After coming down from pandemic-driven hype, solar energy stocks seem to be settling into more of a normal cycle. Shares have moved higher over the past week on strong earnings and the potential for more climate change-related incentives in the U.S.
Is this a sustainable move higher, or is the industry still too risky to buy? I think the answer is starting to become clear.
Image source: Getty Images.
This time really is different
The biggest change in solar over the past decade is the shift in business models. Companies like First Solar (FSLR -1.39%) and SunPower (SPWR -3.09%) once tried to do everything from solar panel manufacturing to installing large solar farms.
But that business model brought risk from interest rates and local politics, which isn't what these companies did well. Turns out that focusing on doing one thing well is a better move. This is known as modularization, as opposed to vertical integration.
We now have companies focusing on manufacturing panels, led by First Solar and Canadian Solar (CSIQ -3.08%), which are benefiting from greater scale and improving efficiency.
FSLR Net Income (TTM) data by YCharts
The first to understand modularization was really SolarEdge (SEDG -2.16%), followed by Enphase Energy (ENPH 0.62%), which provides inverters and power optimizers and has become the industry standard. You can see in the chart that they've been extremely profitable as a result.
SEDG Net Income (TTM) data by YCharts
Even Sunrun (RUN -3.09%) and SunPower (SPWR -3.09%) have done well in focusing on residential solar deployments.
RUN Gross Profit Margin (Quarterly) data by YCharts
Modularization gives solar companies focus, which has allowed most companies to improve margins and build more sustainable businesses long term.
Where should investors buy today?
As much as I like the improving business model in solar, not all stocks are great buys. I think the top manufacturer is First Solar, which has proven the ability to make money through multiple cycles and is now doubling its capacity in the U.S. and around the world just as Congress looks to provide subsidies for building manufacturing plants and installing solar panels.
SunPower has been a terrible performer for years but has really turned a corner recently. Second-quarter 2022 adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) of $15.2 million at a time of rising labor costs and high commodity prices was encouraging. That company also sells most of its solar installations with loans, not leases like Sunrun. This puts interest rate risk on banks or buyers, not Sunrun.
Finally, a basket of Enphase and SolarEdge is a great buy because they hold a valuable position but will likely trade off market share as market trends change. But they're both well positioned to grow as solar is adopted worldwide.
Now is a great time to buy solar energy stocks, but I would buy leaders and stay diversified because we never know what segment of the market is going to create the most value long term.
