Residential solar stocks surged on Tuesday after Goldman Sachs analyst Brian Lee upgraded Vivint Solar (NYSE:VSLR) and Sunrun (NASDAQ:RUN) to a buy rating and speculated that Vivint could be a buyout target. One day's move doesn't make a trend, but it is an interesting datapoint as investors think about what the future of the residential solar industry looks like.
This is one segment in the booming solar industry that's taken a big step back in the past year, and Vivint and Tesla's (NASDAQ:TSLA) SolarCity have both seen installations fall substantially. Here's why a buyout may make sense, and why it's not necessarily a sign that all is well with these companies.
The problem with national solar installers
Over the past two years, national installers have been facing an uphill battle against smaller solar installers. GTM Research's U.S. Downstream Distributed Solar Service report showed that non-big-three installers have grown from 45% of the market in Q2 2015 to 59% in Q4 2016, and probably increased in Q1 2017 after Tesla and Vivint saw installations fall.
What national installers face is a difficult time competing against smaller installers that are more nimble and have a lower cost structure. If you look at Vivint Solar's cost per watt of $2.98 in Q1 2017 and Sunrun's incredibly high $3.38 per watt they're not all that competitive with smaller installers.
EnergySage reports that national pricing in the second half of 2016 (the latest data available) has sale prices for residential solar at $3.36 per watt. And prices in Arizona ($2.97 per watt), Florida ($3.03 per watt), and Virginia ($3.02 per watt) can be far lower than the average. And remember, these aren't company costs like what Vivint and Sunrun are reporting, they're actual sale prices that a customer would see. Depending on the location, Sunrun and Vivint may actually lose money competing against the average price regional installers are quoting.
Add to this the fact that Vivint and Sunrun were built on a leasing model that's losing market share to loan and cash sales and it makes for a tough strategic position. Higher costs and the wrong business model doesn't scream buyout candidate to me.
Liquidation could maximize value
What could be interesting in a buyout is liquidating Vivint Solar and Sunrun's assets. After years of selling leases, both are holding onto billions in future contracted revenue and "retained value," a metric once favored in residential solar. Vivint Solar reports $652 million in net retained value after pulling out debt and adding back cash, which amounts to $5.90 per share. Sunrun reports $1.07 billion in net earning asset, which is about $10 per share. It's no coincidence that when Brian Lee upgraded Vivint and Sunrun he put price targets of $6 and $10 respectively.
In a potential buyout, it's very likely that a buyer would look to spinoff existing operating assets and capture as much of that retained value on the balance sheet as possible. When that's complete, the buyer may continue operating the companies with a focus on profitable regions or split them up into a number of powerful regional solar installers.
Not the ending residential solar installers have advertised
The fact of the matter is that the future of residential solar is moving further and further away from the national model that made Vivint Solar, Sunrun, and SolarCity popular names for investors. And the value that's left in any of those names resides almost entirely in the contracts they signed with customers in years past.
Even in the price targets of an analyst who thinks mergers and acquisitions are going to take place in residential solar, he's putting little to no value on future operations. That's because national installers are no longer competitive with nimble, local and regional companies. And without a differentiated product to sell (which they don't have), their futures look very bleak indeed.