Enphase Energy (ENPH 3.80%) is the second-worst-performing stock in the S&P 500 this year, outperforming only its largest competitor, SolarEdge Technologies (SEDG 2.81%). Over the previous three years, Enphase was up more than 900%, driven by a booming solar industry and a scorching hot growth rate. But even as the stock has cooled off, the company is still putting up good results while retaining a high gross margin.
Let's take a look at why the solar stock is down roughly 70% this year even though Enphase itself is still a great company.
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The pros and cons of cyclical growth stocks
If there's one particularly high-risk, high-reward combination in the stock market, it's a cyclical growth stock.
A cyclical company's results tend to ebb and flow based on the market cycle. Some well-known examples include package delivery stocks like United Parcel Service and FedEx, oil and gas companies, construction companies like Caterpillar, banks, automakers, and restaurants. Even Apple is cyclical, because it depends on a healthy consumer and high discretionary spending. Companies like UPS and Caterpillar are consistently profitable, they're valued based on their earnings, and they pay growing dividends. Dividends add an incentive to hold a stock through periods of volatility.
Enphase Energy is different. As a top player in a hot industry -- its microinverters are a key solar panel component -- Enphase's red-hot run over the past few years was due to its breakneck revenue growth rate and total addressable market, not its earnings. Although it's been consistently profitable, it doesn't pay a dividend. And the $110 million it spent on buybacks in the third quarter was partially offset by $43.8 million in stock-based compensation.
When everything is going right, a cyclical growth stock can be a market darling. When everything starts taking a turn for the worse, the stock can quickly look overpriced. And impatient investors who got into a stock solely to ride the wave and not for the long-term investment thesis may quickly sell the stock for other opportunities. In other words, there was a lot of "hot money" in Enphase. We saw a similar dynamic play out in meme stocks and growth stocks during the 2020 run-up. Since then, there has been a major correction in many of those names.
In sum, the price of a cyclical growth stock is oftentimes detached from reality, both to the upside and the downside. We saw it with Enphase's massive run-up, which was, in hindsight, too far too fast. This isn't to say that Enphase can't make new all-time highs in the future. But for future growth in the stock price to be sustainable, the company needs time to mature so that its results can support a higher valuation.
Short-term pain for potential long-term gain
Earlier this year, Enphase thought it could return to growth by the end of 2023. Instead, the downturn has only gotten worse, with Q4 2023 revenue expected to come in at $300 million to $350 million. For context, Q4 2022 revenue was $724.7 million.
A 50% or so drop in revenue in a single year for a stock that is valued based on its sales growth is a death sentence. On the Q3 earnings call, Enphase even said that the whole first half of 2024 could be tough as well, but it is hopeful things could turn around in the second half.
Enphase is saying that the downturn is lasting longer than expected, mainly due to higher interest rates in the U.S. and deteriorating macroeconomic conditions in Europe. High interest rates make it more expensive to finance a project, which is a problem for solar since it is competing with existing and established energy solutions. Switching to solar is less attractive when interest rates are high or the economy isn't doing well. But when interest rates are low, the proposition becomes a lot more attractive.
Despite the near-term challenges, Enphase is incredibly bullish on its business long-term. It's making some significant cost cuts, including a 12% reduction in non-GAAP operating expenses in Q4 compared to Q3. And it admits there are more cost cuts to be made.
It still has an incredible balance sheet with more cash than debt. As mentioned, Enphase bought back just $110 million of its stock in Q3. It has authorization to buy back up to $1 billion worth of shares. That is good, because Enphase can make the majority of its buybacks at a much lower price.
How to approach Enphase right now
Enphase stock's brutal decline is an excellent lesson on the dangers of investing in cyclical growth stocks during an industry-wide boom, and how quickly results can take a turn for the worse.
For long-term investors, nothing has changed about Enphase. It's still an ultra-high-margin business that continues to develop compelling technology and vertically integrate its business across the solar system.
Enphase isn't the kind of stock you want to aggressively buy the dip on or chase as it runs higher. Rather, it's better to build a position you're comfortable with by dollar-cost averaging over time. This strategy can help you avoid getting caught up in the hypervolatility of the stock's price action.
Enphase stock may continue to go in and out of favor on Wall Street for a while. And for that reason, it wouldn't be surprising if Enphase stock remains below $100 a share until a turnaround looks more likely. However, management is navigating challenges well and doing an excellent job of investing in sustainable growth in the business. For that reason, Enphase remains a great company that is worth investing in even if the stock looks like a wreck right now.
