistent development of strong growth. No matter whether it is the organisation SolarPower Europe or the International Energy Association, they both expect strong global growth creating an interesting marketplace for the companies who operate herein. The World Economic Forum is even bold enough to state, that by 2030, solar power might have become the world's most important energy source. They forecast the cost of solar power becoming unbeatable by other energy sources making it a clear number one whenever feasible and for sufficiently sunny regions of the world.
Solar Power Europe.org Global Market Outlook, Solar Power 2020-2024, p. 24
Deep Diving TAN
The Invesco Solar Portfolio ETF is made up of 40 companies divided into Technology, Utilities, Real Estate and Industrials with Technology making up roughly 70% and Utilities making up roughly 24%.
Picking a winner in an immature industry that's still fragmented and has a long growth runway ahead can be very difficult, making an ETF a natural alternative since it provides exposure to a number of future losers but hopefully also a handful of ten baggers who will ensure market beating returns. I consider it a fallacy if I suggested I for certain could pick the future winners of the industry at this point, so going with an ETF is the more risk averse option, and in my opinion, intelligent choice.
Having said that, price matters and I want to understand what is in the basket and how those holdings are priced in the market. We have recently seen TAN retrace its steps significantly albeit still showing more than 280% in return YoY. The questions if whether that provides an interesting entry point for a new investment.
The most recent articles covering TAN shows a bullish rating having been published both at the ETF trading top and its new plateau. Below, I've included the top 9 holdings of TAN ranked by their ETF weight totalling 53.2% making up more than half of the ETF and therefore being a fair representation of its holdings.
Authors Own Creation: Sources, Annual Reports, Seeking Alpha & MarketScreener.com
The table comes with a number of financial metrics that I find valuable to obtain a better understanding of the ETF holdings and their current performance and pricing.
- Despite the massive growth in the industry as presented earlier, we can observe quite disappointing revenue growth rates measured on a 3Y horizon for five out of nine of the holding, being First Solar Inc (FSLR), Xinyi Solar Holdings (OTCPK:XISHY), GCL-Poly Energy Holdings (OTCPK:GCPEF), SunPower Corp (SPWR) and Canadian Solar Inc (CSIQ) who exhibit growth ranging from -55% to 73% with three companies posting negative revenue growth for the period.
- The average revenue of the top nine is $1.6 billion with the largest company being Canadian Solar raking in $3.4 billion. For those who aren't too familiar with the industry, they should know that Canadian Solar is a veteran of the industry and was also its largest player going back 8-10 years. Canadian Solar has been hovering around $2.9-3.4 billion in revenue since 2014 effectively at a standstill despite global installed capacity standing at more than 300%+ since 2014. This speaks to the eroding effect of a constant cost pressure as the industry is reaching towards maturity at one point. In Canadian Solar's defence, it should be mentioned the company has been profitable for all the years from 2014 and until now, however posting wildly fluctuating net income numbers.
- Another observation is the relationship between YoY returns averaging at 418% compared to an average market cap of $10.1 billion. One year ago, the average market cap would have been $2.5 billion before the 418% take off. These companies have gone through the roof with all the money that has entered green investments such as TAN. In my ICLN article, I had a section covering the impact of the current interest rate environment. You should ask yourself what has fundamentally changed within these companies or the marketplace within the latest year that can justify a 400+% return. Meanwhile, we have during early 2021 seen the interest rate tick upwards. With a low interest rate, anything is possible within an excel sheet looking far into the future as is the case for these companies where you don't have a 30-year track record as you would from a dividend king or blue chip company. However, a rising interest rate environment will create a downward moving pressure on these companies as the future cash flows are eroded by the higher interest rate.
