Description

Intro:

SolarEdge Technologies (SEDG), a manufacturer of solar system components (inverters to convert DC to AC, optimizers to improve system performance and achieve electrical code compliance) is facing a combination of imminent headwinds which we believe are not well appreciated by investors:

1.    Competitive pressures mounting across Europe and the US from established inverter manufacturers and credible new entrants: Huawei, Enphase (ENPH), Generac (GNRC), and plenty of others

2.    Equipment failure rates and service level deterioration that we believe have alienated the installer base and will lead to higher product warranty reserves and brand erosion

a.    SolarEdge has also aggressively raised prices in an industry where high single digit annual pricing declines (or even higher) are the norm, undermining its positioning as a more cost-effective alternative to Enphase

3.    Significant pull-forward of revenues into 2019 as channel partners stockpile ahead of the investor tax credit step-down at year-end. We believe this dynamic overstates current-period growth and will lead to depressed demand in 2020

In the face of these looming threats, exuberant solar investors have bid the stock up to a lofty multiple on consensus earnings that extrapolate the current unsustainable trajectory far into the future. We believe the combination of competition, diminished brand equity and the normalization of pull-forwards will reduce earnings and compress the forward multiple towards the long-term average, resulting in 50% downside from current over the next 6-12 months.

Background:

In the wake of updates to the National Electrical Code (NEC 2017), only inverter manufacturers whose solutions include module-level rapid shutdown are permissible, penalizing previously dominant string inverter manufacturers such as SMA Solar and Fronius and benefitting Enphase and SolarEdge. As a result, SolarEdge (whose inverter + optimizer configuration is usually less expensive than Enphase’s microinverters) has rapidly gained leading share in the US residential market. According to Wood Mackenzie, SEDG residential market share has expanded from <5% in 2013 to 60% as of 2Q19. 

Falling component costs are a key pillar of the long-term solar bull case, allowing solar + storage to eventually compete against traditional fossil fuel-based power generation technologies without government subsidies. Accordingly, SolarEdge revenues per watt have historically fallen at an average rate of 10% Y-o-Y (2015-2018). More recently, with competition forced from the market by the NEC rules and the US-China trade war, SEDG has actually raised North America price per watt by 13% Y-o-Y, in defiance of the multiyear trend.

While component shortages and import tariffs have been blamed for the rising prices, one has only to look at the healthy gross margins reported by SEDG—which remain in the mid-30s despite the impact of dilutive acquisitions, expedited shipping costs, and the tariffs—to understand that a benign competitive backdrop has likely been the true driver of the price increases. We believe that environment is about to change.

Competitor 1: Huawei threat in the US is delayed for now, but escalating in international business

We advocated a short position in SEDG in the past when the entry of Huawei into the US residential market with a superior optimized string inverter solution seemed likely to extinguish SolarEdge’s rising star (see that report here, also includes background on the confluence of events that led us to where we are today in residential solar). Huawei was (and is) already the leading manufacturer of solar inverters for the utility-scale markets globally, and case studies from other markets suggested they would quickly make an impact. As it happened, geopolitical sparring between the Trump administration and China forced Huawei from the market before the new product could gain traction, and contributed to the +117% YTD rally in SEDG shares.  

The threat from Huawei is far from over, however. Our checks with industry participants in Europe suggest that after the fiasco with the US, Huawei has redirected significant residential inverter inventories into Western Europe at discounted prices. We believe this has resulted in share losses in key SolarEdge stronghold markets that are being masked in the reported results by excess sell-in and demand pull-forwards.

One large Dutch distributor estimated Huawei’s share of European residential has recently climbed as high as 20%, with price gaps of 30-40% vs. SolarEdge. He also noted that SEDG hasn’t reduced prices in three years in his markets, despite the lack of a tariff impact on European sales.

An executive of one of SEDG’s competitors noted “Huawei has become larger [so far in 2019] in all countries in Europe and in both segments [residential / commercial]…Huawei will be a bigger challenge than SolarEdge in the future.”

This is especially interesting given the strong SEDG reported results in Europe so far in 2019, with 71% growth “mainly in the Netherlands, Germany, Sweden and Poland.” In fact, adjusting out the impact of dilutive M&A, Europe accounted for 83% of the entire company’s Y-o-Y growth in the first half of 2019.

The Dutch solar market, which is SEDG’s largest international market, has reported strong growth that seems likely to continue into 2020 and beyond, but with Huawei closing in and US-based competitor Enphase reporting the Netherlands as one of its top two markets in Europe, we believe SEDG’s market share is unsustainable and potentially distorted by channel stuffing.

