In this week's episode of Industry Focus: Energy, host Nick Sciple and Motley Fool analyst Jason Hall dig into the solar inverter industry, especially the two companies that make up the majority of the market -- Enphase (NASDAQ:ENPH) and SolarEdge (NASDAQ:SEDG). Tune in to learn:

  • What an inverter is and why it's such a hot commodity.
  • What Enphase and SolarEdge do and what sets them apart from each other.
  • Citron's short report on these two, and some arguments against them.
  • The most important trends and metrics for investors to watch with these two.
  • How the solar inverter market could grow from here.
  • Which of these two solar powerhouses looks like the better buy today.

And much more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Oct. 17, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, Oct. 17, and we're discussing Enphase and SolarEdge, manufacturers of components that are critical to growing the solar energy industry. I'm your host, Nick Sciple. Today I'm joined by Motley Fool contributor Jason Hall via Skype. How's it going, Jason?

Jason Hall: It's good! I mentioned before the show, I'm in real estate purgatory right now. We're in the process of buying a bigger house. We're in that in-between phase where we are selling our property and trying to close on buying and there's a bunch of stuff we can't do. I'm trying to act like nothing's happening and I'm failing miserably at it. I'm really distracted, so I'm very happy to be on this show and let you distract me for the next half an hour. 

Sciple: I hear you, Jason. I'm sure it's tough. One of those biggest purchases you'll make in a lifetime, and hanging in the gap between that finalizing. Another thing that's probably been affecting you out there in California has been these blackouts running through. How has that affected you? 

Hall: Hoo, buddy. No. 1, I totally understand the idea of doing these blackouts. You have to remember, a year ago this time I was in Ireland. My wife was on a workshop there so we lived there for two months. And I was watching on my Ring, as my neighbor at 4 o'clock in the morning sprayed water on the roof of my house because embers were blowing from the wildfires a mile away into our neighborhood. I get the idea of turning off the grid to prevent wildfire. It's a major problem out here. But these rolling blackouts actually hit home about a week and a half ago. The local utilities, Southern California Edison, turned off power in a large section of the area I live in unannounced, because of some risks. And it was right when we were trying to finalize the contract on the property that we're buying and were pushing a deadline. It had a material impact on our ability to get a contract done. It's a mess, it really is. What we're going to talk about today is actually really relevant to that. 

Sciple: Sure. Our grid nationwide, not just in California, it's been around for a long period of time, and because of the movements toward cleaner energy and bringing our infrastructure up to date, there have been a lot of investments in renewable. What we're going to talk about today specifically is solar. 

Solar manufacturing costs have fallen significantly over the past several years, which has made them particularly competitive with traditional energy sources. The area we're going to talk about today with Enphase and SolarEdge are power inverters. These are key components that we need for solar panels. For folks who aren't familiar with these products, Jason, can you give our listeners a high-level overview of what power inverters do and the role they play in a solar system as a larger component?

Hall: The short version is, the power grid operates on AC, alternating current. That's the best way to transmit electricity over long distances with reduced losses. The solar panels generate DC power. To make the power from solar panels usable in your house, and to connect them to the grid, you have to have an inverter to take that energy and convert it into the usable current that the system works. It's as important as the panel, because if you don't have it, you can't do anything with the electricity.

Sciple: There's been a trend in more recent years to change how we use inverters, moving more toward -- in the past, we'd use string inverters. We'd have a large number of panels and then one inverter that would take that entire stream of energy. We've been moving more recently into these module level power electronics where there's an inverter or a product at each solar panel. That's where SolarEdge and Enphase do their work. They have 95% global share in this space. Over 80% of installations last year in California involved module level power electronics. I think that's part of what's driven the great performance of these stocks over the past year. Jason, can you talk a little bit about that?

Hall: You'll hear the term "module" and you'll hear the term "panel." They're the same thing. Module and panel are the same thing. The short version is that in the U.S. -- and you're starting to see it around the world, too -- for safety reasons, having the ability to cut off power directly at the panel is becoming a bigger and bigger concern. Here's the thing. Let's say you have a dozen solar panels on your roof and you've got a string inverter in your garage, taking that DC and converting it to AC. If the grid turns off, the inverter will disconnect your panels from the grid. But the panels are still sending current through the line that connects them to the inverter. So there's still fire risk. It's dangerous for first responders. Let's say your house catches on fire. It creates a risk for first responders that might be dealing with that emergency on your property. So by having the micro-inverter, which is what Enphase is a leader with, on the panel, or in SolarEdge's case, something they call a power optimizer on the panel, so if the grid turns off, then the panel itself, the power never leaves that component that's actually attached to the panel. So it's not traveling through wires to get to anywhere else. So it's a big safety gain.