- In conjunction with the previous point, we can also observe the average revenue from these companies during 2020 standing at $1.6 billion. With the previous section in mind, there is no doubt that this industry will experience growth, but at the same time being contested by the consistent cost pressure squeezing margins and eroding future profits and revenues. This stands in stark contrast to the current price you pay for the companies. I've included Prices to Sales ratios for current- and coming year as I see more value in this metric compared to P/E ratios when dealing with immature growth companies. I have however also included the P/E ratio for these companies averaging at 44 with Sunrun Inc (RUN) and GCL-Poly Energy Holdings positing negative P/E ratios. Coming back to P/S, if you look it up in any accounting or financial analysis textbook you would most likely find that a P/S ratio above 4 is considered very high with anywhere between 1-2 being acceptable. The general market currently trades at around P/S 2.5. For these companies the average ratio is 8.7 ranging as high as 26.4 and 13.3 for Enphase Energy and Sunrun. P/S forward is slightly lower at average 6.4 as revenue growth is expected, but still with Enphase and Sunrun at 19.7 and 8.9 respectively. These are absolute staggering numbers seen from my perspective given the runway ahead to reduce those to more sustainable levels.
Can These Companies Grow Into Their Valuations?
Considering the P/S ratios mentioned before, it makes me want to rub my eyes and ask if we can expect the companies to grow into these ratios eventually. They are in a growing marketplace sure, but let's try and see how far they have to come, in order to reduce their P/S ratios to more acceptable and market consensus levels, forgetting about the average P/E ratio at 44 which is also illogical. It is a matter of personal opinion but I consider the general market rather heated as of right now and it currently trades at P/S around 2.5 which is above my previous textbook example of wanting to see companies trade somewhere between P/S ratio 1 to 2. Recognising that these are growth companies in an immature sector, I would say it is unlikely to expect ratios below 2 anywhere soon, but we do see Canadian Solar trade at 0.8 current and 0.5 forward. In general, investors are willing to pay more for companies with a growth runway, which is why we should also expect elevated P/S ratios compared to the general market or more stable blue chip companies.
Authors Own Creation
The table above shows the exact same companies as the previous, still ranked according to ETF weight despite having removed that metric. It shows current P/S ratio, and then I've calculated the revenue required to reach P/S ratio of 6, 4, 2 and 1. This is done, to specify exactly what would have to happen for these companies to come down in valuation while keeping the market cap stable. Let's look at a few examples.
- Enphase Energy would have to grow its revenue 656% to see its P/S ratio reduced from 26.4 to 4 by reaching a revenue of $5 billion from its current $774 million. Revenue would have to grow 1289% to see its P/S ratio reduced from 26.4 to 2. Enphase Energy grew its revenue by an impressive 171% over the last three years, but we should remember that is coming off small revenue levels and having to go from $774 million to $5 billion is a different ballgame and even more so trying to reach $9.9 billion. As such, if we expect the stock to trade at P/S ratio somewhere between 4 and 2 eventually which would still be high compared to Canadian Solar, we should expect the company to reach that level around 12 years from now assuming they can maintain a 3Y growth ratio of 171% throughout that entire period which I would consider extremely unlikely.
- SolarEdge Technologies (SEDG) would have to grow its revenue 240% to see its P/S ratio reduced from 9.6 to 4 in order to reach a revenue of $3.4 billion up from $1.4 billion today, and 479% if it should see the P/S ratio reduced all the way down to 2. Maintaining its current growth rate over three years of 140% would see its revenue reach $4 billion after nine years which is the equivalent of a P/S ratio of 3.5. Maintaining that growth ratio for an additional three years would see its revenue reach $6.8 billion and a P/S ratio of 2.04. Again, as was the case for Enphase Energy I can't help but consider that extremely unlikely to happen.
- First Solar trades at a P/S ratio of 3.4 which is well below the average which stands at 8.7, however First Solar saw its revenue decline by 8% over the last three years. First Solar's revenue back in 2011 stood at $2.7 billion, the same as 2020. Since 2011, the revenue has reached as high as $4.1 billion in 2015 and as low as $2.2 billion in 2018, virtually making this exercise impossible. First Solar would have to grow its revenue to $4.5 billion in order to reach a P/S ratio of 2, which is a significantly higher number than their best throughout the past ten years, with a highly volatile revenue development through the last decade. It is difficult identifying a logical explanation as to why First Solar deserves an above market average valuation as by its current P/S ratio combined with a YoY return of 143%.
- First Solar, GCL-Poly Energy Holdings and SunPower Corp all exhibit lower than average P/S ratios, which is related to their negative revenue growth. Despite this, their P/S ratios are still higher than the general market with P/S ratios between 2.7 and 4.8 all being higher than the general market and significantly higher than what you would expect for companies who struggle with elevating their revenue in such a growing market.
