By AustinWeston Asset Management LLC
One Powered Business
Over the past month, the solar sector has been pummeled by a trifecta of adverse events. The month of September kicked off with the controversial and headline-riddled bankruptcy of Solyndra, as the macroeconomic storm continued to barrage European markets (the world’s largest solar market) with a spate of pain and uncertainty, and several Chinese players suffered from questions of fraud and/or pollution coupled with a government funded oversupply of solar panels. Now, at month end, this triumvirate continues to hinder the sector, as none of these negative catalysts have subsided from the public’s concern.
Consequently, any player with exposure to the solar sector, whether large or small, at risk or sustainable, has been thrown out the proverbial door by investors. In such a situation, especially amidst volatile, downward moving markets, investors quickly sell first and think later. They do this without dissociating the good from the bad. In light of this, the prudent investor can distill the relevant information in order to identify companies with an ample margin of safety to not only survive, but also to thrive.
Last year at this time, pontificators wondered whether solar panels would ever reach grid-parity with carbon-based energy and whether that very fact would ultimately lead to the demise of solar as an energy alternative. Fast-forward to this year, and those very same pontificators question whether the sharp drop in system pricing ultimately will destroy the industry. As is often the case, the truth lies somewhere in the middle. The rapid drop in pricing will certainly kill some industry players (and has already), while setting the stage for others to prosper longer-term. Inevitably there will be winners in this industry, but for now we are simply in the “shakeout” phase.
We believe one such company that will be a winner is Power-One, Inc (PWER). PWER designs and manufactures power conversion and power management solutions for the renewable energy industry as well as for data centers (servers, networks, storage, etc…). The company builds and sells power inverters that convert DC power to AC power for solar panels and wind turbines, and AC to DC or DC to DC for data center demands. These devices are required in the vast majority of renewable energy generation projects and in data center/industrial projects where superior computing performance and power efficiency is desired by the system architects.
Power-One’s History
PWER entered the renewable energy space in 2006. In 2008 they restructured their management team and in 2009 their capital structure, in order to harness their technological advantages, protect current value, and scale into a market orders of magnitude larger than when they first entered, and which grows every year. Competition in this industry is high, given the applications and technologies have been around for decades now. Competitors include multinational engineering firms, electrical supply conglomerates, and other smaller niche manufacturers. However, PWER owns the best technology in the industry – its converters are more efficient (meaning less energy is lost in the conversion process), and they operate at this high efficiency over larger power generation ranges than any of their competitors.
It’s not difficult to find reviews of the company’s products by searching the web, and on PWER’s investor relations page (in a few presentations), they identify “blue chip” customers in their portfolio including: Wirsol, Suntech Power, Donauer Solar Systems, SunEdison, BP Solar, Google, Facebook, Cisco, IBM, Siemens, Lockheed Martin, Electrolux, Motorola, Ericsson, and many others. In the renewable energy space in particular, PWER has transitioned from a new entrant to a dominant player. They’ve become second in market share in a matter of a few years, and this share should continue to improve as explained below.
One might question how a company of this limited size controls such technological might, but the real question is why haven’t the bigger electrical/power supply companies been able to engineer a decent competitor to go after the $20 billion+ markets (and growing) in which PWER competes? That’s a valid question, but the answer merely reaffirms the company’s dominant position. With PWER’s power conversion efficiencies in excess of 98% in its larger scale applications, they have achieved 4% greater efficiencies than their closest competitor. When talking about renewable energy, it’s particularly important to note that these high-level efficiencies are further improving the cost efficacy of the technology. For a larger competitor, it would cost too much money to develop a technology that can compete or beat PWER’s on this front.
A better question would be: why hasn’t a large electrical or power supply company bought this business, harnessing its technology, market share, and recently scaled footprint? A large business with the distribution channels and relationships could stand to gain market share even quicker than their current pace. Further, with the former founder of SunPower Corporation now a member of PWER’s board, alongside a couple Silver Lake Managing Directors, PWER has certainly grabbed the interests of a few discerning technologists and successful investors able to appreciate the dominant product and opportunity this company possesses.
Sizing up the Valuation
Next, on the topic of valuation, what has drawn us to this investment most is you don’t need much to go right for your investment to earn substantial upside. First, at a price below $5 per share right now, the market cap of this business is below $550 million. With 2011 earnings expected in excess of $115 million, the business is currently priced at less than 5x forward earnings, and a mere 1.59x EBITDA. Considering the business is active in two markets that benefit from secular tailwinds and is expected to grow world-wide at a 20%+ CAGR for the next five years or more, this multiple seems a bit low. While we don’t need the growth to justify our valuation interest, it certainly doesn’t dampen our enthusiasm for the business.
