Description

It's not difficult to be negative about SEDG... The company sports three very vocal bears on the sellside (Goldman Sachs, Vertical Group, and Williams Research) with an average share price target of $25.66m, or ~30% lower than today's price.  This is also a popular short; per the latest Bloomberg data, 27% of the float is sold short (yet borrow cost is only 1% and stock trades $45MM per day).   As such, I am not going to re-invent the wheel here and write you a book report on SEDG.  Rather, I am going to simply explain why we think the stock will fall 56-67% further from the current price within the next 6 months to a price of $12-16 per share.

SEDG is effectively a single product company that produces optimizers and inverters for the residential and commercial and industrial ("C&I") solar markets.  In a residential installation, one solar inverter (see Wikipedia if you don't know what this is: https://en.wikipedia.org/wiki/Solar_inverter) is installed, with each solar panel on the rooftop requiring one solar optimizer.  The optimizer has three principal functions: (1) improves the efficiency of the solar array by de-powering a shaded module without sacrificing the broader solar array's power level, (2) enables the homeowner to monitor the efficiency/output of each individual panel on the roof, and (3) provides rapid shutdown functionality, a necessary technical requirement under NEC 2014 and NEC 2017 regulatory requirements in the United States: https://www.solarpowerworldonline.com/2018/04/how-to-meet-nec-2017-rapid-shutdown-requirements/

Legacy solar inverter manufacturers had been caught flat-footed, poorly anticipating NEC 2014 and NEC 2017 from a product roadmap perspective.  NEC 2017 requires rapid shutdown at the module level (rather than at the solar array level, which was required under NEC 2014) beginning January 1, 2019.  US solar installers have been gradually shifting away from legacy string inverters (produced by ABB, SMA Solar, Fronius, Delta Electric, KACO, among others) since the adoption of NEC 2014, and have accelerated this shift over the last 12 months in anticipation of the more stringent NEC 2017 implementation at the beginning of next year.  The two main beneficiaries of this market share shift have been SEDG and ENPH (ENPH acquired the number #3 "MLPE" manufacturer Solarbridge, which had become effectively a captive manufacturer for SPWR).

Per GTM Research, SEDG has benefited even more strongly than ENPH since SEDG's solar optimizers are lower cost than ENPH's microinverters (both MLPE devices meet NEC 2017 standards): https://www.greentechmedia.com/research/report/the-global-pv-inverter-and-mlpe-market-shares-h2-2018

This is a classic first-mover/first-loser short set up.  Huawei, which had long been delayed, launched its directly competitive solar optimizer/inverter product in the US market in 2018 3Q after releasing the product in Europe in 2018 1Q and in Australia in 2017 4Q: https://www.pv-tech.org/products/huawei-fusionhome-smart-energy-solution-is-its-first-residential-product-of

SEDG generated peak EBIT margins of 19.5% in 2018 1Q, and margins have already fallen to 14.4% as of 3Q (even absent material Huawei competition in the core US market, which represents 50%+ of SEDG's revenue and an even greater percentage on an EBIT basis).  Over the next 4 quarters, SEDG margins will also suffer from the US-China trade war, with 10% tariffs on SEDG production (outsourced in China) implemented September 24th that will rise to 25% by January 1, 2019.  SEDG has guided to 30-32% GAAP gross margins for 4Q, down from a peak of 37.9% enjoyed in 2018 1Q.  SEDG plans to move production to Eastern Europe (to avoid the tariffs) and is implementing a price increase January 1, 2019 to attempt to offset the margin pressure.

What this means is that SEDG is attempting to pull forward demand into 2018 4Q.   On the 3Q print, SEDG guided for 4Q revenue of $245-255MM vs then Consensus of only ~$222MM.  We attribute the raise relates to (1) pull-forward demand ahead of the telegraphed price increase for 2019 1Q and (2) potentially murky acquisition accounting (see the last paragraph of this write-up on Kokam and Gamatronics acquisitions).

The threat SEDG faces from Huawei is obvious.  SEDG is attempting to sue Huawei in Manheim Germany to thwart Huawei's European rollout: https://www.solaredge.com/us/solaredge-files-patent-infringement-lawsuit-against-huawei-and-distributor-in-germany

Importantly, SEDG is currently not attempting to sue Huawei in the US, which is SEDG's most important market by a large margin.  The Huawei product in Europe has different technical specs given unique regulatory requirements in the US.  If SEDG was planning on suing Huawei in the US, in our view, this would have happened in advance of SPI Anaheim, the largest US solar trade show that occurred September 14-17.  Note that SEDG sued Huawei the day before SPI Munich began (May 15-17) in an effort to threaten Huawei's distributor customers.  Huawei has told us they have over 100 IP lawyers and do not anticipate patent issues in any markets.  

