Description

SunEdison (SUNE) is a compelling investment opportunity with 100%+ upside from multiple catalysts in the next 4-12 months.  This meaningful upside exists because SUNE is a complicated amalgamation of a semiconductor and solar business with difficult to understand accounting and a volatile past.  The business has historically suffered from poor capital allocation and struggled with the boom/bust cycle of the solar sector.  As recently as 18 months ago, there was fear that SunEdison (then known as MEMC (ticker WFR)) would be a bankruptcy candidate (with the stock going from as high as $80 a share down to ~$1 over the last several years).  The stock, now trading at $11.46, has been weak in the last few days, dropping 15% from its recent highs, primarily as a result of technical selling from recently issued convertible bonds.  The company has been planning multiple strategic transactions, including both spins/IPO’s, which will require the covenant flexibility offered by these converts.  As a result of these strategic actions, the secular strength of the solar business, and the actions of an incredibly talented activist investor (Altai Capital) and Company CFO, we expect the SUNE sum-of-the-parts story to play out favorably over the next 4-12 months – Ultimately, we think the stock is worth low-mid-$20 per share.

Sun Edison has four sources of value:  a silicon wafer developer and manufacturer (SunEdison Semiconductors) that will be partially IPO’ed in Q1 2014, a polysilicon JV with Samsung, and the core business: SunEdison, a core developer of solar energy projects, that will soon have a new yield vehicle that will own solar systems.  We believe our price target will be realized through a string of catalysts in 1H 2014.

General Overview of Solar

The solar market has been built on government subsidies for “green” energy.  This subsidy system was created to provide an economic incentive to deploy solar, despite a high cost of deployment.  Constraints on the scope of these subsidy systems, primarily in Western Europe, have led to a boom/bust cycle as industry participants churned out systems prior to subsidy contractions, leaving significant excess manufacturing capacity. This has led to significant declines in the cost of solar systems, leading to a new economic paradigm for the solar industry – Grid parity and positive non-subsidized economics.

There is much academic/sell-side work on the development of the solar space, so we won’t rehash what’s already out there.  But the core of the thesis is that as system pricing continues to decline, the # of grid parity markets (markets where levelized costs of solar electricity to the end customer is no more expensive than electricity from the grid) will increase exponentially.  This phenomenon is a function of the country (and its irradiation), marginal cost of electricity, and cost of a fully-installed systems.  Solar system pricing has come down ~15-20% per year (for both ASP and COGS), while electricity pricing, on-average, has increased ~2% annually.  Many high electricity cost/highly irradiated markets have already achieved grid parity (including parts of the Southwestern US, Southern Europe, Japan, Australia and Chile), while many more are on the cusp (Northeast US, Mexico, Argentina, parts of China, etc.).  By the end of the decade, grid parity will have been achieved for 75-80% of European electricity consumption (from ~25% today), 95%+ in the Americas (5-10% today), 85% in APAC (20% today), and ~30% in Africa (5% today, lower due to grid restrictions and capacity factors in South Africa and Egypt that represent 2/3 of African electricity).

Tying all this together, annual solar MW (megawatts) installs are expected to increase at a CAGR of 17% in the coming 5 years (from 35MW this year to >75MW).  The primary growth is coming from Distributed Generation (see below), which will nearly triple, supplemented by growth in both utility scale and residential installs.

Sun Edison

There are several reasons why we are comfortable with the value imbedded in the solar business.  The core SunEd business is a developer/E&C (engineering and construction) company, operating in the solar space.  This business, with its significant backlog of projects, gives visibility into future revenue and profitability as the Company rapidly grows the number of MW completed.  In addition, the Company is simultaneously growing its development of Distributed Generation (“DG”) projects, which typically cater to smaller rooftop commercial/government projects and may complete intra-quarter without ever showing up in the backlog.  This creates a flow business from which the Company is able to develop projects in addition to the traditional pipeline/backlog source.