That is just a few examples but I'm sure you get the picture at this point. I have a difficult time understanding what has allowed these stocks to appreciate massively over the last year, except for the sake of just having a massive inflow of funds as everybody wants to be invited for the party. Most of these companies, even if they maintain their stellar growth for a decade, will still not have grown into their current valuations while assuming the market cap remains stable. I fully appreciate the fact, that renewables will play a vital role in the energy transformation, but how it will be divided ten years from now is virtually impossible to predict with a high degree of certainty, and these valuations requires one to assume a significant amount of risk while just waiting for it all to play out. We have seen companies from the list who haven't seen their revenue move in the last ten years, who is to say that couldn't happen for some of those companies who have been posting great revenue growth recently, but will they do so for ten plus years straight?
Risks
Having determined that most of the ETF holdings will have to undergo significant revenue growth for a long period of time, I think there is a few risks that should be mentioned which makes it even more difficult to predict whether that is feasible or not.
There are quite a few risks associated with investing in an immature market such as this and there is one particular risk I would like to highlight here, which is the reliance on subsidies. The industry is in between places as it's probably soon about to come off "the drug" that is subsidies. A couple of news headlines would be, that China has increased its renewables subsidies for 2021 with solar taking the lions share, as well as the Netherlands having increased theirs also. However, general subsidies are expected to move lower as we explore the 2020's and come closer to 2030. They might have disappeared entirely at some point in the future as forecasted by the International Renewable Energy Association.
As investors, we have to recognise that such changes may cause significant shifts within companies as they risk becoming unprofitable or see existing markets conduct political changes as other energy sources suddenly become more competitive as changes happen in the supply chain depending on whether it is suppliers, customers, end producers or others who benefit from subsidies. These political changes make it incredibly hard to forecast market developments as the tides may change depending on political stability and legislation.
A very fitting example here would be the case of Sunrun, who barely managed to secure a positive net income during 2018 and 2019 accumulating at $53 million before seeing at negative -$173.4 million net income in 2020 wipe out several years hard earned profits. As Sunrun has relied on subsidies from its foundation and until now, it may have trouble securing profits for its residential solar panel business once the current tax break regime ends, if it isn't renewed.
Risk of Being Diluted
Considering my previous modelling of required revenue levels to attain P/S ratios of different brackets shows the staggering growth required for some of these companies to grow into their valuations. Considering the profits are negative for some and thin for others there is a high chance that these companies will need to issue new shares to fund their journey. This may have an adverse impact on your expected returns depending on how the situation develops. Imagine the needed expansion in individual companies' asset bases in order to produce to a current revenue level multiplied by a factor of 5X to 10X. That doesn't come for free and will most likely be accompanied by a continuous downwards moving cost pressure. It could be tempting for management or company owners to issue new shares during a period of elevated share prices. It could become expensive for main street shareholders.
Conclusion
The transformation towards a renewable energy base is undeniable, with solar energy being a significant contributor. Invesco Solar Portfolio ETF has recently seen a pullback in its performance from its February high of $122 per share compared to its current trading price at $90 per share. Despite this, I still find the valuation much too rich at this point. I've looked at the top 9 ETF holdings making up 53% of the total holdings and found that no matter how I look at the valuations, it is a dangerous play. These nine holdings have seen their stock prices appreciate an average 418% YoY with a current P/E at 44, P/S at 8.7 and forward P/S at 6.4. These are companies with an average market cap of $10 billion and average revenue of $1.6 billion. Some of these holdings struggle with their revenue growth while other struggle with profitability. I've found companies who have been in this industry for a decade not able to elevate their revenue despite the industry having grown tenfold during that period. Despite being in a market which will see strong growth for many years, I see no logical explanation that can justify the current valuations. I've forecasted the required growth for these companies to grow into typical market averages when measure on P/S and even if the most successful growers maintain their growth averages, it would take more than a decade to come down from their valuations. Considering the risk and uncertainty concerning how an immature marketplace develops with strong competition and reliance on subsidies, it is a very risky play. The ETF is highly overvalued the way I see it, and the valuation you buy into will matter, also if you plan to hold for an extended period. I fear the risk of capital destruction if I initiated a position at this level.
This article was written by
Analyst’s 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.
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