When analyzing the solar industry, one of the biggest questions I ponder is: What does the future of the residential solar market look like? Thus far, SolarCity (NASDAQ:SCTY.DL) has been far and away the most successful company, building a footprint that spans 15 states with more added regularly and the company plans to install as much as 1 gigawatt of solar next year.
Behind SolarCity are a number of large and small companies taking a variety of different strategies. SunPower (NASDAQ:SPWR) uses an independent dealer network to install its panels, providing leasing and loan financing. Sunrun and Clean Power Finance provide financial leases but until recently stayed out of the installation game. NRG Energy (NYSE:NRG) is building a strategy that could show how utilities can get into residential solar. And that's just scratching the surface of the companies and strategies taking shape in residential solar.
It's far too early to say that one company or strategy has won, but understanding the landscape and where companies fit in is important for investors. From there, we can look at trends and see where likely winners are. So, let's look at what these companies are doing and what the industry might look like in the future.
What is residential solar?
When going and get a quote for a residential solar-power system from a company like SolarCity, or an independent installer, there are many components to deal with, including solar panels, racking, inverters, installation labor, and financing.
Explained below is how these pieces interact, and at the end of this article we'll be able to piece together some sort of picture of how the solar industry works and how it might unfold in the future.
All residential solar projects incorporate essentially the same equipment. There are the solar panels, racking to attach them to the roof, wiring, an inverter/meter to turn DC current into AC current, and usually a monitoring platform.
The first and most important component is the solar panel, which actually turns the sun's energy into electrical energy. Generally speaking, there are three groups of panels available to homeowners. There are multi-crystalline panels that are the least expensive and generally around 15% efficient at converting sunlight into electricity. These include Trina Solar, Yingli Green Energy panels, and Kyocera as well as others outside of China.
Monocrystalline panels are slightly more efficient and are also made by Yingli as well as JA Solar and many others. These panels are typically 15% to 17% efficient and can be higher for some manufacturers.
The next level is a back contact monocrystalline panel, which is what SunPower makes. The company's current X-Series product is 21.5% efficient and 23% panels will be made when its new manufacturing facility opens next year. SunPower's panels are typically more expensive on a per watt basis than the companies mentioned above, but that doesn't mean each kW-hr of electricity costs more. Click here to see an article which lays out how SunPower can generate electricity at a lower cost than competitors, even with a more expensive panel.
Inverters turn the DC current from a solar panel into AC current that the grid runs on and is typically a separate component, although some modules now come with a micro inverter already installed. Enphase (NASDAQ:ENPH) is a big name in this market along with Power-One, which was acquired by ABB last year. The challenge is that differentiation is very difficult in the inverter market, which increases price competition and has kept Enphase, in particular, from reporting a profit.
Items like monitoring, racking, and wiring may differ slightly based on the company and will primarily change or be standardized to lower installation costs. When it comes to equipment, the panel is key and for many companies, and that's the first choice consumers are going to make.
When SolarCity or another dealer give a solar quote, they're more than likely working for an installer, which is where a majority of the cost that goes into building a residential solar-power system. These are the people who come to your house and put up the panels, connect them to the grid, and perform maintenance over the term of a lease.
Performing installation efficiently is also where the best companies are lowering costs. SolarCity would like to get to the point where every crew is installing two systems per day, one in the morning and one in the afternoon. Some of the equipment, like racking, from Zep Solar, an acquisition last year, create efficiencies in that process.
What differentiates installers is the quality of the system they build and the quality of customer service in the sales process and beyond. SolarCity is building a national network and standardizes some of this process while smaller independent dealers will work with a variety of partners to build and finance a system. It's these financing offers that really differentiate dealers and installers.
One of the biggest differentiators over the last three years in residential solar is financing. SolarCity didn't invent the solar lease, but it brought it to the masses and hopes to have 1 million solar leases in place by 2018.
What drove the success of the solar lease was the relatively high cost of residential solar-power systems and the complexity of taking advantage of tax credits. If you think about a 5 kilowatt solar system that costs $25,000, it's a big bite for a homeowner to write that large of a check or take that kind of loan. But SolarCity, Sunrun, CleanPower Finance, and SunPower are just a few companies who now offer solar in bite size pieces in the form of a lease that comes with a lower monthly cost per kW-hr than electricity from the grid in many locations.
