Image source: SunEdison.
On the surface, you wouldn't think a financial swap that reduces both long- and short-term debt would be a bad thing for a highly indebted company. But for SunEdison Inc (SUNE +0.00%), the announcement that it was swapping debt for equity and a reduced amount of debt was met with scorn on Wall Street. On Thursday, shares dropped 39%, and all of the hopeful signs from the last month seemed to be undone in a moment.
The problem for SunEdison is that it got so indebted that creditors started demanding higher and higher interest rates. At the same time, the company was forced to pivot strategies to selling projects to third parties, which is lower margin than holding them on the balance sheet. The combination of higher borrowing costs and lower margins may be too much for SunEdison to overcome.
The thing with debt...
For renewable energy companies, debt can be a valuable tool for boosting returns. Debt can help fund projects that are in construction and then sold to third parties or used as a part of financing projects long term.
The problems with debt start to show if returns don't exceed the cost of debt. And with $11.7 billion in debt, $7.9 billion of which is at the parent company, the cost of debt is high for SunEdison.
Image source: SunEdison.
Let's work backward from what we know about SunEdison's debt situation. At the end of the third quarter, the company had $7.88 billion in debt on the balance sheet at the corporate level (this doesn't include yieldco debt that's currently consolidated on the balance sheet). This debt had a weighted average annual interest rate of 4.13%, meaning annual interest cost would be $236 million. This debt profile will change with exchanges made in the last three months, but it gives us a start as to how to look at the company.
According to analyst Sven Eenmaa at Stifel Financial Corp., the exchange offer made on Thursday will actually increase interest expense annually by about $40 million because it exchanged low interest rate convertible debt for higher interest rate term debt. With this included, SunEdison's interest costs are about $276 million per year.
On top of that interest payment, SunEdison plans to spend $600 million annually on operating expenses. That's down significantly from 2015, but let's give the company the benefit of the doubt. Ballpark, SunEdison has to generate $876 million in gross profit annually just to break even.
To get an idea of what it would take to generate that much money, I've built a simple model below. I've included three margin profiles, starting with a low margin of 9% on third-party sales up to 17%, which is what SunEdison projects as its own margin on projects. I've assumed that renewable energy projects can be sold for about $2 per watt, right around what SunEdison generated from sales in the third quarter.
|
Low Margin |
Medium Margin |
High Margin | |
|---|---|---|---|
|
Gross Margin |
9% |
13% |
17% |
|
Necessary Sales |
$9.73 billion |
$6.74 billion |
$5.15 billion |
|
GW Sold Annually |
4.9 GW |
3.4 GW |
2.6 GW |
Calculations by author.
As you can see, SunEdison has to grow from the midpoint of its 2015 guidance of 2.2 GW installed just to break even. And from there, it would have to generate higher margins than it has in the past. And that's not accounting for paying down debt, that's just maintaining debt levels.
Just breaking even will be a challenge based on the numbers above, but it's possible with an expected 3.5 GW installed in 2016. The real problems start to emerge when you start looking at its future cost of debt.
LIBOR plus what???
The interest costs I calculated above were based on third-quarter interest rates, which combined to be a rate of 4.13%. But the $725 million term loans announced yesterday came with interest rates of LIBOR + 10%, or about 10.85% as of today at 6-month LIBOR rates.
That's an insanely high interest rate compared to competitors like First Solar and SunPower, who are paying LIBOR plus 3.5% or less on short-term debt. Not only does that mean interest costs may be increasing further in the future, it make it harder for SunEdison to build projects with competitive financing structures versus competitors.
If interest rates trend higher, as the most recent offering shows, the numbers I outlined above aren't anywhere close to what they might need to be for long-term profitability. To paint the picture, consider this: A 10% interest rate on $7.9 billion in debt is $790 million, and when added to the $600 million in operating costs, there's a possibility the company would need to generate $1.39 billion in gross margin annually just to break even. Of course, by then, SunEdison would have refinanced its business, because an interest rate that high is simply unsustainable.
SunEdison faces an uphill battle
The general theme here is that SunEdison's business is moving toward the lower-margin business of selling projects to third parties at the same time its borrowing costs are trending higher. That's a slippery slope for any business, and it doesn't bode well for SunEdison, especially when it's competing against companies with much lower cost structures.
As an investor, I'm staying far away from a high-risk company like SunEdison. It's possible the company survives all of these challenges, but the path it's currently on is unsustainable, and I think there's a lot more dilution and/or restructuring to be done before it gets out from under its messy financial situation.
The history of highly indebted companies in renewable energy isn't good, and the path forward for SunEdison doesn't look like a profitable one for investors.
