Allied Market Research projects the global solar market will grow more than 20% annually through 2026. But that promise has not been reflected in most solar stocks, many of which are down even on a 10-year basis. Competition and commodification have crimped margins and profits for many panel producers despite a growing market. Two rare, outperforming solar stocks bucking this trend are SolarEdge (NASDAQ:SEDG) and Enphase Energy (NASDAQ:ENPH), whose stories shed light on their success and forecast a brighter future. 

Energy, regardless of its source, is a commodity. Enduring businesses go beyond supplying commodities; they solve problems. And both Enphase and SolarEdge have their roots in solving problems for the solar industry. 

One major friction point in a solar energy setup is solving for the AC/DC issue. Solar panels only put out DC electrical current, but most modern homes, appliances, and the grid itself operate on AC current. In 2000, Sandia Laboratories invented solar inverters to solve this problem, but created a new one in the process: Efficiency. The inverters, connected to many panels, were only as efficient as the slowest panel in the chain.

Inverters attached to the back of solar panels.

Image source: Getty Images.

The SolarEdge solution

SolarEdge solved this through power optimizers, devices attached to each solar panel that maximize efficiency and eliminate the lowest-common-denominator effect. Its success with optimizers and inverters allows it to continue to innovate around the entire installation. 

SolarEdge recently introduced EnergyHub, a do-it-all inverter that can redirect excess DC current into a battery for use later. It can charge your car or your generator, and you can attach as many batteries as your home may require -- and control everything via a mobile app. Even before EnergyHub hit the market, the company's existing line of products drove record sales and revenue in the first quarter of 2020. Adding EnergyHub could mean even faster growth. 

According to a Wood Mackenzie report from the end of 2019, SolarEdge commanded 60% of the U.S. residential inverter market. Solar installations are sticky business: Parts need replacing and systems need servicing. When homeowners or businesses look to expand capacity or upgrade to newer products such as SmartHub, they are likely to do so with their existing brand. SolarEdge's lead in market share gives it a tremendous opportunity to offer more services and products to its existing customers.

The Enphase answer 

Enphase has a similar story. Also founded in 2006, it solved the AC/DC issue with microinverters, which convert the DC current at the source of each individual solar panel. Like SolarEdge's optimizers, this helps a system get the most production from each panel. Other benefits to this solution include the ability to monitor panel performance, also something SolarEdge's products offer. 

Enphase offers its customers an ecosystem of storage solutions. Its Ensemble product has scalable storage and elegant design, and touts its ability to operate even during blackouts, something still atypical of most setups. In first-quarter 2020, Enphase saw year-over-year revenue growth of 105%. Enphase now controls about 20% of the U.S. residential inverter market. 

The company's "Enphase Upgrade" program intends to keep and grow relationships with its current customers. A year and a half in, 8,300 customers have registered for the program, which offers various, relatively inexpensive ways to easily upgrade an existing solar setup to newer technology. 

Greenbacks from green energy

SolarEdge and Enphase have a track record of finding efficiencies in solar technology for their customers. How efficient are their businesses for their shareholders?

Enphase and SolarEdge sport some of the highest gross margins among publicly traded solar stocks. Combined, they represent 80% of the domestic solar inverter market, and they do not compete solely on price. The vast majority of U.S. solar installs will choose one system or the other, which funnels to one brand or the other at the inverter. 

For the last 12 months, Enphase and SolarEdge had gross margins of 36.8% and 33.6%. Compare that to their not-yet-profitable competitor, Sunpower (NASDAQ:SPWR), which places much greater emphasis on selling panels -- and posts a much smaller gross margin of 14%. 

With higher margins, Enphase and SolarEdge are able to turn more of their revenue into free cash flow and profit. Free cash flow in particular gives companies the freedom and the options to return money to shareholders, pay down debt, or reinvest in the business. For the last quarter, SolarEdge generated $80 million in free cash flow, while Enphase turned in $35 million. In the same quarter, Sunpower burned $185 million in free cash.  

Playing from behind is costly. Sunpower boasted that it gained 10,000 customers in its most recent quarter. Remember that Enphase has almost that many enrolled in its premium warranty program. Sunpower is pouring its resources into growing its market share. 50% of new homes equipped with solar are using Sunpower. This trend is more of a threat to SolarEdge than it is to Enphase, which has a contract to supply Sunpower with inverters at least through 2023. 

For now, it's clear that the industry pie is getting larger, and all three companies can expect to grow for years to come. But Enphase and SolarEdge appear to have the power to ride the growth wave more profitably than others in the industry. 

Why not both?

The solar industry could see some headwinds. Congress may not renew tax credits in 2021. Trade uncertainties threaten supply chain stability. None of those headwinds are new. Both SolarEdge and Enphase have seen their strongest growth amid the China tariff disputes and have shown supply chain resiliency through the COVID-19 crisis. 

And while federal tax incentives may expire, both companies could enjoy other legislative tailwinds. A new California law that took effect this year requires new homes to install solar systems, a catalyst that might help Sunpower most. For long-term investors looking to start a basket of solar stocks, Enphase and SolarEdge could be well worth the look.

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.