The solar industry has been on a hot streak in 2019 as estimates for installations go up and margins slowly begin to stabilize across the industry. On the front lines, companies like Sunrun (NASDAQ:RUN), which installs residential solar systems, are experiencing steady demand, which is what they need to keep money flowing through their finance business.
Sunrun's stock is already up 52% so far this year, but investors should still be wondering if there's further upside for a solar company with the No. 1 market share in residential solar. Here's a look at why I think caution is the best path forward.
What Sunrun does
It's important to understand how Sunrun's business works. The company installs solar panels on a homeowner's roof, and instead of selling them to the homeowner, it sells electricity through a long-term lease of 20 years or more with the option to renew for another 10 years (which will be important later). So the up-front cost of selling and installing the solar project is financed by Sunrun, not the homeowner.
The company then turns around and sells the tax benefits -- like the investment tax credit, state subsidies, or accelerated depreciation -- to investors and often sells a portion of expected cash flow from the customer as well. This financing brings in cash that Sunrun hopes will fully offset the cost of each installation.
What's left for Sunrun is what's known as retained earnings, or what it calls net earning assets. This is the company's estimate of the present value of all future cash flows; at the end of the second quarter, it stood at $1.4 billion, or $12 per share.
The problem with net earning assets
As much as Sunrun may point to net earning assets as a measure of value, investors should look at the number with skepticism. I highlighted my problems with retained value (a similar metric) here, but the biggest issue I have is an assumption that customers will renew their leases of solar panels after the initial 20-year contract. A 20-year-old panel will be obsolete, and it'll likely be cheaper to get a new solar installation than renew a lease.
Of the $1.4 billion in value that Sunrun reports, $1.1 billion of that is based on renewal estimates. That means there's only $300 million of contracted earning assets, which isn't a lot compared with the company's $1.6 billion market cap.
Sunrun's cost problem
The other problem Sunrun has is rapidly rising costs for sales and marketing. In the second quarter of 2019, the company reported $0.80 per watt in sales and marketing costs, versus $0.70 in 2018 and $0.52 in 2017.
The low-hanging fruit for residential solar installers has been picked, and now companies are having to spend more to find new customers. That's not a good trend. And when you add in stagnating installation costs, it means the expense Sunrun incurs for each installation is actually rising.
Caution is the name of the game
I think Sunrun holds a valuable position in the solar industry with a commanding spot atop residential solar. But its financing and cost structure are concerning for long-term investors and may eventually allow competitors to take market share.
Shorting the stock is crazy, given the growth potential for solar energy in the U.S. But Sunrun isn't a buy today and would need to trade at a significant discount to calculated net earning assets for me to consider it for my portfolio.