In the case of Enphase with the micro-inverters, there's also some benefit in terms of better reliability. If a single inverter goes down, you still have the output coming from the rest of the system. So you don't have that single point of failure like you do with the string inverter system, where if the inverter goes down, you lose all the output from all of your panels.

Sciple: Yeah. Those safety issues have been brought to light in recent months. You had the Walmart-Tesla lawsuit, which traced back to some issues when it came to insulation and inverters and things like that. Jason, when you look at both these companies, their performance year to date -- SolarEdge up 140%, Enphase up over 420% -- has what's been driving that been this push toward module level power electronics that's set these stocks rocketing up?

Hall: I think there's a couple of factors. No. 1, they both focus mainly on residential and commercial solar, distributed solar. It's been a great year for distributed solar, especially in the U.S., which is big markets for both of these companies. There's a little bit of the rising tide lifts all boats going on. If you look at the Invesco Solar ETF, which tracks about two dozen companies that have either complete solar exposure or very, very heavy solar exposure, it's up 58% year to date. Now, a lot of that is, frankly, Enphase. But if you look across the industry, you look at the solar panel manufacturers, some of the bigger names are up, 25%, 30%, 40%. You look at the solar installers, like Vivint Solar and Sunrun -- they're having fantastic years for investors too. Those are the companies that are directly relational to Enphase and SolarEdge because they're the ones going out and doing these distributed solar residential and commercial installations. It's a little bit of just the market. 

But also, these two companies, they've consolidated the U.S. market, especially. I think it's fair to call them a duopoly at this point. There isn't any other major competitor that is anywhere close to the market share that they have, especially in residential solar in the U.S. So it's a little bit of both. 

There's other things going on, too. Both companies are starting to take steps to go into energy storage. They're starting to diversify a little bit, add a little bit of optionality to how they can find ways to grow. There's multiple things that are going on.

Sciple: Last question before we, on the back half of the show, dive into each of these companies more specifically. You talked about the duopoly that's taken place in the market. There have been a little bit of rumblings from short sellers saying that may not be durable, most notably, Citron Research back in September. For listeners who might not be familiar with that thesis, what's the main thrust of what those folks are saying? What credence do you give to it? Yes or no?

Hall: Citron released a report in mid-September. The day the report came out, the stocks dropped around 10% each. Since then, since the 12th of September, they're up. Nine percent for Enphase, and SolarEdge is up about 17%. So I don't think the market's buying what Citron was saying. I think part of that is because the nature of these so-called reports that Citron releases; they're really heavy imagery. In my opinion, I think it really focuses on trying to elicit an emotional reaction, and scare longs into selling a stock, not so much to pitch a short thesis. I think approach is not working so well this time around. 

With that said, there's some validity to some of the things that Citron highlighted. As we just said, the U.S. has largely become a duopoly for these two companies for inverters. They control almost 90% of the U.S. market. A big part of that, though, is that they have really strong dealer relationships. Enphase also has some really strong relationships with some of the panel makers that are putting their micro-inverters -- they're coming out of the factory with these micro-inverters on them. It's not like somebody else is going to knock that off at the dealer level, the installer level. So it's more than just the changing of the regulations that's given them an advantage.

With that said, this is too big of a market. There's too much opportunity for profit. There's too much opportunity for growth for these two to remain so dominant in the U.S. I think the company that Citron highlighted was called Generac. If you're not familiar with them, they're big in the generators business, home generators, industrial-sized generators for hospitals and that kind of thing.

The interesting thing about it is, Citron highlighted Generac as a potential disruptor for Enphase and SolarEdge, but also, they would be disrupting other companies like Tesla with their batteries, some of the other companies that are doing energy storage. The reality is, Generac is in a reactionary mode right now because it is being disrupted by energy storage. The reality is that energy storage costs are coming down so much that you can pair solar with energy storage, and especially in a residential environment, you don't need a Generac generator.

Generac has to go after this market because they're going to be losing a lot of market share to renewables and energy storage, just because people are going to be using it for their energy needs anyway. They don't have any choice but to go after it.