Estimating SEDG 1H19 Dutch market share:

·      SEDG reports revenues annually by geography, and we can estimate MW shipped by geography assuming North America $/watt holds for the US and ROW $/watt holds for every other region

·      From there, annualizing the 1H19 reported growth rates, we can compare the resulting 2019E SEDG MW shipped by region with the Bloomberg New Energy Finance projections for each individual market, allowing a rough approximation of SEDG market share by country

o  We additionally made one adjustment to reflect the mix of growth in favor of the Netherlands, as noted in conference call commentary throughout 2019 to date

·      The resulting approximation suggests that SEDG market share in the Netherlands is tracking up 1000bps this year, despite on-the-ground observers seeing share gains from Huawei:

The German market is on pace to hit its 52GW policy target early in 2020, beyond which there is no clear program in place to incentivize further solar buildout. One distributor remarked to us that the German market could be cut in half following the achievement of the 52GW target, and we believe SEDG has benefitted from the elevated demand in Germany as homeowners rush to install solar before government support disappears next year.

Competitor 2: Generac is a poorly understood competitor that has big potential in solar

In the US, meanwhile, a recent report from Citron research highlighted a little-known new entrant, Generac. Our work supports a similar conclusion to Citron, although Generac is just one of a host of concerns that investors should be focused on when it comes to SolarEdge. 

To briefly recap, Generac is already the dominant player in backup generators, and the entry into solar will allow the company to leverage its existing generator distribution footprint and global supply chain to rapidly scale up and achieve lower costs in this adjacent market. Generac’s solution would most directly compete with SolarEdge’s full product range including the StorEdge battery storage solution, not the LG Chem or Tesla standalone batteries, since Generac is offering integrated inverters, optimizers, home energy management software/hardware and storage. This Generac solution closely resembles the plan advanced by SolarEdge for an end-to-end, turnkey residential storage product suite. We believe Generac can improve upon the SEDG solution with a more scalable product, advanced energy management software through the Neurio acquisition, and seamless integration with home standby generators.

In the wake of the Citron report, a couple of solar bulls on the sell-side jumped to the defense of SolarEdge, but so far even the industry analysts seem not to grasp that Generac now manufactures their own power electronics (inverters + optimizers), and that future iterations, such as the product targeted for launch in 4Q19, will enjoy costs >50% lower than the Pika product in the market today. Sell-side analysts such as Roth and Northland argue that their channel checks in the market indicate Pika is too expensive relative to SEDG’s solution but don’t realize they are channel checking the generation 1 Pika product and not the Generation 2 Generac branded product that will be revealed at SPI on September 23rd(and commercially released this November).  Furthermore, like the Huawei Fusion Smart Home solution, the Generac solution is battery optional (a consumer can opt to install the system without batteries and opt to plug in a battery later). Also like Huawei’s residential product, Generac’s solution allows for selective optimization of modules; this feature makes the system disruptively cheaper than SEDG’s own optimizers that still require one optimizer per panel. This confusion has created an opportunity for investors who are willing to do the work to fully understand the implications of a massive, US-based entrant that is covered by no solar analysts.

Competitor 3: Cracks are already appearing in the core domestic business as Enphase comes back from the brink

While SEDG has dazzled so far in 2019 with its international performance, company disclosure allows us to back into the pricing and volume trends within each region—and for the first two quarters of 2019, SEDG megawatts shipped appear to be declining in the key North American market:

The declines reported by SolarEdge are in stark contrast to the rest of the publicly-traded solar companies focused on the US; Sunrun (RUN) has reported 19% installation volume growth YTD and guides to >15% for the year, Vivint (VSLR) has reported 16% installation growth YTD and guides to 15% for the year, Sunnova (NOVA) is guiding to 30% customer growth for the year, and inverter rival Enphase has reported 90% US revenue growth YTD and guides to 124% in the third quarter of 2019, mostly in the US.

Enphase bears further investigation, given it is SolarEdge’s main challenger in the US residential market. After an initial period of success in which ENPH U.S. residential market share peaked at 32% in 3Q14 according to Wood Mackenzie, we believe a combination of deteriorating customer service, uncompetitive pricing vs. SolarEdge, and product quality issues resulted in ENPH market share dropping to 18% in 3Q18 and adjusted gross margins plummeting from 33% in 2014 to 18% in 2016. As the Enphase declines steepened, channel partners pulled away from the company as fears surfaced that they were on the brink of financial ruin (the market cap dropped to under $70mm) and might struggle to backstop the multiyear product warranties underpinning each new microinverter sale. SolarEdge was the main beneficiary of its closest competitor’s distress. Now, however, bolstered by a new management team that has revived ENPH’s fortunes and restored the brand to life with tweaks to product pricing, technology and customer service, ENPH is clearly taking share from SEDG and we expect this trend to continue (the widely-followed Wood Mackenzie dataset captures share trends only on a lag, as observations are recorded when a system is connected to the grid, which typically occurs months after the component is sold by the manufacturer—thus the Wood Mackenzie data do not yet reflect any share losses for SEDG as of 2Q19).

