The solar power industry has gone through a major strategic shift over the last five years. Previously, the leading companies were aiming for vertical integration across everything from solar panels and inverters to racking and finance, now the more common approach is for each business to focus on one thing that it can do particularly well. As a result, strength in the industry has aligned around a number of specialists up and down the supply chain.
One company that was ahead of the curve on this trend was SolarEdge Technologies (SEDG -0.86%), the power optimizer and inverter manufacturer. And its growth prospects make it a much better buy than solar energy stock First Solar (FSLR 0.41%), which is one of the industry's longtime leaders.
How SolarEdge outperformed the market
SolarEdge started out as a producer of power optimizers for the residential solar market. Those products served a key need because module-level power electronics (power optimizers or microinverters) started to be required by regulators, and SolarEdge's devices could slightly improve solar-panel performance.
From optimizers, the company moved into inverters, a sister product that sits downstream from the electricity flow from the panel. With these two products, SolarEdge was firmly in control of the "brains" of solar installations.
The beauty of this model was that SolarEdge tech could work with any solar panel and could be used by any installer. Because it wasn't locked into any one product line or market, the company's growth had fewer limits.
SolarEdge also outsources most of its manufacturing, which reduces limits to growth by putting the burden of adding capacity on suppliers. Compare this to First Solar, which can really only grow as big as its solar manufacturing capacity will allow (unless it spends a lot to expand capacity) and is limited to the utility-scale market where its products are primarily sold.
New growth opportunities emerge in residential and commercial solar
What has driven excitement about SolarEdge recently is the size of its potential opportunity in the energy storage segment -- a nascent but exciting market. When installing a solar power system, it makes sense to either put the battery next to the inverter or to embed the inverter into the energy storage system, which makes SolarEdge a natural producer of such products.
The storage business is young, especially in the residential and light commercial markets where SolarEdge has its strongest foothold, but it's a massive potential market in the long term. Electricity storage systems could be sold as add-ons to solar systems, or they could be sold as a service to homeowners, generating value from services sold to the grid in what are known as virtual power plants. Whatever the business model is, SolarEdge is built to provide the products and services needed to grow the market.
Again, if we compare this to First Solar's business the opportunity in energy storage are smaller. Storage is being purchased by utilities and added to utility-scale solar developments, but First Solar is reducing its exposure to the development business and therefore has little upside in energy storage. SolarEdge simply has more growth opportunities than First Solar today.
Where SolarEdge could trip up
The one thing I worry about with SolarEdge is that investors may have gotten ahead of themselves on pricing the company's potential into the stock. Shares currently trade at a whopping eight times sales and nearly 70 times earnings. Are such high multiples warranted?
SEDG PS Ratio data by YCharts
SolarEdge does have great growth prospects, but it faces a lot of competition as well. Microinverters are taking market share from power optimizers, and with Sunrun and Vivint Solar's recent merger, the installer market has consolidated. That could put volume and pricing pressure on SolarEdge as installers try to use their size and clout to get better deals from suppliers.
Competition from Chinese manufacturers has long been a threat as well. There's nothing stopping low-cost producers from taking market share in these products, just as they did with solar panels more than a decade ago. The same factors limiting First Solar's growth and margins could plague SolarEdge as well.
While it's important for investors to understand the risks, SolarEdge Technologies is still a top solar stock, and I would recommend it over First Solar. If it can successfully execute an energy storage strategy, this company could keep growing for another decade or more.