The lease company then takes care of the tax credits by selling them to equity investors, performs maintenance, and makes a tidy margin in the process. SolarCity estimates that its systems installed in the first quarter will generate $1.83 per watt in retained value, or the present value of all future cash flows. Considering the fact that installation costs are now likely below $3 per watt (versus the $5 example I used previously), that's an incredibly high margin and is why SolarCity has the valuation it does.
If there's one constant about solar, it's that nothing stays the same for long and that will likely go for leases as well. What could challenge the lease long-term is growth in solar loans. These are personal loans to build solar projects and are still in the development phase.
There are two reasons loans may grow as a percentage of solar-power systems in the future. First, the investment tax credit will go from 30% to 10% in 2017 -- unless it's extended -- and it will be easier for homeowners to use the credit themselves.
The second factor is that system costs are falling rapidly. If the $25,000 system referenced previously costs $10,000 in five years -- or the same $2.00 per watt that utility scale systems are built for today -- it'll give homeowners more incentive to get a loan or pay cash.
On Monday, SunPower announced a $200 million loan partnership with Admirals bank to expand its loan offerings. Loans are growing, it's just a question of what percentage of the residential solar market they'll have in the future.
The solar market may not be dominated by loans or cash sales in the future, but it'll likely be a larger piece of the pie. To give some reference, leases are about 20% of the auto market and I wouldn't be shocked to see the industry trend in that direction long-term.
How it all fits together
So, how should you be investing in residential solar?
The market is growing rapidly, up 38% in Q1 to 232 megawatts nationally. Companies with exposure to the market like SolarCity, who installed 67 megawatts of residential solar, and SunPower, who installed 35 megawatts of U.S. residential solar are two to watch.
What's key to understand right now is how companies are differentiating themselves.
SolarCity is growing through scale, lowering costs by standardizing installations, and efficiently accessing capital markets to finance its leases. Keep in mind that SolarCity's management has explicitly stated that it wants to own projects, meaning lease is its future. SolarCity ran a 5% gross margin on systems it sold last quarter, so leases are where it adds value to shareholders.
NRG Energy is growing in the residential market, recently acquiring Roof Diagnostics Solar, who was the fifth largest installer in the country. Look for NRG to leverage its large balance sheet to provide low costs and use established relationships with customers to sell solar. If a big company is going to take a significant share of residential solar my money would be on NRG Energy.
SunPower is the only solar panel maker in this group, but it makes the most efficient panels in the industry at 21.5% and rising. That means consumers can pack more power generation on a single rooftop, lowering balance of system costs per watt. Unlike SolarCity, SunPower doesn't favor lease, offering loans and cash sales. Last quarter, it sold 24 of 35 megawatts for cash. It's expanding in leases but look for it to be more balanced, for better or worse. SunPower is also the only international player in this group, installing 108 megawatts of international residential solar last quarter. Keep in mind too that, unlike SolarCity, SunPower doesn't "own the trucks," instead working primarily with independent dealers.
RGS Energy is an independent installer that has traditionally worked with Sunrun and Clean Power Finance for leasing financing. It is moving into financing its own projects now and will sell leases, loans, or cash projects to customers. This is the smallest installer but has high potential to go along with high risk given the large competitors getting into this space.
Foolish bottom line
Who wins in the residential solar market depends on how the market plays out. If leases are the dominant sales method then SolarCity is the clear leader and has the scale to hit its 1 million customer target by 2018.
If loans and cash become a bigger part of the market then I see RGS Energy and SunPower stealing share because of their flexible model. NRG Energy is a wildcard that isn't yet established enough to know how they'll fit in the market but I'd also expect them to be a big player.
RGS Energy gets the benefit of being financing agnostic while also not being tied to a technology, like SunPower is. That's why this is an intriguing company, despite the risk of being small in size.
Don't underestimate how technology fits into residential solar as well. SunPower's panels generate about 50% more power than a typical SolarCity installation, which uses Trina Solar, REC Solar, or another standard panel. As costs come down, efficiency will become more important.
The advantage for SolarCity, NRG Energy, RGS Energy, and others is that they can buy whatever panels are most economical. That gives flexibility to adapt as new technology comes out.
There are a lot of moving parts in residential solar and it'll take years to figure out who the biggest winners are. I'm betting on companies with superior technology and flexibility in financing, because I don't think leases will be a majority of the market in five years. So, SunPower is my bet and RGS Energy is my dark horse.
Remember, you should take in as much information as possible to develop your own opinion. Stay tuned to see how the industry plays out because the only thing we know for sure is that the solar industry of tomorrow will look very different from the one we see today.