Description

The current valuation of Enphase Energy (ENPH) presents a compelling opportunity to invest in a highly profitable company within the renewable energy sector.  In contrast to the solar panel industry, which often resembles a commoditized market, Enphase operates in the inverter segment, characterized by high barriers to entry.  Enphase and SolarEdge together have 90% market share with Enphase holding 48%, which continues to expand annually.  It has built a strong reputation for delivering reliable, efficient, and customer-centric product and service that translated into impressive financial performance, including 65% annual revenue growth, 45% gross margin, and 30% operating margin. 

Despite these achievements and strong fundamentals, ENPH’s share price has experienced a 60% decline year-over-year, primarily due to external factors like high-interest rate and the introduction of California’s NEM 3.0 regulation.  These factors have dramatically affected demand in recent months, but I anticipate a resurgence as homeowners face increasing utility bills and moderation in interest rate.  Moreover, if the stock does not see a significant upward revaluation, ENPH can leverage its strong free cash flow generation to repurchase shares at favorable prices.

Change in California incentive program

On April 15, 2023, California introduced a major change to how homeowners are compensated for excess solar energy generation.  Under the prior policy, NEM 2.0, surplus energy generated during the day was sold to utility companies at the same rate homeowners would normally pay for electricity.  This incentivized customers to maximize their solar generation and export any excess for compensation, resulting in a 4-5 year payback period—the time it takes for solar owners to recover their investment—for solar systems. 

However, the new policy NEM 3.0, which came into effect on April 15, 2023, reduces this compensation by 75%.  It provides less credit to homeowners for selling energy during off-peak hours when solar generation is high and more credit during peak hours when solar energy isn’t generated.  As a result, the payback period for a standard solar-only system now extends to 8-9 years, doubling the payback period.

Furthermore, those who obtained permits before April 15^th are grandfathered into the more favorable NEM 2.0 terms.  This led many homeowners to expedite their solar installations in the first half of the year, causing a significant drop in demand in the latter half.   To compound matters, interest rates have reached a 20 year high, further impacting the financial calculations of solar. 

Also, under NEM 3.0, homeowners now need to consider batteries to optimize savings.  With a solar + battery system, excess energy can be stored during the day and be used in the evening, or it can be pushed back to the grid during peak hours when export rates are at their highest.  However, a standard-sized battery would add approximately $10k in upfront costs to a solar-only system of $20k.

Although NEM 3.0 is specific to California, the state’s status as the largest solar market means its decisions could influence other states to adopt similar measures. 

This combination of factors—pre-NEM 3.0 installation rush, higher initial costs due to battery storage, and increasing interest rates—resulted in a significant drop in residential solar demand.  And this market dynamic coincided with easing of supply chain issues, leading to an accumulation of inventory in the ecosystem, affecting Enphase’s revenue growth in 3Q23. 

However, I think this is about to change.  Global utility rates are expected to continue increasing, which would enhance the benefits of solar panels and shorten the payback period.  For example, PG&E plans to increase electricity bills by 13% in 2024, and Southern California Edison has proposed a substantial rate increase of 45% through 2028 over already approved rates.  Additionally, interest rates appear to have peaked, with the 10-year treasury decreasing 100 bps in the past 2 months and the Fed forecasting three rate cuts in 2024.  These two factors should stimulate demand for ENPH once again. 

Competitive Advantage

In the US residential solar industry, Enphase and SolarEdge are the two leading companies, holding a combined market share of 90%.  Enphase leads with 48% share, while SolarEdge has 40%.  This is a notable change from 2019, when SolarEdge was dominant with 60% share and Enphase had only 20%.  Enphase’s turnaround is largely credited to CEO Badri Kothandaraman, who took the helm in 2018.

Prior to 2018, Enphase struggled with product failures, leading to unreliability, increased installer costs, and a damaged reputation.  Revenues were falling and the company was rapidly using up its cash reserves.  However, under Badri’s leadership, Enphase focused on improving product quality and customer service, which were crucial in gaining market share from SolarEdge.