Enphase historically focuses on the long tail of small local installers (50% of the 2.4GW US residential market installs <4MW p.a. according to Wood Mackenzie), whereas SolarEdge is focused on the top national installers and distributors. We believe the concentration of SEDG revenues with a few, highly sophisticated buyers is a structural disadvantage, as these buyers will be the first to qualify alternative sources of supply.

To take the example of the California solar initiative dataset, which aggregates individual interconnections of residential and commercial systems, SolarEdge share within the top residential installers was 77% while share within the rest of the market was only 52% as of 6/30/19 (SEDG had 58% share in the data overall).

Given SEDG’s more concentrated exposure among the top installers compared to ENPH, we view SEDG as being significantly more vulnerable to early share loss to GNRC. GNRC highlighted at their analyst day that they are already engaged in discussions with RUN, VSLR, and CED Greentech, which we believe are likely to be SEDG’s three largest customers. CED Greentech is a 19.4% customer as noted in the 2018 SolarEdge 10-K, or 36% of US sales.

Competitor 4, 5, 6, 7…..: Numerous competitive angles both new and old reinforce our view that this industry is highly commoditized with low barriers to entry. The current level of SolarEdge market share is unsustainable and it’s not a matter of ifa reversion to the mean occurs, but when

The string inverter manufacturers displaced by NEC 2017 are not going away, and have reformulated their offerings to comply with the electrical code, often in conjunction with Tigo’s rapid-shutdown devices. While there have been mixed reviews from the market so far, companies such as Ginlong, SMA Solar, Delta Electronics and Fronius are quality operators with dominant positions in other major global markets, and we believe they will continue to refine their solutions, which already deliver meaningful cost benefits when compared with SolarEdge inverters + optimizers.

Another interesting competitor is AP Systems, which manufacturers a cost-effective microinverter solution and has grown share sequentially for seven quarters off a small base.

There have long been rumors about a Texas Instruments chip integrated into the solar module itself, which could render SEDG inverters completely unnecessary, and the upcoming Solar Power International conference in Salt Lake City would be a prime opportunity for market participants to unveil this or other as-yet unknown technologies, any of which could spell ruin for SolarEdge. Smaller rivals such as Hoymiles Converter Technology, Pulsiv Solar, Altenergy and Sparq Systems may have lower odds of success individually, but collectively represent a formidable challenge to SEDG’s market position.

The broader point is that from the perspective of a SolarEdge investor, there are more than a handful of bankable competitors at any given time, each looking at the company’s 30%+ gross margins and happy to settle for much less in a commoditized and competitive industry where lowering costs is the primary objective of customers.

Equipment failure rates appear to be ticking up with the move to the Set App configuration. Add this to lengthening equipment lead-times and aggressive pricing, and SEDG has a major brand problem on its hands that should compound its current share losses.

Williams Research, a persistent bear on SEDG, has been publishing reports highlighting high failure rates on SEDG inverters for several months.  While last year when we were doing channel checks on SEDG we were unable to validate Williams’ claims, our more recent call work with US and international distributors and installers suggests instances of higher than expected failure rates.  While it’s impossible to quantify the failure rates of the new Set App components at such an early stage, we have heard negative feedback from several frustrated buyers. The typical pattern is of a buyer who chose SEDG initially for its strong brand, great customer service and dependable technology compared to Enphase, only to have order lead-times stretch out past a dozen weeks, aggressive price increases that have eroded the cost advantage over Enphase, and now bad products that are harder to install and may require a costly replacement.

Some snippets from our discussions:

·      European distributor: “SolarEdge lead times are 3-4 months for some products. Used to always be in-stock, was 6-8 weeks last year.”

·      US distributor: “We are hearing about field failures of [SolarEdge] equipment, and difficulty in commissioning the product. They removed the screen, and in practice that’s been challenging. Lots of frustration and people are talking about not wanting all of their eggs in one basket. People aren’t bailing from SEDG, just trying to get another brand in to balance them out.”

