Description

The Apology

Sunedison has been written up before on VIC but enough has changed with this fast evolving company that a fresh write-up may hopefully prove useful. This write-up should be viewed as an addition to the excellent work previously done on VIC in this name.

As an apology I know that SUNE is up 20% in the past week on the heels of its First Wind acquisition. But as this write-up will hopefully show, SUNE is still exceptionally cheap relative to its intrinsic value which we peg around $40-$45. Furthermore, for people with an allergic reaction to purchasing anything just up 20%, SUNE is worth understanding and adding to one’s mental database. This is a stock which demonstrates significant short-medium term price volatility within what I believe is a powerful secular uptrend. In other words, buyers with strong opportunistic streaks are likely to get periodic tactical windows to accumulate positions if they already understand the story well enough to act fast.

The Big Picture

We originally came to Sunedison a couple of years ago when the stock was sub-$5. At the time, Sunedison had a semiconductor unit and a solar business. While we were new to solar at the time and knew little beyond the fact that the sector was in a down cycle, we could purchase SUNE for almost no premium beyond the value of the semiconductor segment thus creating a very inexpensive option. Since that time we grew far more comfortable understanding the solar opportunity and SUNE’s role in the solar value chain. In tandem the Solar industry experienced a massive boom which –as we will discuss – is being driven by far reaching secular vs. cyclical factors.

The core business of Sunedison is building, operating, and (sometimes) owning renewable energy projects. Until recently these projects were exclusively solar, but with the acquisition of First Wind, SUNE broadened its portfolio into wind power as well. To distinguish SUNE from certain solar peers, SUNE’s focus has been mainly on utility scale projects. These are larger scale solar projects which enter into long term (~20 year) contracts with utilities to sell power at contractually fixed prices. Other solar companies have more of a focus on either distributed generation (think of rooftop panels atop a big box retailer) or residential. That said, the opportunity set and margins in distributed/residential are juicy and SUNE is moving to capture growth in those areas. SUNE is also a global player. Of its 5.1 GW solar pipeline/backlog, approximately 50% of projects are US, 23% EMEA/Latam, and 22% Emerging Markets. Note that this slightly overestimates the non-US component as many distributed/residential projects have short cycles and never hit the backlog.

SUNE achieves gross margins around 20% when it constructs and sells a project. In the last year SUNE realized it was leaving a huge amount of its economics on the table by selling versus retaining these projects. As a solution, SUNE launched a yieldco –Terraform (TERP)1 – which purchases completed developed market renewable projects from SUNE under a ROFR arrangement with the mandate of paying the bulk of those steady project cash-flows out as dividends. SUNE holds a 65% equity interest in TERP along with incentive distribution rights (“IDRs”) which become increasing valuable in the future. SUNE also collects a nice income stream for operating projects for itself, TERP, and third parties.

It is worth taking a moment to give a brief summary of the widely misunderstood global solar opportunity. General attitudes still view solar energy as a fringe factor in energy markets kept afloat by government subsidies. It is obviously true that solar has the attractive property of curtailing carbon emissions and air pollution. But put those hippy-dippy things aside for the moment.2 Our “aha” moment in solar came when we realized that solar is increasingly superior to conventional energy sources on a pure economic basis without subsidies or non-economic societal niceties.

The precise point at which “grid parity” is achieved (i.e., when solar energy is at variable cost parity with conventional energy generation) varies by geography due to factors such as weather patterns and the regional cost of commodities (i.e., natural gas). The mental framework to keep in mind is that the efficiency of solar power has been and continues to improve at an incredible Moore’s-law like pace and shows no signs of abating while we are pretty much as good at extracting energy from a unit of conventional fossil fuel as we are going to get. Thus, every year more and more of the world passes the point of grid parity where solar power becomes a compelling economic alternative.3 The global solar boom is being driven by this process of technology driven cost competitiveness and should continue for quite some time.

Solar stocks unfortunately have a bad reputation among value investors and are lumped into a bucket with social media, etc… as momentum/story names. Political headlines in recent years (i.e., Solyndra) haven’t helped matters. We would urge investors to look under the hood at the very real economics of solar with fresh eyes. The disconnect between the reality of solar competitiveness and perceptions of solar as the pet cause of “do-gooders” probably creates the opportunity in SUNE today.

The Numbers

We arrive at a present value for SUNE around $40-$45 with the potential for significant upside optionality.

