SolarEdge Technologies Inc. (NASDAQ:SEDG) has been one of the few residential solar companies to weather the storm of the past year unscathed. It's outperformed its main customers, SolarCity (NASDAQ:SCTY.DL) and Vivint Solar (NYSE:VSLR), and has continued to grow revenue and profits. Now that it's providing a key component to residential solar systems, is there anything that can upset the company's upward trajectory?

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What SolarEdge Technologies does
SolarEdge's main products are power optimizers, which are attached to each solar panel on a roof to maximize the electrical output of the entire system. These optimizers still require a large string inverter, which turns DC power from a solar panel into AC power that can be used by the grid. Essentially, they're an add-on part.

An array of solar panels with the sun setting behind them

Image source: Getty Images.

The company has expanded into other products, like monitoring and inverters, but its business is rooted in those optimizers. Each time a new system installer like SolarCity or Vivint Solar decides to go with SolarEdge's product, it can result in massive amounts of growth for the company. The industry has moved toward power optimizers as a solution to its need to regulate solar production at the panel level, and the company has ridden this wave of growth to become the business we know today.

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SolarEdge doesn't control the end customer
The biggest challenge SolarEdge faces in growing its business and expanding its profits is that it's a small supplier to consumer-facing players in the solar market. It doesn't make solar panels, and it doesn't develop the solar customer base. It's reliant on others designing its product into their systems, and given the fickleness of that clientele, that's proven to be an erratic business model for many companies.

We've seen companies like Power One and Enphase Energy come and go as popular suppliers in the solar industry, and that's just in the neighboring inverter market. Panel manufacturers from Q Cells to Suntech Power have also gone bankrupt trying to sell into the competitive solar market. Solar is a tough business, and now we're seeing pressure from both sides of SolarEdge's business. 

The coming threats
As residential solar companies try to cut costs, they're moving as much work as possible from the roof to the manufacturing floor. Companies like SunPower are building microinverters right into solar panels, making them plug-and-play for installers. Trina Solar is even building Tigo Energy power optimizers into its Trinasmart modules. SolarCity is also building its own solar panel manufacturing plant, and spending more on R&D. Could it develop its own power optimizer or microinverter to install on these panels in the factory, like SunPower?

Since the solar panel is the most important single component of a solar power system, panel manufacturers have choices about what components to include, making for a competitive market.

I've talked about the threats from upstream competition in the solar components market, but pressure from downstream is equally important. If SolarCity or Vivint Solar decides to move to microinverters or to another power optimizer supplier, it could sink SolarEdge's business very quickly.

The biggest risk for SolarEdge is that it doesn't control more than a small chunk of the solar value chain. It's trying to expand the capabilities it has into inverters and monitoring, but no component company has been very successful doing that. A more powerful position is owning the customer (SolarCity and Vivint) or the panel manufacturing (SunPower and Trina Solar). That's where I would focus my investment dollars, rather than in the component market, where you're going to be squeezed from all sides.