 A major constraint on the growth of the Sun Ed business has been a lack of adequate capital.  Typical solar projects are funded with cheap project level debt (as most have power purchase agreements (PPA) with highly rated utilities or businesses). But, at the project level, Sun Ed is required to put up equity, which is trapped until the project is sold.  In early 2012, facing liquidity issues, Sun Ed slowed the development pipeline to conserve cash.   This action materially reduced growth in 2013 (as pipeline projects take 6-12 months to convert into revenue and earnings).  Fortunately, the Company has completely eliminated its capital constraints following the recent capital raises.  The Company went from senior secured financings at 7.75-10% interest rates to a total unsecured balance sheet of covenant light convertible bonds.  This provides significant strategic flexibility as well as incremental senior and secured debt capacity.

In terms of system installations, SunEdison completed 280 MW in 2011 growing to 430 MW in 2012 and to ~525 MW in 2013E and the Company expects the pace of growth to accelerate.  Current Q4 2013 guidance is for a ramp to ~325 MW installed with a 2014 run-rate of 200MW-250MW per quarter and a sustainable pace thereafter of 250MW-400MW per quarter.  While there is execution risk with a ramp of this scale, the Company’s 1.1 GW backlog (with executed PPA’s or other energy off-take agreement in place) and 3.1 GW pipeline, create heightened visibility on development.  Additionally, 550+ MW under-construction at Q3 2013 provide insight into projects that are likely to be completed in the next 1-2 quarters.

DG is the other area of focus for SunEdison.  This market is growing rapidly from 12 GW of installs (out of 33 GW total solar installs) in 2013 to 20 GW (out of 47 GW total) by 2015.  And in North America, where SUNE expects its market share to ramp from 6.5% to 12% in the next 3 years, the market is expected to grow from 1.2 GW in 2013 to 2.0 GW in 2015 (SUNE is on pace to install ~70 MW DG this year, more than doubling next year).

Additionally, international growth, where the Company has a significant presence (currently makes up ~40%-50% of pipeline/backlog), is expected to accelerate, with installs in China, India, Southeast Asia, Latin America and sub-Saharan Africa expected to double by 2016.  Finally SUNE will increase focus on residential development in the US (using a capital light, outsourcing approach) as this segment provides higher ASP’s/Margins.  As costs continue to decline and grid parity is achieved, residential development should accelerate (~8 GW residential installs in 2013, doubling by 2018). 

Included in our valuation of the development segment is the Company’s O&M (operations and maintenance) segment.  SUNE has the ability to manage systems from both 3^rd parties as well as those that they develop, build and sell, charging a recurring fee of $.02 per Watt per year (currently managing ~1.3 GW with 300 MW from 3^rd party projects) with little incremental corporate costs.  This is revenue comparable to maintenance revenues recognized by software companies, and as MW developed grows, this revenue stream, with high margins and high renewal rates, will grow rapidly.

There is a natural tension in terms of value allocation between the development business and the yield co (i.e. projects dropped into the yield co are more accretive to the enterprise but at the same time, reduce the value of the developer as it doesn’t recognize the economics from selling the systems).  We have assumed that as the business ramps system completions, a greater portion will go into the yield co, as that is the most accretive mechanism for monetization.  So conservatively assuming only 20%-25% of developed systems are dropped into the yield co, and including all corporate expenses and interest, we estimate that the business will generate ~$.45 per share of FCF in 2015.  Using a 15x multiple and discount back, gets about $6 per share.  We would not that we triangulate this using a traditional DCF (that does a better job capturing our expected LT growth), that leads to an equity value estimate of $2.15B ($8.00 per share).

Retained Solar Projects (Yield Co)

The Company has become increasingly aggressive in its retention of valuable, high-return systems on its balance sheet.  Because of its position in the supply chain, SUNE has a unique ability to assess the quality of projects, including market position, PPA counterparty risk, and financing availability (tax credits, etc.) enabling the Company to pick those projects that have the lowest risk and highest IRR’s.  This is evidenced by the Company’s recent decision to retain an incremental 25 MW on their balance sheet in Q4 (to 140 MW, from previous guidance of 105 MW).

