The solar power market has some of the highest potential in the world today -- with the possibility of multi-trillion dollar outlays. But despite that potential, the industry has seen dozens of bankruptcies, including high profile companies like SunEdison, Solyndra, and Suntech Power.
Considering all of the turmoil, there are several good reasons to avoid the sector altogether.
1. Falling costs have strange consequences
One of the biggest reasons solar energy has become so competitive and has so much potential is that the costs per kilowatt generated are falling. But falling costs can mean falling revenue and margins for solar companies.
When you look at the challenges most solar manufacturers have faced over the past five years, a lot of them stem from companies taking on debt and making large investments in manufacturing equipment, then watching the hardware coming off those production lines become less and less valuable each year.
2. Financing is always a challenge
In the solar installation business, financing is a constant challenge. Debt is often used by developers to build projects; those projects then need to be either sold or financed long term. In the case of SunEdison, for example, what drove it to bankruptcy was the financial market losing faith in the company, raising the cost of capital and shutting down financing. TerraForm Power (NASDAQ:TERP) and TerraForm Global (NASDAQ:GLBL) have seen the same effect as well -- their stock prices fell to the point where their dividend yield got so high they could no longer buy growth projects accretively, which was their plan all along.
Manufacturing is even tougher. After Chinese solar manufacturers declared bankruptcy and defaulted on billions in loans, few parties are interested in funding new solar manufacturing plants now.
Whether a company is expanding its manufacturing operations or building projects, financing is always needed, and can be very fickle. In a fast changing industry, that's a major challenge.
3. Changes happen quickly
Regardless of whether a company operates in the manufacturing, project development, or technology segment of the solar industry, evolution is rapid, which can make investing very difficult. Country-specific demand can rise and fall swiftly depending on government subsidies. (See the rise and fall of solar markets in Germany or Spain.) The component demands of installers can change very quickly. (Enphase Energy IPO'd with a lot of hype, only to see customers change preferences.) And consumer preferences can shift without warning. (Where once people demanded solar leases, now the demand is for loan products and systems that customers own.)
Many companies focus on creating value in one segment of the market; if that segment sees a change in demand, they can get into trouble quickly. Many times, those changes are out of a company's control as well.
The companies that have survived through the market's ups and downs, like First Solar (NASDAQ:FSLR) and SunPower (NASDAQ:SPWR), have both managed change and built businesses diverse enough withstand it. But that doesn't mean either company's stock is up over the past decade.
When you look at the risk for SolarCity (NASDAQ:SCTY), deriving a vast majority of demand from the U.S., particularly a small set of states, in the residential and commercial market doesn't leave much room for adaptation if markets change. That's a risk investors should keep in mind.
4. Low rates of return
To keep the cost of solar energy low, the rates of return for solar projects must also be low. 8point3 Energy Partners, a yieldco sponsored by First Solar and SunPower, recently said that it's buying projects with an internal rate of return of only around 8%. SolarCity discounts its cash flows at 6% in NPV calculations. TerraForm Power and TerraForm Global were even more aggressive in buying projects and leveraging them with debt, which is what got them into so much trouble.
If interest rates rise or investors demand higher rates of return for solar projects, the underlying value of assets will go down as well. That will squeeze already thin margins and lead to more financial distress. If you want to see how quickly rising costs can strangle a company, just look at SunEdison.
Foolish bottom line
There are a lot of reasons to hate solar stocks, and the four companies I focused on above should top the list. But despite all of the challenges, this is a high potential industry for investors willing to weather the storm. If you can look past the negatives, there could be riches ahead.
Travis Hoium owns shares of 8point3 Energy Partners, First Solar, and SunPower. The Motley Fool owns shares of and recommends SolarCity. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.