The renewables business represents approximately 94% of PWER’s current operating earnings (though the mix has evolved over the last year to be less dependent on renewable), and as of 2Q 2011, 82% of that segment comes from Europe. Italy makes up the bulk, or about 47% of PWER’s total current operating earnings, and the rest of Europe represents approximately 38% of PWER’s operating earnings. In all, Europe accounts for about 84% of PWER’s current operating income. That said, we have already seen a massive decline in European solar demand – on the order of 40% in total GWs installed in Italy, 50% in Germany, and 20% in the rest of Europe – and according to the company’s most recent earnings transcripts, they expect to see a second half improvement in the Euro area relative to the first half. Even through this significant market contraction, PWER’s top and bottom lines have stayed generally intact. Seasonality also has a role in the first half sluggishness, but most of the last two quarters’ relative decline in top and bottom line has certainly come from the weakness in Europe. Despite these challenges, over that time period, PWER’s global market share has risen from 13% to 15% (or a 15% increase) of the global inverter market. Perhaps more importantly US/Canada/Asia have grown significantly – growing from approximately 4% of PWER’s renewables revenues to 18%, and earning 17% of PWER’s operating income. Similarly, the company’s data center/industrial segment, representing 30% of the top-line and 6% in bottom-line, has grown by approximately 50% over the last year (this time last year it wasn’t yet operating earnings positive).
The main takeaway here is as follows: even though PWER expects improvement into the second-half of the year, Europe has given this business a black eye. So, let’s think about a few scenarios: if earnings deteriorate by another 30% from current company expectations for full year 2011, meaning we see Europe hit by another 50% decline in gross demand, PWER’s net income should register somewhere around $90 million for FY 2011. This assumes NO growth in the US/Canada/Asia renewables markets, and no growth in the data center business. If we take that as trough net income, and run this business out for four years from today with the $90m figure, add in net-debt, add the impact of the company’s deferred tax assets on net-income over that period, and use a 15% WACC, we’re looking at today’s stock price. What this means is quite simple: you can own PWER today at a valuation that assumes the business is DEAD in four years (liquidated at its net-debt value) and discounted using a very conservative cost of capital in present value terms, leaving a 15% IRR.
It’s tough for us to think a business with the technological advantage of PWER, involved in business areas that are about to, or have reached, substantial efficiencies in pricing relative to other electricity sources, and which has just begun scaling into markets such as the US and Asia (markets expected to grow at substantial rates over the next decade) to be priced at a valuation comparable to a dying run-off with nothing more than its net current asset value realizable at the end of its life.
Conversely, if we assume a trough net-income figure around the $90 million value mentioned above (again being pretty conservative), and using a 12x multiple, you can easily come up with a $1 billion business. There are about 36 million shares that will dilute the current shareholders (now at 104 million shares outstanding), but these are through convertible debt and preferred offerings with in-the-money exercise prices in the $11+ range. Therefore, at these prices, we’ll have to at least double before being concerned with dilution pressures. If the business is valued just a bit more rationally, using a $120m forward net income value at a 12x multiple, PWER should be worth at least $10.50 per share (assuming full dilution from the 36 million shares above), or a 100% upside investment. Finally, if we factor in a bit of growth into this business by assuming a 4% growth rate in the bottom line over the next 10 years, with fully diluted shares outstanding of 140.3 million, the DCF value yields a pretty attractive 25% IRR at today’s prices over that 10 year horizon.
PWER’s Place in The Solar Landscape
There are obviously a few headlines impacting this business’ valuation, most of which are temporary issues or viewed irrationally by sellers. Given that PWER’s business is heavily reliant on the solar industry currently, it is being treated as a solar business. However, PWER doesn’t have to deal with the same fundamental issues facing a panel manufacturer. Solar panel prices continue to suffer given the oversupply out of China and due to older technologies being eclipsed by higher efficiency, longer-term options. PWER’s product is a component in a solar project and is separate from the cost of panels. In current solar panel systems, power inverters typically represent around 10% of the total system’s cost – while the major cost (around 60% of the total system) is driven by the panel prices. PWER’s pricing should not be affected materially by the decline in unit costs of panels, as their product isn’t hindered by oversupply and is a separate technology from the panels themselves.