Badri introduced a target operating model of 30-20-10, signifying goals of 30% gross margin, 20% opex, and 10% operating income.  Through strict pricing control and continuous improvements, ENPH surpassed these targets, achieving a 45% GM and 20% operating income, outperforming SolarEdge’s 30% GM and 10% operating income.

Another important differentiator is ENPH’s inverter technology.  For those less familiar with inverters, the key role of an inverter is to convert direct current (DC) that is generated at the solar panel into alternating current (AC) that can be used by home appliances.  There are three main types of inverters: string inverters, power optimizers, and microinverters. 

String inverters, used by companies like Tesla, connect panels in a series and convert DC to AC at a central location.  These are simple and cost-effective because they require only one inverter, but are less efficient when there are shadings or have a complex roof structure.  Under string inverters, electricity production at each panel is limited by the lowest-producing panel, so if there is shading or defect at one of the panels, overall energy production is reduced. 

Alternatively, a microinverter, which is used by Enphase, has higher efficiency and better flexibility.  It installs an inverter under each solar panel, converting DC to AC at the panel level.  This allows each panel to operate at its best, unaffected by others and enables monitoring of each panel’s performance.

A hybrid approach between string inverters and microinverters is power optimizers, which is used by SolarEdge.  In this system, each panel has an optimizer at the panel level to allow panels to function independently, similar to microinverters, and sends DC to a single inverter for conversion to AC, similar to string inverters.

Although both Enphase and SolarEdge systems provide panel-level energy efficiency, in speaking with installers, Enphase inverters have several advantages over SolarEdge’s:

• Ease of installation and use: Enphase is often described as being similar to an iPhone in terms of ease of use and setup, making it user-friendly and straightforward.  This ‘dummy proof’ quality is particularly advantageous for newcomers to the solar installation industry.  SolarEdge, on the other hand, is likened to an Android phone, offering greater customization but requiring more expertise for setup.  This distinction can reduce labor cost and expedite installation, making Enphase an attractive choice for installation companies and contractors.
• Lower failure rates and better reliability: Enphase microinverters have demonstrated fewer failures compared to SolarEdge inverters.  This reliability factor is significant for installers and homeowners as inverter failures can lead to significant system downtime.  When an inverter fails, homeowners may miss out on solar generation until it is serviced, which could take days or weeks.  Failure of an inverter often necessitates service visits or ‘truck rolls’, which can be costly and time-consuming for installers.  This is especially true for failures that are not easily accessible or require extensive work for repair.  In the case of SolarEdge, a single inverter failure can render the entire system inactive.  In contrast, an Enphase inverter failure affects only the respective solar panel, allowing other panels to continue generating power.  This reliability advantage has prompted several large installers to switch to Enphase for its straightforward and dependable technology.
• Customer Service: installers frequently report superior service from Enphase.  The company places a strong emphasis on reducing call wait times and improving Net Promoter Scores (NPS).  Conversely, installers have noted lengthy wait times when seeking assistance from SolarEdge, which has created hesitancy in using their products.  
• Stable supply chain: Enphase has maintained a stable supply of its products, avoiding the significant issues that have affected some competitors.  Enphase has consistently produced at a relatively normal rate, meeting market demand without supply disruptions.  The uniformity and modularity of Enphase’s microinverters offer logistical advantages.  In contrast, SolarEdge’s extensive range of products (SKUs) has posed challenges for installers in terms of consistency in getting the required products.  Additionally, during the height of supply chain disruptions, SolarEdge faced delays in fulfilling orders, with lead times extending up to nine months from placement of purchase orders.  While this situation improved over time, it highlights the supply challenges SolarEdge has faced.
• Grid-agnostic: the Enphase IQ 8 microinverter has a unique feature that sets it apart from many of its competitors: it is a grid-agnostic product.  This means that in the event of a grid outage, the IQ 8 can continue to generate power and keep running appliances without a backup battery as long as there is sunlight.  This capability is particularly significant in areas prone to frequent power outages or unstable grid conditions as it allows for continued energy production and use during power outages. 
• Fire risk: Enphase systems convert DC to AC directly at the solar panel, reducing the presence of high DC voltage throughout the system.  This approach potentially lowers the risk of fire hazards compared to string inverters, which handle DC voltages.  
• Battery system: a slight disadvantage ENPH might have is in terms of battery storage capabilities, primarily due to DC coupling.  Batteries use DC power, so SolarEdge requires only one DC/AC conversion.  In contrast, Enphase involves three conversions: from DC to AC at the panel, from AC back to DC for battery storage, and again from DC to AC for grid supply, potentially resulting in slightly lower efficiency.

