Description

Thought this was timely so apologize if organization of the writeup is less than optimal.

Investment Framing

If debt issuance makes you cash flow positive, then Pop4Pres is opening up a bunch of credit card accounts, maxing them out, and then IPO’ing himself.  Who wants to invest?

Kidding aside, RUN called itself “structurally cash flow positive” in 2017.  Cash and restricted cash increased $43m YoY “adjusted for one-time items including accelerated inventory purchasing (approximately $20 million) and $8.8 million related to a prior business acquisition” (so really $14m) AND its debt increased by $389m.  Therefore, excluding debt issuance, cash burn was ~$375m.  That is not “structurally cash flow positive”; in fact, that is exactly the opposite and 100% dependent on capital markets.

Business Description

• What RUN is not: an innovative solar company with some sort of proprietary energy technology
• What RUN is: a combination roofing company, marketing organization, and financial engineer entirely dependent on debt

Financials

• Back to basics - what are returns on capital?
• Numerator
• Pre-tax lease gross margin as the numerator (i.e., ignoring all corporate costs)
• Very generous definition of ROIC
• Company has plenty of NOLs so in fairness wouldn’t be a taxpayer for a while

• Denominator

• 80% of B/S in on B/S systems as mentioned aboveImplies most of the B/S is for the lease business

• 90% of MW deployed are leased x remaining 10% of assets

• 90% of MW deployed are leased so those stay on the balance sheet as “Solar Energy Systems, Net” which itself is 80% of assets

• View lease margin over the entire balance sheet

• Treat panel sales separately

• No matter how you measure returns, they’re low
  • Reviewed a handful of capital-intense lease/rental businesses and almost none have gross margins that high (e.g., autos, railcars, equipment rental companies, etc.)
  • Typically 25%-40%
  • RUN business is arguably lower maintenance once the panels are installed so if all the stars align maybe they get above 40%
  • Sub-2% on an actual basis
  • ~5% assuming lease business gets to 60% gross margin from 20% today

• Blended cost of debt is 4.5%, although cash interest over average debt was higher (~4.9%) last quarter and income statement interest is higher (although looks like this is largely accounting conventions)
• If the business triples lease margin and has zero opex it barely earns its cost of capital at the gross margin level

“Cash Flow Positive” Claim

• Company made the claim of being “structurally cash flow positive” last year
• Does not provide bridges from GAAP numbers
• The footnote is easy enough to understand
  • But investors don’t know all the adjustments that would have to be made and hence would have to just take management’s word for the claim rather than deciding for themselves what really is “cash flow.”
• Almost feels as if the company knows the SEC wouldn’t be happy about the claims
• Does not disclose this “cash flow” number in press releases or even a consistent non-GAAP table
• Nonchalantly displays it on a slide like the above
• And calls out that the company is “cash flow positive” at the top of the first page of its quarterly earnings release without providing the number

• Re-arranging the cash flow statement is helpful
• Clearly the company is not “structurally cash flow positive”
• The company burned $100m in cash from operations in the last twelve months and $394m in FCF

• MW deployed was down YoY, but cash burn was up YoY in Q1

• Panel costs are only part of the equation and are not falling much anymore

• Management will probably say that it’s gearing up for Q2

• The bigger piece is labor, racking, etc. (i.e., laying the roof)

• Bull case says look at PPA math, ignore today; but if RUN grows deployments, it burns more cash.  Apparently if it shrinks deployments, it burns more cash too...

• The business had more cumulative MW deployed than it did last year (i.e., more leases generating revenue), but should have had lower install costs / equipment capex for the period due to the lower deployments

• “Payments for the Cost of Solar Energy Systems, Leased and to be Leased” was +2% YoY even though MW deployed was -7% YoY