The Company has announced its intention to separate these assets into a yield vehicle (similar to NRG Yield) which we believe will materially lower capital costs associated with project development and highlight/enhance the value of their growing on-balance sheet project portfolio (going from 80 MW in 2012 to 200+ MW in 2013E to 400MW-600MW by the time of the IPO).  The Company recently highlighted that they derive $1.97 per MW value from retaining and dropping assets into a yield co compared to $.74 per MW for systems that are sold.  Ostensibly, the Company is able to capture value from improved cost of capital, system lives that exceed 20 years and friction costs/required returns for other parties involved in system monetization (see slide 15 in Q3 earnings presentation).  Because the Company has a 3+ GW pipeline, SUNE will be able to create a virtuous cycle of asset development followed by in-house monetization into a yield co (similar to MLP/GP structures) that can feed on itself.

As mentioned above, the proportion of systems retained vs. sold drives the value of this part of the solar business (in relation to the core development and sales business), and depending on how aggressively the Company is able to ramp the retained portion in the coming years, we estimate the NPV accretion from the yield co is worth ~$2.0B ($7.50 per share).  Again we triangulate this using FCF, with yield co generating annual run-rate FCF to the equity >$100M by 2H 2015, and using a 5% dividend yield (wide to both NYLD and PEGI, despite our view that the development pipeline for incremental growth at yield co is better defined and in our estimation lower-risk) and discounting back to today gets ~$1.9B ($7.00 per share).

SunEdison Semiconductor

The semiconductor business, which is straightforward to value but discounted by the market because it is included in the SUNE umbrella, is in the process of being partially spun out (which should help illuminate the value of this business).  We would note that the spun-out Company may eventually be an acquisition candidate (5 player industry that should consolidate) but that is not in our base case.  Based on the valuation of publicly traded comps (Sumco, Shin-etsu and Wacher), on 2013E trough sales of slightly over $900M and a .9x multiple (discount to peer median multiple in mid-1x) or a mid-cycle EBITDA of ~$200M (per Company) and a 6x multiple (peers mid-cycle in 6x-8x range), we believe this segment is worth $800M-$1.2B ($3.00-$4.50 per share).

Samsung JV

The Company has invested $175M (mostly non-cash in the form of a supply agreement) for a 50% ownership in a JV (with Samsung owning the balance) that manufactures polysilicon, which when fully ramped will manufacture 10K MT of poly and be among the lowest cost producers in the world (expected to produce at cash cost of $12/kg vs. current market in $18-$20/kg range).  We value the Company’s 50% share between $300M ($1 per share) @$22 stabilized poly and $450M ($1.50 per share) @$25 stabilized poly, and note the sensitivity here to recoveries in poly pricing translates into $1 per share of value to SUNE for every $7 move in poly pricing.

Putting all the pieces together, we get ranges of outcomes of $20+ per share vs. current price of $11.50

Catalyst

1.)    Yield Vehicle – This is the biggest incremental value creator for SUNE on a go-forward basis – First vehicle expected to be launched post-semiconductor IPO, sometime in Q2 2014

2.)    Q4 Earnings – Significant ramp-up of system completions guided for Q4 which will reset forward run-rate expectations for the business and cause revaluation of core solar development business – Expected Feb 2014

3.)    Semiconductor segment partial IPO – Scheduled for Q1 2014

4.)    Analyst Day – Company will have a forum to convey significant additional information to the Street re: their plans to increase the systems that they develop, retain and drop into a yield co, which is highly accretive – Only one or two sell-side analysts published on this post Q3 earnings, so most are behind the 8-ball and having more info from the Company will catalyze reevaluation of price-targets – They are looking to schedule their analyst day late Feb – early Mar

5.)    Solar City & other solar ABS – SCTY recently completed a $55M asset-backed securitization for a pool of solar projects @4.8% – assuming continued health of ABS market (Blackstone just did a single-family rental securitization at <2%) the pricing of these types of vehicles in coming months will meaningfully bring down cost of capital for solar developers

6.)    Samsung polysilicon JV begins production – This plant will be among the lowest-cost poly producers in the world with $12 cash costs, hedging the Company from moves in poly prices – goes online 1H 2014 with full ramp by 2H 2014