I think there's a good chance they're going to be successful. But I don't think it's necessarily going to take an $84-per-share Enphase and make it a $7-per-share company, or cut $52 SolarEdge in half to a $24 stock. Especially when you consider that, if you look at the market itself, even if SolarEdge and Enphase do start ceding some market share in the U.S. -- which I think they will; it's reasonable to expect they will -- that doesn't mean they're not going to continue growing. The market is going to continue to get bigger. Then you look around the world at the market opportunity, where these modular level power electronics are just starting to get traction -- the market opportunity is absolutely enormous.

Sciple: OK, Jason, now I want to talk a little bit about each of these companies individually and what sets them apart. The first one I want to talk about is SolarEdge, ticker SEDG. It's got a market cap of about $4.1 billion. It's the market leader in power inverters in the U.S., with about a 60% market share. When you look at SolarEdge's technology, how is it differentiated from maybe what Enphase or other competitors are doing?

Hall: As the initiative for the module level power electronics started to get going, SolarEdge saw an opportunity to do something that was a lot more cost effective than doing the micro-inverters, but also a way to generate more efficient power from each panel from the system. What they do is they lead with power optimizers, which are installed at the panel level. That's the module level part of the deal.

These power optimizers do that. They balance the current that comes from each panel, helping maximize the efficiency of the output, and then provide that level of safety of being able to cut off the current at the panel if there is a need to do that. But then they still use a string inverter where you're connecting to a single inverter for a number of panels. If it's a residential installation, you're going to have a single inverter connected to all of your panels. If it's a larger commercial install, and you have a ton of panels, you're still going to have multiples, but it's not going to be a one-to-one ratio. So it's the balance of maximizing the output of the install and accomplishing a lower cost profile vs. doing the micro inverters.

Sciple: Right. Versus Enphase's micro-inverter, you might not be quite as efficient, but your cost is going to come down relative to those, and you get benefits relative to the basic string inverter. Obviously, there's a lot of room for SolarEdge to continue growing. I said they had a 60% market share in the U.S. However, globally, they only have a 40% global market share. There's still a lot of room to grow for their main central technology. However, the company through acquisition has been trying to diversify into other areas in the solar value chain that are adjacent to the industries that it's in. Can you talk a little bit about that and what the company's strategy is there?

Hall: Yeah. The other thing is, within the inverter business and power optimizer business, you have to remember, at this point, they're still a distributed solar, focusing heavily on residential. They haven't even tapped utility scale solar, which they're going to be moving into in the next couple of years.

But in terms of diversifying into other areas that are related, in 2018, and then again early 2019, they made three key acquisitions. They purchased Gamatronic, which is a company that focuses on uninterrupted power supply. You think about a data center that needs a large battery backup. That kind of thing is what Gamatronic's business is. They acquired that in 2018. In late 2018, they purchased Kokam. It's a tier-one lithium battery maker based in [South] Korea in the same area that there's a lot of other tier-one battery makers.

There's tons of applications for that when you're talking about renewables and solar. You think about the energy storage system for residential that might go in a garage, utility scale energy storage, where you can start using batteries to start replacing peaker natural gas plants, and even some baseload applications. At the utility scale, electric vehicles. There's a tie-in with the batteries for the Gamatronic business that it bought. Aerospace applications; marine applications. You're starting to see hybrid marine vehicles like tugboats and that sort of thing. There's this wide variety of overlap for the Kokam business it's acquired.

It also ties into SMRE, which is a business it bought at the beginning of the year which makes integrated power train and electronic components for electric vehicles. You're talking about a hypergrowth industry. The global electric vehicle market is growing very quickly. Being a key supplier there is a great place for the company to be. Again, tying it back into residential and commercial solar, you start thinking about EV charging, this is a company that's really good at managing power coming out of solar. So,it falls right into its core competencies, and there's tons of overlap in all of these businesses. Even if on the surface, it might seem like it doesn't fit, there really is a lot of overlap.

Sciple: When you think about charging an electric vehicle, the same concept applies as with solar. You have alternating current coming from the grid; you want to switch that to direct current going into your battery. The same concept applies, the same basic technology applies.

Hall: Yep, absolutely. Again, it's not even just the technology; it's the distribution and relationships that it will be able to leverage. SolarEdge is very well connected as a distributor in the solar industry. That opens doors for its ability to be able to sell energy storage systems with its solar installer partners, and its other distributor partners. It can leverage Kokam immediately. Then you think about SMRE, the EV power train and electronics company it bought; again, it can leverage those relationships to make the most out of Kokam. There's all this really good overlap. It's going to take several years to play out. There's no getting around it. Inverters and power optimizers are going to drive the lion's share of its results for three or four years, at least. But these are hypergrowth businesses. I think there's a great opportunity to take advantage of what it's good at across all these things and continue to grow.

