According to the U.S. Department of Energy, by 2050, Earth's population will increase to 9.4 billion, per capita GDP will double, and global energy demand will double.
The International Energy Agency (IEA) projects that by 2035, $48 trillion will need to be spent on global energy infrastructure ($2 trillion/year). In addition, $550 billion a year will be needed to improve energy efficiency.
With mounting global concerns about CO2 emissions and climate change, interest in (and spending on) solar power is growing -- and for good reason. The energy contained in sunlight hitting the earth for one hour could power the earth for a year, and only 1% of U.S. power comes from solar, meaning a long and immense growth runway for potential long-term investors.
However, the solar industry is a battlefield littered with the corpses of dead companies and broken dreams. This article will explain what the challenges are for the solar industry and why long-term investors looking to cash in on the promise of a future solar bonanza should stick to the best-in-breed operators such as SunPower (NASDAQ:SPWR) and, at least for the time being, avoid SolarCity (NASDAQ:SCTY.DL).
Distributed Solar: a tough industry but immense potential
According to analysts at Citigroup, today it costs $2.4/watt to install a solar system. The U.S. Department of Energy estimates this cost will decline to $1/watt by 2020, cheaper than gas or coal power, and Citigroup believes it may decline to $0.65/watt.
This commoditization of the solar industry is bad news for solar panel makers, but wonderful news for the distributed solar industry. In 2013, 12% of all new U.S. energy capacity was distributed solar power, and SolarCity has big plans to become the leader in this fast-growing industry, with a potential market size of $63 billion.
SolarCity's business model is to pay to have solar systems installed on homes and businesses. The owners sign a long-term (20-year) contract that guarantees cheaper electricity for them and ensures stable cash flows for SolarCity.
The company is targeting 1 million customers by mid 2018, representing 70% CAGR customer growth from 2013, and 6 GW of capacity.
In its latest quarterly report, SolarCity reported 100,609 customers, 649 MW of total capacity, and $2.5 billion in contracts signed.
With management guiding for new installations of 500-550 MW in 2014 and 900-1,000 MW in 2015 and SolarCity ahead of schedule on its cost reduction plan, why would I argue against investing in the stock at this time? Simple: Though though I think SolarCity is a great company, at current valuations, I believe it represents a bad investment for several key reasons.
|Year||Solar City Losses (actual or predicted)|
As seen in the above graph and table, SolarCity is not only growing its installed base and contract backlog, but also its share count and its losses. With $520 million in cash and -$785 million in levered cash flow, the company will need to continue to issue shares to raise money to stay afloat. This will make eventual profitability and EPS growth more difficult because of large shareholder dilution.
Add in the fact that revenues at SolarCity are growing slower than expenses (and that a 30% solar tax credit is expiring at the end of 2016), and SolarCity shareholders may find themselves owning continually diluted shares of a fast-growing but ever less profitable company for years on end -- S&P Capital IQ analysts are predicting -24% CAGR EPS growth for the next decade. For all of this risk, investors are being asked to pay 23.2 times sales compared to SunPower's 1.7 times sales, while SunPower is profitable and cash flow positive.
SunPower: best of breed technology and profitable to boot
Investors should consider SunPower over SolarCity for three key reasons: valuation, profitability, and industry-leading technology.
SunPower is trading at 20 times forward earnings (S&P Capital IQ analysts predict 18.9% CAGR EPS growth over the next decade), and with net margins of 8.4% and levered free cash flow of $218 million/year, the company doesn't have to worry about funding its operations through debt or equity issuances.
In addition, SunPower is a technological leader in the field, with its latest Maxeon Panel delivering industry-leading efficiency (23%) and reliability (0.25% annual power degradation vs 1.3% for competitors).
In fact, in the last three years, SunPower's panels have increased efficiency by 10% while cutting cost/watt by 35% -- very important trends in an age of solar commoditization. The result of this reliability and efficiency is that over a 25-year period, SunPower's panels will deliver 75% more power than competitors' panels.
Foolish bottom line
SolarCity represents a good company but not necessarily investment -- especially at its current sky-high valuations. Unless management can bring costs under control and successfully execute on its ambitious growth plans, shareholders are likely to be continually diluted and earn sub-par returns, if not lose money outright.
SunPower, on the other hand, represents a best-of-breed industry leader that is already highly profitable and has the technological edge to differentiate itself from its competition, thus maintaining and even growing its margins.