How do we win from here?

The Street is still modeling 18% EBIT margins for SEDG in 2019.  We believe margins are heading irreversibly lower in the short term due to:

Market share loss: SEDG's largest three customers in the US are TSLA, RUN, and VSLR.  We have recently spoken with RUN and VSLR and both companies say they are trialing the Huawei product.  Huawei has confirmed this with us as well.   While we don't know exactly when this customer shift occurs, we think some SEDG market share loss of among these key accounts is likely to happen within 6 months.  When it becomes known that Huawei has won one of these customers, we expect another large leg down in SEDG's share price.

Pricing: Huawei doesn't even need to win big new customers.  The threat of Huawei now having a credible alternative product to SEDG is enough to force SEDG to substantially drop their pricing (despite SEDG's threats to actually raise price in 2019).  For context, in the history of the solar equipment manufacturing industry, no company has ever maintained 18% EBIT margins.  Among public peers, no one has even maintained 8-10% margins.  

Furthermore, Huawei (the largest solar inverter company globally by market share due to their strong presence in utility-scale and C&I inverters) is not the only company gunning for SEDG's market share.  Our field work suggests that many of the leading string inverter companies that lost market share to SEDG in the US are working on launching their own NEC 2017 compliant inverter products in 2019.  

Valuation

As a long-time observer of the boom & bust solar industry, we know that this industry does not neatly correct to some theoretical normalized margin.  When it rains in the solar industry, it pours.  S92 GR has flirted with a sub $200MM enterprise value in past cycles, and ENPH's enterprise value has been sub $100MM.  There have also been bankruptcies of publicly traded inverter companies like Satcon.  When the market realizes that SEDG is just another commodity manufacturer, we expect the market to over-correct to the downside.  

We think that before things get better, SEDG is likely actually to experience negative GAAP EPS for a period of time due to a combination of market share and ASP pressure.  You can conduct your own spreadsheet math to realize how easy it is for this to occur.  Nonetheless, for conservatism, at an 8% EBIT margin on $700MM of normalized sales (likely to get here by 2020), we pencil out ~$1.00 of earnings power.  8x $ 1.00 gets us an $8 enterprise value, plus $8 of net cash (2018 3Q net cash adjusted for 100% purchase of Kokam for $117MM plus an estimated $50mm of 6-months forward net cash generation).

To level set, in our price target analysis, we are valuing the enterprise value of SEDG at ~$375MM ($1.00 of normalized EPS x 8x multiple).  The current enterprise value of SMA Solar (S92 GY) is only 312MM euros.  In the first 9 months of 2018, SMA Solar sold 6,216MWs of inverters, compared to SEDG's reported volume of only 2,868MM MWs.  SMA historically has the strongest brand in residential and C&I solar globally (despite recent share loss in the US to SEDG due to NEC 2017), so we don't think this is an outrageous comp.  The valuation discrepancy today between SEDG (current TEV of $1.4bn USD) vs SMA Solar (312MM Euros) highlights the high degree of overearning SEDG has enjoyed due to its prior dominance of the MLPE solar inverter industry niche.

So $8 of Enterprise Value ($375MM) plus $8 of net cash --> Base Case of $16, or 56% downside within 6 months.

A very reasonable downside case scenario would be $4 of Enterprise Value (~$200MM) plus $8 of net cash --> $12 share price, or 67% downside within 6 months.

To be clear, we are calling this a 6-month price target because we believe the negative trajectory of this business is going to be very clear to the market within 6 months.  We are likely to see market share loss to Huawei, numerous competitive MLPE launches from the remaining string inverter companies, and pricing pressure (despite SEDG's claim they will raise prices in January).

SEDG's newfound acquisition strategy 

SEDG acquired Gamatronics, publicly traded universal power supply company in Israel, in July for $11.2MM.  The company has been shrinking revenue every year since 2010 and has recently reported negative EBITDA.  

SEDG acquired Kokam, a publicly traded tier 2 (or tier 3?) lithium ion battery manufacturer listed in Korea, in October for $117MM ($88mm for 75% with remaining shares to be purchased over time).  In the last twelve months, Kokam shrank its revenue 46% and the company not only has negative LTM EBITDA, but also negative LTM gross profit.

As short sellers, we are delighted to see SEDG embark on this acquisition strategy to attempt to diversify away from the company's solar inverter business.  Our SEDG target price may ultimately end up being lower should SEDG continue to unload its remaining net cash balance sheet in this fashion.

Catalyst

• Negative earnings revisions from market share loss and pricing pressure.
• Headlines surrounding loss of market share in key customer accounts (TSLA, RUN, VSLR)