TERP

SUNE owns 65MM shares of its yieldco. In its recent First Wind Acquisition call, SUNE/TERP provided a roadmap to expected dividend distributions of:

• $1.30 2015

• $1.53 2016

• $1.90 2017

• $2.28 2018

• $2.61 2019

Note that these numbers are almost certainly too low. On its last earnings call TERP provided 2015 dividend guidance of $0.90. Here we are only halfway through 4Q and TERP has already raised this number twice by a total of nearly 45%! The delta is mainly due to TERP purchasing highly accretive renewable projects outside of SUNE’s production stream. And yet these projections assume that over the next two years TERP makes no additional third party acquisitions. In other words, this is guidance based on a static portfolio of TERP's existing assets and identified future SUNE dropdowns.  If TERP continues to make third party acquisitions, even at a rate vastly below what we have seen in the past month, then these numbers have a strong upward bias (and we strongly believe TERP will continue to do these deals).  

Still, just using the $1.90 dividend projected from today’s visible project stream, TERP is worth $45 at a 4.5% dividend yield plus accumulated 2015/2016 dividends. A 4.5% dividend rate does not seem extreme given market comps today and current projections for 15-20% annual dividend growth continuing in 2018 and 2019. Discounting this back two years at 10% provides a current PV/Share of TERP of $37 (not too far from today’s trading price of $32 as a reality check) and $2420MM of value to SUNE.

But an even bigger source of value for SUNE of TERP is the IDR stream. Like many managers of GP/LP structures, SUNE is entitled to incentive distributions once TERP dividend growth passes certain thresholds. These IDRs should grow to around $275MM in 2019 (with the same caveats around an upside bias to these numbers as in the dividend section above). Using a 20x multiple (which is at the low end of industry comps) and a 15% discount rate on these 2019 numbers we arrive at $3145 PV to SUNE from the IDRs.

Devco/Management

SUNE’s most recent guidance calls for 3 GW of solar project production and 900 MW of wind projects in 2017. We assume slight ASP compression in $/MW by 2017 ($2.50) and use our best estimate of wind ASPs using numbers drawn from the First Wind announcement ($1.62). We also assume some gross margin compression from todays 20%+ levels to 18% by 2017 due to increased competition. After corporate G&A, interest expense, and taxes, the Devco should produce net income of $894MM in 2017 which we give a 12 multiple. Discounting the value back two years at 15% the Devco is worth $8114 to SUNE.

A second, often overlooked, source of value for SUNE is in its management revenues on owned and third party projects. SUNE collects approximately 0.02/MW in revenues on projects it operates with a 40% profit margin. Our projections for a management portfolio at YE16 of nearly 10GW is worth approx.. $600MM in PV for SUNE at a 15x multiple.

SEMI

Finally, SUNE still owns 24MM shares of its spun-out semiconductor business worth $276MM after-tax assuming a zero-cost basis (we don’t have the cost basis and use zero to be conservative although this isn’t really a needle mover). It is ironic that the value of this SEMI stake originally anchored our first SUNE position and is now such a minor part of the valuation.

Total

Putting it all together we have present values of:

• TERP $2420

• IDR $3145

• Devco $8114

• Service $612

• SEMI $276

• Total $14556

• Shares 335

• Total Value/shr $43.45

Risks and Catalysts

With a target value 2x the current stock price we still see tremendous value in SUNE. So what can go wrong?

• Operational risk: SUNE management has shown tremendous value creating skills. Still, their agenda is ambitious. We do not take lightly the difficulty of competently executing their ramp to 3.9 GW of global project production over the next few years – especially as part of that ramp includes a move into wind power.
• Competition: We believe the global solar pie will continue to boom in the foreseeable future creating great opportunities for top-tier players like SUNE. But others are certainly not blind to this opportunity set. There is some risk, for example, that a wave of capital drives down returns for solar project acquisitions. We note that on FSLR’s recent conference call they commented that some players are getting more aggressive on new project bids in the expectation that yieldco’s like TERP create better exit pricing. We assume some compression in project economics but there is a risk we remain too optimistic.
• ITC expiry: At the end of 2015 the Investment Tax Credit is set to sunset from 30% to 10%. We assume that this occurs although there is always some chance Congress acts otherwise. We are not concerned by the ITC expiry for several reasons. First, SUNE/TERP can replace the ITC with debt and the economics are not catastrophic. Second, SUNE is confident that the current visible pipeline of solar project cost improvements will offset the ITC expiration. Finally, SUNE has a global project portfolio which diversifies their risk. There is a chance that we place too much faith in the ability of solar cost efficiencies to offset ITC expiry. Moreover, from a tactical perspective, while we assume ITC sunset, we are not sure the rest of the world does. Solar stocks tend to attract waves of generalist trader buying and selling which can frustrate the short-medium term equilibrium of fundamental value investors. If/when the ITC sunsets its possible SUNE and its brethren see a wave of selling/shorting despite what we view as a fundamental non-issue.
• Residual value: A significant part of the economics for SUNE/TERP projects depends on residual value. If a long term PPA contracts for 20 years of power then residual value is an estimate of the remaining value of the project’s life beyond that point (~10 years). We are confident that the projects should have residual value. Much of a solar project’s value depends on land/regulatory permitting/etc… which all remain even if you assume a wholesale replacement of production technology after two decades to modernize efficiencies. Still, we admit that our visibility and ability to verify projections with current data are weakest around the residual value factor.
• Regulatory backlash: Rumblings are emerging from conventional utilities about the threat posed by solar power.  In particular, distributed/residential projects benefit from a pricing structure which arguably does not compensate utilities for providing grid access to solar users for when the sun doesn't shine.  Some kind of regulatory backlash against solar is an eventual possibility. We remain of the view that the economics of solar are sufficiently compelling that accomodation can be reached with the utilities without seriously impairing the solar opportunity.
• Silly market participants: This is both a risk and an opportunity. Solar stocks – SUNE included – attract waves of fast uninformed money. For example, before breaking out after announcing the First Wind deal, SUNE was being hammered down in correlation with oil prices. While SUNE doesn’t really have any real overlap with oil (which is a minor portion of power generation) this didn’t stop the stock from trading as if it was an Oklahoma fracker. Caveat emptor that investors in SUNE will need their full powers of discipline and strong stomachs to avoid the euphoria/despair caused by noise traders. Although they are slowly getting better, a sell-side which for the most part doesn’t do a good job of understanding or explaining SUNE doesn’t help matters. I will also repeat that those with a savvy trading bent can exploit this noise quite profitably.