·      US distributor: “SolarEdge failure issues are not secret, they are widely acknowledged. I haven’t seen a shift away from SolarEdge in terms of volume, but a lot more emphasis on getting quotes from other inverter manufacturers.”

·      US installer: “My salespeople called up their clients, and got feedback that there were issues with the SolarEdge inverters. In hearing these stories, they gravitated towards the Enphase product.”

·      European inverter manufacturer: “I have heard that SolarEdge has rising failure rates, and it’s not just rumors.”

While this would be unmodeled upside in the base case laid out below, we believe there is serious harm being done to the SolarEdge brand, with more and more reports of SolarEdge dealers and installers moving to source alternate power electronics. A bear case would be a scenario like the Enphase collapse of 2014-2017, in which elevated product warranty accruals weigh on margins, massive recalls damage customer faith in SolarEdge technology, and market share craters.

Lastly, the US investor tax credit is due to fall from 30% to 26% at the end of 2019, which has led to a temporary growth tailwind in 2019 that could significantly overstate underlying earnings power and revenue growth.

As we highlighted above, the average industry commentary is calling for US solar installation growth of  ~15% in 2019: RUN says >15%, VSLR says 15%, NOVA says 30%, Wood Mackenzie forecasts 17% US solar growth (includes C&I and utility-scale), while Bloomberg New Energy Finance is forecasting 15% growth at the midpoint for the US solar market (includes C&I and utility-scale).

But simply adding ENPH and SEDG consensus revenue projections together, which should account for ~90% of the US residential market, we get 43% growth in 2019 in the US adjusted for Enphase’s acquisition of SunPower’s microinverter business (ENPH growing 116% and SEDG growing 12%). One important reason for the disconnect between installation growth and inverter shipment growth is the federal investor tax credit step-down. For homeowners and developers wishing to be grandfathered in under the higher subsidy rate, the safe harbor provision in the IRS rules require the purchase of at least 5% of solar system value before the end of the year. This would mean elevated module, inverter and balance of system orders ahead of the end of the year, even though in many cases these projects won’t be installed until 2020.

SEDG’s key customers, the large national installers and distributors, possess the financial strength to tie up cash in component inventory stockpiles, magnifying SEDG’s potential exposure to a one-off revenue pull-forward from the ITC rules.

So with US inverter sales expected to grow 43% in 2019 (as represented by SEDG + ENPH consensus expectations), there is an excess sell-in of 28ppts, $205mm or ~$685MW. In reality the pull-forward is lower than $205mm because a) the other 10% (of MW shipped by manufacturers which are neither SEDG nor ENPH) is declining precipitously, and b) inverter pricing is up Y-o-Y, accounting for a portion of the revenue growth. Assuming 5ppts of benefit from string inverter declines and 15ppts from pricing increases, there is still an ~8ppt benefit from the ITC pull-forward in 2019, or +$42mm for SEDG.

Valuation:

As sentiment has run ahead of fundamentals, SEDG has traded up more than 100% YTD and sits at 15x next year’s consensus EBITDA, vs. long-term average multiple 9.5x.

Confronted with declining market share both domestically and abroad from the competitive headwinds discussed above, in a US market that we believe will be depressed in 2020 from the ITC step-down hangover, SEDG will have little choice but to lower ASPs to remain competitive, a move that will drag margins downward.

We assume a base case scenario in which SEDG US market share declines 500bps from 2019 to 2020, Netherlands share declines 300bps, and other regions are flat to up. End market MW growth assumption is based on the Bloomberg New Energy Finance midpoint projections for 2019 and 2020 for the residential and commercial markets where SEDG predominantly plays. These projections call for 28% Y-o-Y MW growth in 2019 and 20% growth in 2020. Additionally, we move $42mm of revenue from 2020 into 2019 as discussed above to capture the ITC pull-forward.

Pricing resumes the historical average downward trajectory, but there are three discrete impacts from pricing: (1) like-for-like price decreases of 8-12% driven by competition, (2) negative regional mix as the ITC pull-forward depresses 2020 growth in the high-ASP US market, (3) pass-through of supply-chain savings as manufacturing is moved over to Vietnam. The combination should reduce blended ASP per watt by ~16% next year, pulling gross margins down by 700bps as SEDG must become more competitive.

At 9.5x 2020 EBITDA of $181mm, SEDG is worth only $38 per share, -50% from current, while rolling another year out results in even more equity value downside per share.

Catalyst

Competitor technology unveiled at SPI Sept 23

Earnings miss driven by ASP declines and share loss