In mid-September, Citron Research, a leading short-selling firm led by Andrew Left, released a report predicting that SolarEdge Technologies (SEDG -1.25%) and Enphase Energy (ENPH 0.21%) were about to get disrupted, and that their share prices would fall to $52 and $7, respectively. To reach those levels, SolarEdge stock would have to fall 45%, and Enphase stock would lose 81% of its value.
Unlikely, right? Not so fast. These have been two of the best-performing renewable energy stocks this year. SolarEdge shares are up 166% since the beginning of the year, while Enphase stock has surged an incredible 444% -- seriously big gains in a very short period of time, largely the result of changes to U.S. electrical code that has left the two companies with almost 90% market share of inverters for U.S. residential solar systems. In other words, investors are betting big on future profits, not recent results. That makes both companies ripe for a sell-off if things don't go swimmingly.
But are these two leaders really set to be crushed by Generac (GNRC 1.07%)? Best known for its home and industrial power generators, this is the company Citron Research called out as the next big disrupter set to swoop in, take big chunks of market share, and drive prices -- and profits -- down sharply. Let's take a closer look at what investors should expect going forward.
Ripe for competition
If there's one thing that investors shouldn't disregard about the Citron report, it's how SolarEdge and Enphase's market share in the U.S. has happened in a way that opens both up to competition. Without getting too deep into the weeds, changes to U.S. electrical code implemented new rules that, at the start of 2019, required new rooftop solar panel installations to include power electronics on the panel that could shut off power directly at the solar panel.
This rule change, combined with Chinese electronics giant Huawei essentially being forced out of the U.S. market, created a supply vacuum, leaving SolarEdge and Enphase as the only two major inverter suppliers that meet U.S. code. As a result, the two are on track to own almost 90% of residential rooftop solar inverter sales in the U.S. in 2019, and it's unlikely they will see that dominance challenged in the next year. It will take time for any competitor to bring a product to market, develop distribution channels, and move into the market.
But looking out a year or more, it seems like a certainty that other companies will seize the opportunity to jump into the U.S. residential inverter market. Generac very well could be one of those new competitive entrants.
The disrupter or the disrupted?
But I think it's a stretch to call Generac a disrupter for SolarEdge and Enphase. Generac's recent acquisitions of Neurio Technology and Pika Energy got it into the solar power electronics space, but they aren't really differentiators. They don't bring anything novel or create any unique competitive advantages that will allow Generac to disrupt the two market leaders. Moreover, Generac is starting from ground zero; it doesn't have supply relationships with solar manufacturers, distributors, or installers at this point, and it also lacks a track record. This means installers will be risking their reputations on an unproven product. SolarEdge and Enphase are already well-known, trusted suppliers with long-standing and deep relationships.
That's not to say Generac won't be successful; I expect that over time, it probably will be. But it's a mistake to call Generac's move to compete in the solar power component segment a disruption of the space. It isn't.
To the contrary, Generac is playing defense, because it is about to be disrupted by the industry it's entering. The advent of cheap solar panels and energy storage is probably already starting to disrupt Generac. Think about it this way: Why spend thousands of dollars on a generator when solar panels and a battery storage system that will pay for itself in reduced utility expense can also provide power if and when the grid goes down? That's the future Generac will be competing against.
Generac isn't moving into solar inverters and battery storage because it sees a market opportunity. It's doing it because a significant portion of its business is at risk of being rendered irrelevant as a side effect of distributed solar and cheap batteries.
What should investors expect?
Don't draw the conclusion that SolarEdge and Enphase stock prices aren't going to fall simply because Generac may not be the disrupter it is being purported to be. To the contrary, SolarEdge and Enphase trade at premium valuations that could set them up for big sell-offs if either fails to meet expectations.
Their valuations, both price to sales and price to cash flows, have climbed sharply along with their stock prices since the beginning of the year. Investors have pushed up both companies' stock prices largely based on expectations for continued growth, not the results they have delivered this year.
And if either suffers a hiccup, of if there's even a sniff of bad news for residential solar, a lot of the gains investors have enjoyed over the past nine months could get erased in a quick and sudden sell-off. And if I'm being completely honest with myself, I wouldn't be surprised to see one -- probably Enphase, which trades for a spicy seven times sales -- or both fall by 30% or more at some point in the next year or two.
I just don't buy into the thesis that Generac is going to be the catalyst. Moreover, I'm of the opinion that a major sell-off for either company would likely create an opportunity to buy more. They're fantastic companies with excellent products, deep ties across the solar industry, and expanding market opportunities as energy storage becomes more relevant and mainstream.
But with that said, I've also added Generac to my watch list. This isn't some zero-sum game; the residential and commercial solar market has plenty of room for another great power electronics maker, and Generac needs to reinvent itself or risk being rendered irrelevant.