Sciple: You're seeing that in their numbers. Their most recent quarter, revenue was up almost 20% quarter over quarter, over 40% year over year. Record revenue from solar products. Record operating income. Their capacity is up 25%. Really firing on all cylinders. When you look at their recent earnings report, anything that stands out to you or that investors should be paying attention to from their financials?

Hall: This is one of the things that I really like about this business. It's just not a high-growth business; this is also a business that generates strong cash flows, and it has a great balance sheet. It's not that the company has gone out and over-leveraged itself to make these acquisitions or to try to get ahead of the competition. It's a very well-run business. They invest a lot of money in research and development. Gross margins have been pretty strong. Those can go up and down over time. But the thing that I really like about the core business now is, they just brought a lot of capacity online. I think they've added, like, 25% to their manufacturing capacity. And they still have huge backlog. That to me says that we should continue to see that really strong operating income continues, even if we do start to see competition ramp up over the next year or two.

Sciple: Last thing we'll talk about with the company is, they tragically lost their founder and longtime CEO, Guy Sella, back in August. He was replaced as CEO just a few days before his passing. Obviously, when you lose a co-founder and someone who had led the company over a long period of time, that is going to cause some turbulence at the business. How has the company been able to manage that? What's management look like going forward?

Hall: First, it's horrible. It's terribly sad. The guy was like 55 years old. I turn 43 in December, and 55 feels a lot closer to me now than it ever has. So that's the first thing. That's tough. A lot of the people in the company, especially in management, have been there since the beginning, or very close to it. So a lot of people at the company have known this man for a decade and a half. 

With that said, I think it's too early to say how it's going to affect the company. He wasn't the only founder. There are four other co-founders that are still serving in executive roles, and some pretty important roles. The head of R&D, chief software architect, chief information officer are all co-founders of the company that have been here since it was founded in 2006. But if you look beyond and start looking at their CEO that was just brought in, he's been there since 2008, so it's not like he's brand new to the company. So I think from a corporate culture perspective, there's a lot of things that look good. From an innovative perspective, there's still a lot of key people that are still involved. When you look at the board of directors, you see a lot of the same thing -- board members that have been there for a decade or more. So I think the company's culture is going to remain strong. But you never know what's going to happen with a company that loses somebody that was so identified with that particular company.

Sciple: Sure. Yeah, hopefully the culture is strong. Again, as we've mentioned, there are significant opportunities for this business going forward as they move into -- obviously, their core business is experiencing significant growth, as well as these adjacent industries. 

Moving on to Enphase, ticker ENPH. A little bit smaller than SolarEdge; $2.9 billion market cap. We talked a little bit about their micro-inverters. They pioneered the use of that technology. Any more details that are important to know about Enphase's micro-inverter technology?

Hall: It's a different technology; it's a different approach. It does generate more energy per installation, per panel. But it's more expensive. I think there's places for both. One of the things I like a lot about Enphase is that it has some pretty strong OEM partnerships. SunPower, I think Panasonic, there's one or maybe two others that it has long-term contracts to supply micro-inverters that are installed at the panel. When it goes to a solar installer, that's what they're using. There's no option to go to a Generac or a SolarEdge or another third-party inverter because it's already included. That's a strong competitive advantage. It also should help drive growth as companies like SunPower leverage some of their new manufacturing capacity and start bringing some of their new products online that are going to be in really high demand. 

Again, I'm optimistic that I think its business should continue to grow, and hopefully it'll start moving closer and closer to profitability. It's close, but it's not quite profitable. It's also kind of like SolarEdge, it's moving to expand beyond just the solar power electronics business. It's launching later this year, they're calling it Ensemble, some energy storage products that are part of that.

This is one that hits home for me -- I think a lot of people don't realize, just because you have solar panels, it doesn't make you immune from grid power outages. These systems are designed so that if there's no power coming from the grid, the inverter turns off. The power comes from the panels to protect the grid workers. The grid goes down; your solar panels aren't sending power to your house.

But one of the things with the Ensemble system is, it's looking to change that so you'd have the ability to, if it loses connectivity to the grid, the micro-inverters can still power your home, which is nice. And then you take it to the next step, and you combine it with energy storage, and you could be grid connected but still be able to be completely grid remote, even when the sun's not shining.

I think it's a really smart move, again, because it allows them to leverage their existing distribution partnerships, the relationships that they have, to step into energy storage, which in residential could grow even faster than residential panel sales because you've got a decade of solar systems out there that people are going to start thinking about adding solar to existing solar installations.