Now, what can go right?

• Continued third party acquisitions: The blistering pace of highly accretive third party project acquisitions seen in the first half of 4Q14 has been astounding. Continued project acquisitions would be accretive to our numbers and Street expectations. There is no reason to think that this acquisition stream stops even if it slows from the incredible rate seen so far.  We used to mock the Street for lazily assuming that the TERP portfolio would be static and not grow via acquisition.  We still think that way although the rate of growth has been so high that we no longer try to model it and cop-out with qualitiative comments regarding "upside bias" etc...  There will be a day when some kind of equilibrium in capital markets reduces the accretive appeal of these third-party acquisitions but that day is probably far away.  Keep in mind that all of these third party acquisitions by TERP benefit SUNE via multiple channels (i.e., TERP value, IDR value, and management fees).
• Emerging Market Yieldco: SUNE is launching a second yieldco to focus on its emerging market product portfolio. An emerging market yieldco has the same potential to show explosive growth to SUNE via dividend growth and IDRs as TERP - driven in no small part by third party project acquisitions. None of this is in our numbers.
• Underestimated pipeline: We have almost given up on modeling SUNE as the company keeps updating its views (upwards) faster than we can refresh our Excel worksheets. Guidance of project development pipelines seem to rise every time the company speaks and could still be much too low. For example, in recent weeks SUNE announce an MOU for 5GW of projects in India which if executed would be roughly 1GW/yr from 2016-2020. This alone is nearly half of the 2.1-2.3GW total solar project guidance for 2016. Indeed, since announcing the Indian MOU the company has only increased 2016 pipeline projections by 200MW. While we don’t want to overstate the probabilities of an Indian MOU transitioning to completed projects, it illustrates that SUNE project guidance could still be very conservative.

Catalyst

• Continued third party acquisitions: The blistering pace of highly accretive third party project acquisitions seen in the first half of 4Q14 has been astounding. Continued project acquisitions would be accretive to our numbers and Street expectations. There is no reason to think that this acquisition stream stops even if it slows from the incredible rate seen so far.  We used to mock the Street for lazily assuming that the TERP portfolio would be static and not grow via acquisition.  We still think that way although the rate of growth has been so high that we no longer try to model it and cop-out with qualitiative comments regarding "upside bias" etc...  There will be a day when some kind of equilibrium in capital markets reduces the accretive appeal of these third-party acquisitions but that day is probably far away.  Keep in mind that all of these third party acquisitions by TERP benefit SUNE via multiple channels (i.e., TERP value, IDR value, and management fees).
• Emerging Market Yieldco: SUNE is launching a second yieldco to focus on its emerging market product portfolio. An emerging market yieldco has the same potential to show explosive growth to SUNE via dividend growth and IDRs as TERP - driven in no small part by third party project acquisitions. None of this is in our numbers.
• Underestimated pipeline: We have almost given up on modeling SUNE as the company keeps updating its views (upwards) faster than we can refresh our Excel worksheets. Guidance of project development pipelines seem to rise every time the company speaks and could still be much too low. For example, in recent weeks SUNE announce an MOU for 5GW of projects in India which if executed would be roughly 1GW/yr from 2016-2020. This alone is nearly half of the 2.1-2.3GW total solar project guidance for 2016. Indeed, since announcing the Indian MOU the company has only increased 2016 pipeline projections by 200MW. While we don’t want to overstate the probabilities of an Indian MOU transitioning to completed projects, it illustrates that SUNE project guidance could still be very conservative.