2 Red Flags and 3 Green Flags for Enphase Energy After Its Post-Earnings Sell-Off

Enphase Energy (ENPH 3.80%) has been making headlines for all the wrong reasons. The microinverter maker's third-quarter 2023 revenue guidance suggests negative revenue growth, a far cry from Enphase's scorching-hot growth rate over the last few years.

Let's put the company's negatives and positives out in the open to determine whether Enphase is a good buy now.

Image source: Getty Images.

The rapid rise of Enphase Energy

In the four-year period from 2019 to the end of 2022, Enphase Energy stock produced a staggering 5,500% return, making it one of the greatest growth stories on Wall Street. The outperformance was due to a familiar recipe we've seen in past booms -- investor optimism, a healthy amount of speculation, and the secret ingredient: strong fundamentals. The company's growth was nothing short of phenomenal.

To make the comparison easier, let's look at Enphase's trailing-12-month (TTM) performance over the last five years:

Data sources: Enphase Energy, YCharts.

The company's TTM net income is higher today than its TTM revenue was five years ago. The gross margin has only gotten better. And the company has gone from barely profitable to extremely profitable.

Slowing revenue growth and falling margins

If Enphase were maintaining this growth rate, then by all means, the stock's sell-off would be unjustified. But the reality is business is slowing, and management doesn't see an end in sight, at least in the short term.

As mentioned, the company is guiding for lower revenue in Q3 2023 than it earned in Q3 2022. If its guidance is correct, it would mark the first quarter of year-over-year revenue decline since a brief pandemic-induced slowdown in Q2 2020. The difference is Q2 2020 was followed by red-hot growth, whereas now, there doesn't seem to be a coiled spring that could pole-vault Enphase back to its old growth rate anytime soon.

A key part of Enphase's growth story has been rising gross margins. At first glance, lower margin guidance in the coming quarters is a red flag because it could indicate the company is struggling to offset costs or retain pricing power. While this is true to an extent, there were some encouraging comments from the Q2 earnings call worth paying attention to.

As Enphase rolls out more IQ8 microinverter solutions for different applications, it expects the technology to help boost its gross margin. Enphase has also been rapidly expanding into Europe. In the pursuit of gaining market share, it may be willing to give up a few percentage points of gross margin, which could impact profitability in the short term but be a net positive for the company longer term.

Enphase's CEO Badri Kothandaraman said Enphase is well-known for its service capabilities and quality in Europe, which helps justify charging a premium price for its products.

Enphase's earnings growth is going somewhat unnoticed

Enphase has long been valued based on its future growth and price-to-sales (P/S) ratio. But the company is quite a bit different today from even a few years ago. The story is no longer just sales growth but rather the company's earnings growth, which, when paired with the stock's decline, presents an opportunity investors haven't seen from Enphase stock in quite some time -- the stock is actually not expensive.

ENPH data by YCharts. EPS = earnings per share. PE Ratio = price-to-earnings ratio. PS Ratio = price-to-sales ratio. TTM = trailing 12 months.

There's a lot to unpack in the chart above. But what we can see in the last two years is that Enphase stock has gotten crushed, but its diluted earnings per share is up a staggering 245%, and its revenue is up over 126% -- which has knocked its P/S ratio down to around 7 and its price-to-earnings (P/E) ratio to just 34.1. If you prefer price-to-earnings before interest, taxes, depreciation, and amortization (EBITDA) instead, that ratio is now just 26.7.

If you were to tell investors a year or two ago that they could get Enphase stock for this low of a valuation, they probably wouldn't have believed you. After all, this stock had a P/E ratio over 100 and a P/S ratio over 20 not long ago.

Enphase's present-day valuation tells us Wall Street is doubting its ability to return to growth. Anything can happen in the short term. It's anyone's guess how low Enphase's P/E ratio and stock price could go. But where it stands today is great news for long-term investors because it leaves a lot of room for valuation expansion if Enphase can meaningfully grow its earnings over the next three to five years.

For example, let's say Enphase can double its net income over the next five years. To keep the same P/E ratio, the stock would have to double as well. And a lower P/E ratio would be hard to justify if the industry as a whole enters a new growth cycle, which could lead Enphase's stock price to grow at a faster rate than its earnings. This is a scenario called multiple expansion, and it occurs when investors are excited about a stock's potential and are willing to pay a higher price relative to its earnings.

The brightest green flag of all

If Enphase can remain an industry-leading microinverter and solar system provider, it should be an excellent investment for years or even decades to come. The solar industry is going through a tough time right now as the ripple effects have spread across technology companies, operators, utilities, investment companies, and suppliers. But zoom out, and the future is incredibly optimistic.

The international energy agency (IEA) predicts that global cumulative solar PV capacity will surpass natural gas in 2026 and coal by 2027. In 2027, the IEA forecasts solar will reach a 22.2% share of power capacity, which, when paired with declining capacities of natural gas and coal, makes solar the largest power capacity technology in the world.

Even if this forecast doesn't come true, the trend of growing renewable power generation paired with declining fossil fuel power generation looks likely, giving Enphase a much-needed bright green flag.

Add it all up, and Enphase stock could fall more from here. But the investment thesis makes a lot more sense now that the valuation has come down, and the fundamentals are still excellent despite some slowing growth.