Sciple: Along those lines, you talked about earlier the threat of some of this technology to backup generators. If my solar panels can produce energy for me, or if I can rely on my battery storage, it reduces the demand for those sorts of products. 

Moving onto the financial performance. You mentioned they're not profitable. However, they did meet this year their 30-20-10 financial goal that they've been working toward over time -- 30% gross margin, 20% operating expenses relative to revenue, 10% operating margin. When you look at their financial results so far this year, what stands out to you? What should investors be paying attention to?

Hall: I think it's a nice incremental move forward. If you go back a couple of years ago, just about the entire company's C-suite changed. A lot of times, that's a yellow flag, if not a red flag, with a business, when you see that kind of executive change. But one of the things that's really interesting with Enphase is, even though they've had a lot of change in top leadership, the two co-founders are still there. They're still executives, and they're really focused on product development; they're focused on R&D. They've moved into having really good business operators that are running the show. These two really innovative guys are able to focus on developing innovative products that are going to help them remain a leader in the markets that they're going after. It's great incremental improvement.

I think that's one of the reasons the stock has gone up so much this year. Investors are rewarding what they're seeing as moving toward cash flow positive and positive operating income. They're getting rewarded for that; they definitely are. You have to remember that as much as the stock has gone up, this is still a company that, on a market cap basis, is smaller than SolarEdge, and on a revenues basis is much, much smaller still. There's still tremendous room to continue to grow the business.

Sciple: Sure, yeah. Comparing these two against each other, bringing things full circle, when you look at these two companies, their respective advantages, their respective valuations, those sorts of things, as you sit here today, which one are you most excited about buying? I think you own both of them, right?

Hall: Oh, yeah, I do. It's funny. I mention Tyler Crowe pretty regularly whenever I come on here. Tyler and I are colleagues and friends, and we talk about investing a lot. Going back maybe a year, a year and a half or ago, we were talking about these two companies. He really encouraged me to buy SolarEdge for a lot of reasons. One of them was the strength of the balance sheet, the better cash flows, that sort of thing. And I said, "I'm just going to buy both. I like them both. I agree with what you're saying, but I like Enphase's prospects too." So I just took the amount of money I was going to invest and split it down the middle and bought both. And since then, Enphase has absolutely crushed it. So I rubbed that in to Tyler, reminding him that if I'd have taken his advice, I'd have a lot less money today, [laughs] every opportunity I get.

But to be serious, a lot of those gains for Enphase are multiple increases. I think it trades for almost 7 times sales. SolarEdge trades for like 3.8 times sales. So it's a significantly more premium price to pay for the company right now. You could almost say you're paying for perfection. And I think it's fair to say the stock's probably gotten ahead of itself. I'm not selling. I want to be clear about that. I think even if somebody bought Enphase at today's price, if you fast-forward a decade, you're probably going to make money and you're probably going to have a good shot at outperforming the market, just because of the raw opportunity for the sector.

But if I'm spending money today, SolarEdge hands down is the one that I would buy. Not only is it a little bit cheaper, but you also protect the downside more because its balance sheet is cleaner. It took on a little bit of debt when it made one of the acquisitions, like $22 million of debt that came from that acquisition. It had zero debt before then, and it's going to pay this debt off. Again, its management is littered with co-founders of the company and people that are veterans that have been there for a long time. I also think it has more optionality than Enphase because of the acquisitions that expand beyond just the energy storage. It touches on multiple potential growth industries that I think put it in a better position to use that balance sheet strength to put its capital toward where the best growth is going to be. So again, SolarEdge with a bullet.

Sciple: Totally agree, Jason. As we discussed earlier, this industry has many opportunities for growth. Lots of ways to win. But you look at the valuation, and also, from a market share point of view, SolarEdge is a little bit more entrenched there.

Any last thoughts before we go away?

Hall: Wish me luck on buying my house. Let's just do that. Actually, guess what my new house has included with the purchase?

Sciple: Oh, do you get solar with the new house?

Hall: Solar panels. And they're owned. I'm pretty excited about that. Maybe about a year from now, we can do a show on which energy storage system Jason Hall decided to purchase for his new house. Write it down, folks. Tweet at us if you want us to do that. 

Sciple: Folks, if you want to listen to the end, we'll do a little chit-chat about college football. I'll give Jason a hard time about how Georgia performed last Saturday. 

Hall: Oh, boy!

Sciple: [laughs] But as always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For Jason Hall, I'm Nick Sciple. Thanks for listening and Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.