The only drawback of Enphase inverters is their cost.  They are 15-25% more costly than SolarEdge’s offering and double that of string inverters.  In the current cost-conscious environment, homeowners are seeking more affordable options to minimize initial expenses.  This is creating an opening for new lower-priced entrants, such as Tesla and Asian manufacturers.  Tesla’s market share is small, but it has a strong brand recognition, especially with a lot of customers using Tesla’s Powerwall battery.  However, because it’s a string inverter, it’s not the best option for residential.  Also, inverters are not their main focus of business, so service could lag behind the more established players.  However, Tesla should be monitored closely.

Chinese companies also provide cheaper alternatives.  However, they haven’t been able to make significant inroads in the US market.  Several years ago, Huawei was rumored to enter the US market and caused Enphase shares to fall, but due to geopolitical tensions, trust, security concerns, and trade barriers it never caught on.  Recently, Hoymiles is making noise, but I think it will be difficult for them to build a significant market share for similar issues.  Since inverters are pivotal in data collection and serve as the control center of home solar systems, Chinese brands may continue to face challenges in gaining both political and consumer trust in the US market.

Overall, despite the higher initial cost, Enphase stands out as a superior product, evident in its expanding market share and higher operating margins.  Its strong competitive position, reliable technology, and commitment to customer satisfaction make it a compelling investment opportunity within the renewable energy sector.

Growth Avenues

Enphase is well-recognized in the U.S. market, accounting for 60% of its sales.  It is less known internationally, but the company is now expanding its reach, establishing infrastructure and service teams in Europe, Asia, and South America.  Although international markets present unique challenges, including a stronger presence of Chinese alternatives and distinct regulatory standards, such as the absence of rapid shut-off requirements mandatory in the U.S., Enphase is adopting a detailed and careful approach to position them to capture market share globally. 

The company is also broadening its portfolio, introducing batteries and EV chargers that complement its microinverter technology to create a comprehensive home energy system.  While Enphase might not dominate these new verticals as it does with microinverters, these additions are expected to increase ‘share of wallet’ per home and continue to drive revenue growth.

Valuation

Government incentives, legislative changes, interest rates, and geopolitical events make the solar industry highly cyclical.  To weather through these cycles, Enphase has built a strong balance sheet with net cash of $500M.  This is a significant turnaround from 2018 when it had net debt.  Enphase is also capex light with no big factories.  Therefore, it has high free cash flow generation and has repurchased $1 billion in shares since 2021.  Enphase is estimated to generate $800M this year and projected to generate $1.3 billion by 2027.  Using a growth rate of 15% and 10% cost of capital suggests a DCF fair value of $185-$200/sh.  At 20-25%, it would be $250-$300/sh.  I think these are achievable growth rates compared to 65% annual growth in the past four years.  Solar industry is facing a short-term challenge, but I think the long-term growth will return and Enphase’s superior product and service will allow it to capture a bigger share of a growing pie. 

Catalyst

Share buybacks, lower interest rate, higher utility costs, international expansion, new products.