First Solar Cimarron Project Image

Inverters can be seen dotting the background of this solar installation. Image source: First Solar.

By the end of 2015, there will be a million rooftops in the U.S. with solar panels, and companies like SolarCity (NASDAQ:SCTY) have become household names in the process. But you may not be familiar with a few companies who make components key to turning the energy coming from solar panels into energy that's usable in your outlets at home. The key component I'm talking about is the inverter, which turns DC current from a solar panel into AC current. 

Inverters are components that are getting a lot of attention from solar investors, because they are part of a growth market and they're one of the few profitable parts of the solar industry. But solar inverter manufacturers, like solar panel manufacturers, have long been poor performers as public companies. Knowing why could save you from a disastrous investment in the future.

What's an inverter anyway?
The problem with solar panels is that they produce direct current (DC) electricity, sometimes at varying rates. That needs to be changed to alternating current (AC), which is what the power in your home is. At its core, an inverter simply turns the DC current coming from a solar panel into usable AC current. Over the years, inverter companies like Power-One (acquired by ABB), Enphase Energy (NASDAQ:ENPH), and now SolarEdge (NASDAQ:SEDG) have been market favorites because they've taken a large share of the hot residential solar market.

Power-One rose quickly as the solar industry grew in the late 2000s and early 2010s, powered by string inverters for residential solar systems. Then Enphase Energy became popular because it supplied microinverters, which Vivint Solar (NYSE:VSLR) and others began using to make installations faster.  

SolarEdge is the latest hot inverter stock, although it gets lumped into the inverter market despite really specializing in module-level DC power optimizers, which optimize DC output from different panels before it goes to the inverter. The company has been helped by a new supply agreement with Vivint Solar as well as by SolarCity's growing power optimizer business. Having those two customers essentially made SolarEdge's business, with SolarCity accounting for 24.6% of revenue in fiscal 2015. 

But before calling SolarEdge the next great solar stock, it's important to understand why previous leading inverter manufacturers have failed to gain traction in the market.

What differentiates solar inverters and power optimizers?
At the end of the day, there's really not a lot that differentiates one solar inverter from another. One company may squeeze a little bit more power out of the conversion from DC to AC, but that's all. The real challenge is building products that take advantage of market turns, and then getting electrical approvals to sell those products in booming markets.

SolarEdge has won some of its business in part because it bet on power optimizers, which maximize the DC power coming from each solar module, instead of betting the farm on microinverters. One reason is the cost advantage, and last quarter it averaged $0.35 per watt sold compared to $0.52 at Enphase Energy for microinverters. SolarEdge can have this price advantage in part because it spends about half as much as Enphase Energy on operating expenses, including R&D. Cost may be a winning formula today, but it's not typically the big winning strategy long term.  

To win long term, inverters and/or power optimizers are going to need to become more integral parts of solar systems. Either product as we know it today might vanish, replaced by something more deeply integrated into the solar system.

The big question for today's inverter companies
Whether they're making microinverters, string inverters, or power optimizers, what SolarEdge, Enphase Energy, and others are trying to do is add capabilities to their inverter systems. Simply making power electronics is essentially a commodity business in solar, and as we've seen in the past, a winning formula can be replaced by the next hot solar product. So these companies are trying to add energy management, energy storage, and monitoring solutions.

There's no doubt that this is the right strategy, but the fact still remains that inverter manufacturers are middlemen in the solar industry. They supply a solution that solar module manufacturers and installers need, but as companies like SolarCity and Vivint Solar vertically integrate, why wouldn't they bring inverters, power optimizers, energy monitoring, energy management, and other functions in-house? And if they don't and these businesses become a much larger market, why wouldn't SMA, ABB, GE, Siemens, or another large supplier simply put the resources necessary into building a product that could dominate the market?

SunPower has shown that it's integrating module-level inverters with the acquisition of SolarBridge, formerly a leading microinverter manufacturer on its own. When combined with its energy management system, it is looking to bring as much of the value chain in-house.

SolarCity is doing the same with Silevo and has alluded to the fact that it would like to integrate electronics in a more seamless manner in the future. Why wouldn't all of the major installers simply build this capability in-house, eventually leaving Enphase Energy and SolarEdge out in the cold or, at best, as an acquisition target like Power-One became?   

SolarEdge's future depends on technology
If history is any lesson, the inverter and power optimizer industry will change, and today's industry leaders will either be acquired or beaten out by another company that makes the right bet on the right technology. When you're a middleman in the market, it's tough to control your own destiny, and companies rarely make the right technology bet over and over.

SolarEdge is trying to buck that trend with new HD-Wave technology, which it says can lower costs and improve efficiency of solar systems. We'll see if SolarEdge's bet on this inverter technology becomes the right bet on the future or if this technology is rejected by the market.  

So, while SolarEdge's 121% growth last quarter to $98.4 million and net income of $9.3 million is certainly impressive, it doesn't mean the company will be in the same impressive position five years from now. The solar industry changes quickly, and SolarEdge is at the mercy of the whims of a small number of customers, whom I think will be moving toward bringing power electronics in-house. That trend could hurt this supplier more than today's market observers realize.

There's a reason inverter manufacturers haven't been winning stocks for investors in the past. Advantages are fleeting, and the hot stock today may be a dud in the future. Investors, beware.

Travis Hoium owns shares of SunPower. The Motley Fool owns and recommends SolarCity. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.