Can Sunrun Survive in Today's Rooftop Solar Business?

Image source: SunPower.

There are only a handful of companies that dominate the booming residential solar industry in the U.S. that already has about 1 million customers. SolarCity (SCTY.DL) has a clear lead in the market, and Vivint Solar (VSLR) has been the No. 2 installer for a couple of years. SunPower (SPWR -4.90%) is a traditional industry power -- and then there's Sunrun (RUN -4.84%), which has a unique position in the industry.

Sunrun has long been a provider of financial services and other technology to installers, but it's been building out installation capabilities as it guns for SolarCity and Vivint Solar's position. But as the company has matured on the public markets, there are some strange trends emerging in its finances.

The money-losing solar business
The first thing to point out is that Sunrun isn't exactly a cash cow today. Below are the company's two revenue line items, and the associated costs of the business for 2015. 

Source: Sunrun Q4 2015 earnings release.

You can see that gross margin was just $24.1 million, which is 1/6 the sales and marketing budget, and less than 1/3 what it spent on general and administrative expenses. Sometimes, revenue and margin don't tell the whole story for residential solar companies; but because Sunrun makes most of its money from system and product sales, it's notable that it's nowhere near a profit.

If you want a comparison, Vivint Solar made a profit of $13.1 million in 2015 after distributing tax-equity losses, and SolarCity lost $56.0 million installing 870 MW of solar. Sunrun lost $53.1 million installing 203 MW, or less than a quarter of what SolarCity installed. With a higher percentage of revenue coming from system and product sales, Sunrun should have smaller losses than larger competitors.

Sometimes, the income statement doesn't tell the whole story, though. So let's dive into the cost structures of the industry to see where Sunrun stands.

Cost is key in residential solar
Below is a table of the costs that Sunrun, Vivint Solar, and SolarCity reported during 2015. You can see that Sunrun has cut costs rapidly, but it's still behind competitors.

Source: Company earnings presentations.

Interestingly, Sunrun has higher installation, sales and marketing, and general and administrative costs than both SolarCity and Vivint Solar. How can a company like that compete in a highly competitive solar market?

One thing Sunrun does like to point out is that its internally built systems are lower cost than the $2.81 average for the entire fleet. But at $2.33, they still cost more than the $1.90 installation cost that SolarCity had in the fourth quarter. And Vivint Solar's $2.34 installation cost in Q4 may be unrepresentative of its cost structure because of distractions from the SunEdison acquisition that fell through. It has had install costs of as low as $2.12 in Q2 2015.

No matter how you look at it, Sunrun's cost structure isn't competitive with its peers.

Value creation doesn't add up
Another thing that doesn't seem to make sense with Sunrun is its value metrics. The company says it generated $4.50 per watt of value from its installations in the fourth quarter, which was a whopping 24% more than SolarCity said it generated in value during the same period.

Source: Company earnings presentations. Note: Value of installations includes assumption of renewal.

Since Sunrun has significantly higher installation prices than competitors, it doesn't make sense that it would also be generating more value. And the figure is also consistent with Sunrun reporting a much-higher retained value per watt than SolarCity, a number that SolarCity no longer relies on heavily. In fact, it's a bit ironic that SolarCity's value generation is exactly the same as Sunrun's cost structure.

There are a few potential explanations for this discrepancy, and none of them bode well for Sunrun long term. One is that Sunrun likely has much-higher pricing than SolarCity. This showed up in last year's securitization where Sunrun's customers had an average Power Purcahse Agreement (PPA) price of $0.20 per kWh with a 1.76% escalator, or annual increase in price, compared to a similar securitization done by SolarCity where its systems had a $0.15 per kWh PPA price, and a 2.07% escalator. 

Image source: SunPower.

The other potential problem is a renewal assumption. There isn't much tangible evidence that says customers will renew solar leases or PPAs, so the 90% renewal assumption is optimistic, at best. By 20 years from now when contracts expire, solar prices will be much lower than they are today, and a 20-year-old system would likely underperform a new system.

But Sunrun makes the assumption that most customers will renew their already overpriced contracts. What I think is more likely to happen is that Sunrun will have to pay to remove old solar systems from roofs in 20 years, as it's contracted to do if that's what customers choose. Instead of a renewal value, there could actually be a cost to the company at the end of the contract.

Sunrun also may be convincing more customers to prepay for their leases or PPAs, skewing the net present value of systems, which is the discounted value of all projected future cash flows. This shows up partly in $618.8 million of deferred revenue for Sunrun versus $632.6 million at SolarCity, despite SolarCity deploying nearly four times as many MW of solar.

What's strange is that Sunrun says it's creating more value than competitors in a highly price-sensitive market with significantly higher installation costs.

Nevada could be a BIG problem
Recent changes to Nevada's net metering structure, caused Sunrun to shut down operations in the state. We don't know exactly how many solar systems Sunrun has installed in Nevada, but the company said it dropped its Q1 2016 backlog by 12 MW to 56 MW because of the Nevada exit. In other words, it had expected about 18% of systems in the backlog to be in Nevada in Q1.

Some existing solar customers saw savings from solar evaporate because of the Nevada Public Utilities Commission decision to change net metering compensation from the full retail rate to wholesale rates. As a result, Sunrun could see an increasing number of defaults in Nevada. If even a small percentage of its customers default, it could be a big blow to the value-creation narrative. 

The big problem for Sunrun going forward
I've outlined why Sunrun has an uncompetitive cost structure so far, but that doesn't get to its biggest problem in the future. Sunrun is an installation and finance company in an industry where I don't think installation or finance are businesses you want to be in.

We're already seeing companies like SunPower taking market share by working with installation partners instead of "owning the trucks" themselves. (Ironically, this used to be Sunrun's strategy.) It's also seeing around 70% of customers choose cash or loans versus a PPA or lease. More and more, competitors are offering loans instead of complex PPAs or leases, and GTM Research predicts that loans will rapidly gain market share in the coming years. 

Then there's the fact that Sunrun doesn't have a technology differentiation. SunPower is gaining share because it offers the highest efficiency panels, generating more energy from limited rooftop space. SolarCity is following in those footsteps with its Silevo acquisition, and a new manufacturing plant in New York.

Sunrun doesn't have an efficiency advantage, a cost advantage, and its financing strategy is losing market share. I have a hard time seeing how that leads to greater value creation than competitors unless they're just charging customers more. Long term, I don't see how these factors could lead to a sustainable competitive advantage.

Sunrun just doesn't look like a good bet in a solar industry where competitors have lower costs and better technology. And that's why I'll keep my solar investments elsewhere.