Most importantly, PWER benefits from a superior technology from that of its competitors, lending it pricing power if need be. This is clearly evident by the fact that as PWER has emerged as a dominant player in the renewable power inverter industry, SMA Solar (the number one by market share) has seen its gross margins contract by over 9%, and watched its market-share deteriorate as PWER grabbed 15% of the global inverter market by the end of 2Q 2011. This chart of shipments and ASPs is demonstrative of PWER’s superiority: (https://www.valuewalk.com/wp-content/uploads/2019/11/default-image.png). One can see how PWER’s rise in shipments has come along with a significant deterioration in pricing for SMA Solar, while PWER’s own pricing has remained relatively stable. Most importantly, SMA Solar has ASPs approximately 20% higher than those of PWER’s while their efficiencies are far less. Quite simply, PWER has a better technology at a much cheaper price, and their pricing power will only get better as they bring more capacity online – this started just last quarter. If SMA Solar is going to compete outside of Germany, it will have to at least match PWER on pricing; the problem is: if SMA Solar prices their ASPs at PWER’s current levels, they’ll be net income NEGATIVE on those units. The fact is, SMA Solar, in its current form, can’t compete with PWER. Thus, PWER has another upside catalyst: tremendous market-share grab potential from the largest player in the space; PWER’s pitch: better pricing, better technology, and localized customer service.
Further, PWER benefits from the fact less power loss means greater revenues for the generation projects (utility scale, or in areas with feed-in-tariffs), so their efficiency dominance results in a faster IRR on a total project level than any other competitor. This can’t be priced away by competition because any one-time price differential isn’t worth the loss in efficiency over the life of a panel installation. Collectively, the margin advantage and industry-leading efficiency should help PWER continue to increase its market at the expense of SMA Solar and provide further upside to earnings over time.
It is well known and firmly established that the solar industry in Europe will contract this year, and as discussed above, PWER derives a significant portion of its revenues from the European Zone. What is less well known is PWER’s management has been ahead of the curve in anticipating the changing dynamics of the solar industry. In the first quarter of 2011, the company completed construction and commenced shipments from its Arizona and China-based manufacturing facilities. The timing could not have been more appropriate, as it coincided with the initial decline in European orders and a substantial increase in North American and Asian based orders—the fastest growing solar regions. PWER’s new manufacturing zones, coupled with the surge in demand helped push non-Eurozone revenues from 4% of PWER’s earnings to 18%. Look for this trend to continue over the coming quarters.
In Sum:
On the surface, the rapid drop in system pricing sounds like a major negative for any solar player; however, we view this as an extreme positive for PWER. While total system install prices are being driven down, power efficiencies are being driven higher (with more efficient panels), solar has already achieved grid parity with carbon energy in certain parts of the world. As a result, lower pricing should actually boost unit sales. This will merely increase the demand for PWER’s inverter units as more systems are built. Secondarily, many competitors in the inverter space rely on a few key customers for their business – PWER’s top 10 customers represent less than 25% of their business. And more favorably, the bulk of PWER’s primary customers are not solar panel manufacturers, but distributors and power generation customers directly. Thus, PWER has a grip on the area of the market that will benefit the most from consolidation in the industry as many panel manufactures go out of business.
On the topic of bankruptcies, it is clear the Solyndra bankruptcy has brought a cloud over the entire solar space. Unfortunately, Solyndra is perhaps indicative of the pain panel manufacturers may have to endure over the near term. Thus, while solar manufacturers are sold heavily, PWER is also indiscriminately swept up in the selling; all the while their business possesses the competitive advantages that are unaffected by the panel manufacturers’ problems. This is another example where the market has thrown out a gem due to a clear lack of understanding of the business’ fundamentals, and thus tacks on to it the outrageous valuation discount even if in a tough cycle. It’s to the point where these prices just don’t make any sense.
The unfortunate fact of PWER being so steeply discounted is that it’s quickly becoming a very attractive acquisition target. Everyone from solar manufacturers looking to stabilize their businesses with PWER’s consistent cash flow potential as well as the obvious synergies of offering the inverters alongside the panels in vertically integrated system offerings, to large electrical services and engineering conglomerates who could purchase a cheap, but dominant player in a high growth space, could be looking at PWER as a target. To us, this would be an unfortunate, albeit profitable outcome, as the future growth would fall into the hands of the purchaser. While such a result may reward the investor in the short term, this business has the upside potential to make it a very lucrative investment over many years to come.
Risks:
The primary risks to our thesis on Power-One are the continued decline in European orders, improved technology from large conglomerates that can more readily withstand losses to establish an industry entry-point, and a further deterioration in pricing and margins.
Disclosure: We are long shares of PWER.
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