Why Valuing Solar Stocks Is So Difficult

One of the most challenging things about following solar stocks today is trying to gauge the value of the companies involved in the industry. Since I started following the solar sector for The Motley Fool in 2010, there have been massive shifts in valuation within the industry -- and I think there are at least one or two more revolutions coming in the decade ahead.

With that in mind, let's take a step back and look at where solar companies stand today, where value is being created, and how we can best place our bets on the future of this industry.

The point of value creation is ever evolving
As recently as 2009 the solar industry was dominated by First Solar (FSLR 2.17%), the thin-film company that crushed its competitors with low-cost solar panels. First Solar was so much cheaper than the competition that it could command a gross margin in excess of 50%, and seemed to be untouchable in the solar industry.

FSLR Gross Profit Margin (TTM) data by YCharts

By 2010, First Solar's dominance had come to an end as Chinese solar manufacturers built massive amounts of capacity. They were able to cut costs dramatically, and when demand suddenly lagged supply by a wide margin in 2012 they were able to cut costs at a faster rate than First Solar, closing the cost gap.

But the solar market of 2012 looked very different than the solar market of 2009, and First Solar never returned to the margins it once enjoyed. The change that took place was a rapid decrease in costs for more efficient modules than First Solar could make. Chinese manufacturers like Trina Solar (NYSE: TSL) and Yingli Green Energy (NYSE: YGE) could suddenly make solar panels for the same cost per watt as First Solar, and could squeeze more electricity from each square inch of their panels. Suddenly, higher efficiency was lower cost, which seems counterintuitive -- but I've outlined why that's true here. 

A solar farm built by First Solar. The company now generates most of its revenue building projects like this. Image source: First Solar.

But the reign of the Chinese solar companies didn't last long. Soon the business model would become more important than the panel itself: It turns out that it's more profitable building a complete solar system and either selling it or holding it on the balance sheet rather than just selling a panel.

First Solar (FSLR 2.17%) and SunPower (SPWR -8.41%) learned this fairly early on, acquiring and building project development arms that helped increase profits. But SolarCity (SCTY.DL) took it to the next level, offering solar to residential consumers for $0 down through the solar lease. The company keeps systems on its balance sheet and projects around $2 per watt in long-term retained value versus an installation cost of just over $3 per watt, including overhead costs. 

In the last five years alone, we've seen value creation in solar go from low costs, to low costs and high efficiency, to project construction, to project construction and ownership with long-term cash flows. This changes the short-term "winners", as you can see from the rise and fall of stock prices within the market, but it still may not tell us who will win long-term.

SolarCity has built its business on building and owning rooftop solar installations like this. Image source: SolarCity.

Competition has only just begun
What often goes unappreciated in the solar industry is the fact that competition has only just begun to pick up. SolarCity has proven it has a successful business model in leasing solar systems, but that has attracted new competition from Vivint Solar, SunPower, and even NRG Energy (NRG 1.56%), which recently acquired a residential project builder.

At the end of the day, is there really any difference between a SolarCity system versus a Vivint Solar system? The monitoring interface or billing system may be different, but until recently they've used almost the exact same equipment,  so cost should be the driver in a consumer's decision.

But we're still in the early stages of this competition, and right now there's enough demand to go around. Residential solar companies can still command a 40% or higher retained value margin. Long-term, however, I don't think the business model will differentiate solar companies, as it's too easy to replicate.

SunPower's Maxeon cells create panels with industry leading efficiency as high as 21.5%. Image source: SunPower.

How to differentiate solar companies
When I look in my solar crystal ball, I see a competitive solar market that's driven by technology, not just low costs. SolarCity indicated this in its acquisition of Silevo earlier this year, with Elon Musk highlighting how important it was to pack more power generation on each rooftop. It's cheaper to spend a few more dollars on a solar panel and get 50% more power from each rooftop than it is to install 50% more rooftop systems.

That's why I think differentiation among solar technology will be so important in the future. Efficiency, form factor, and energy storage are just a few of the ways companies can differentiate themselves, and we're starting to see that emerge today.

What investors definitely want to avoid is investing in companies that make a commodity product and have to compete for customers solely on price. That's a recipe for disaster, as First Solar and most Chinese solar manufacturers learned the hard way.

How to value solar stocks
With all of this in mind, how should we be valuing solar stocks today?

The two metrics I think will be most important are the number of MW sold, installed, or financed, and the value created per MW. That value may be net income or some measure of contracted retained value (be sure to subtract operating costs from this figure), which has become popular in the industry. Below I've built a matrix that shows how MW and value per MW interact to give a ballpark of annual value added. 

The challenge here is that not every company will see the same value creation per watt or grow at the same rate. For example, Yingli Green Energy may sell most of its solar panels and generate a value of $0.20 per watt on 1 GW for a total value created per year of $200 million. Another company may install and finance 100 MW and generate $2 per watt in value for the same $200 million in value.

One of the toughest parts of this analysis is predicting where the value will be created 1, 2, 5, or even 10 years from now. SolarCity may be generating $2 per watt in retained value today, but in another five years I don't think that figure will be anywhere near that high given ongoing cost reductions, competition, and different financing models. But will value generation be $0.50 or $1? Only time will tell.

By the same token, we have to consider how durable competitive advantages are. As I outlined above, the companies creating value in solar have shifted multiple times in the last five years alone. I think that will continue in the future, although the pace of change may slow.

Investors need to focus on companies with technological advantages or significant cost advantages over competitors. That's why I own shares of SunPower, the most efficient solar panel maker in the world, because it has a durable competitive advantage. SolarCity is another company to look at, not necessarily because of a technology advantage but because it has built scale in residential solar, which will be difficult to replicate.

While I like both of these companies long-term, it's extremely hard to put a valuation on them given the rapidly changing industry. That's the challenge in following solar.