• Semantics
  • The bull rationale for including this line in operating cash flow is that RUN is monetizing a valuable asset, the tax equity credit by getting proceeds to fund installs
  • That is the also the problem though. The bulk of these cash flows only occur when RUN spends a ridiculous amount of capex to install new systems and gets the funding up front...therefore, the inflows don’t continue if installs stop.  So if installs cease then capex disappears, contributions received disappear and reported operating cash flow would still be massively negative in that situation - what gives?
  • Only a small portion is related to payments received by RUN from the leases, because the tax equity holders get an outsized portion in the early years.  My guess is less than 5% of this line is recurring income to RUN
• These outflows are actually more ongoing in nature because they are covering expenses / are shares of income attributable to JV partners rather than up front financing
• Distributions paid are $57m LTM vs. contributions received of $575m, so including both categories (as I have) flatters RUN’s metrics
• Bulls would probably argue that what I’ve labelled “non-controlling structures” is operational cash flow; but I wouldn’t.  Included in this line is 1) “Contributions received from noncontrolling interests and redeemable noncontrolling interests”, 2) “Distributions paid to noncontrolling interests and redeemable noncontrolling interests” and 3) “Acquisition of Non Controlling Interest.”  I don’t show each individually in the cash flow above, but provide some context below on the first two, which are the largest - you can see the disaggregated amounts in the cash flow statement
• “Contributions received” - “The owner partnership uses the cash contributions received from the tenant partnership to purchase systems from us and/or fund installation of such systems.” 10-K
• “Distributions paid” - “Customer payments made to the tenant partnership are used to pay expenses (including fees to us), make master lease rent payments and pay preferred return distributions to the fund investor.” 10-K

General Thoughts on Economics / Other

• Economics
• 6% discount seems aggressive
  • Long-dated, subordinated cash flows in a debt-laden structure
  • Very rate sensitive analysis - going to an 8% discount rate can reduce NPV/watt by >60%, 10% would make NPVs negative without making any other adjustments
• 90% renewals at year 20 for an additional 10 years on rates that grow at 2.5% inflation seems...optimistic
  • Solar cannibalizes itself at ~15% penetration
  • Driving power prices down may undermine the economics of the PPAs - are customers really going to pay 2.5% more / year for years on end if the supply of solar generation is increasing and feeding more power back into the grid?
  • Is this a case of losing the forest for the trees - i.e., you can model out all the PPA math, but do supply/demand and market dynamics support the mechanical inputs?  What happens if customers think PPA rates are unfavorable? Etc.?
• Doesn’t look like creation costs are coming down much
  • Most of this cost is sales and marketing and installation
  • Unlikely to get much more leverage here in my opinion
• Will competition force RUN’s hand into more panel sales than leases?
  • Likely better for the consumer, can pay in installments and benefit from not being locked into escalating power agreement
  • Not a good business - basically like selling TVs
• We could debate PPAs all day, but a few thoughts:
• Germany Example
• Has moved aggressively towards renewables, yet German CO2 emissions per person have been flat to up as renewables’ share increases.  Have to keep dirty coal plants running because they are most cost effective to turn on/off to deal with intermittency of renewables
• https://www.forbes.com/sites/jamesconca/2017/10/10/why-arent-renewables-decreasing-germanys-carbon-emissions/#aeadf8b68e15
• California Example
  • http://environmentalprogress.org/big-news/2018/2/12/electricity-prices-rose-three-times-more-in-california-than-in-rest-of-us-in-2017
• https://www.bloomberg.com/news/articles/2018-05-09/think-solar-is-upending-california-s-power-grid-now-just-wait
• Is seen as an energy leader, but benefits disproportionately accrue to the wealthy and power costs go up for everyone else
• Glut of power also causes issues on the grid, which is another concern for governments
• New rule will potentially exacerbate home price issues

Why Now?

• News flows have been a positive tailwind and shares are up 100% in the last year
• California solar mandate
• Florida will allow leasing
• Bullish sellside sentiment
• Q1 2018
  • The bull case is don’t pay attention to today’s cash flows, do your PPA math, and you get positive NPV
  • However, Q1 = fewer deployments and higher burn - does that make sense?
  • Another part of the bull case on RUN is that it will take share as others pull back from leasing
  • Maybe owners are seeing more value in buying and the market goes in that direction instead
  • Solarcity, which is owned by TSLA, which has no problem burning cash, says that the lease model is too much of a burden…
  • http://buffalonews.com/2017/04/28/solarcity-move-away-leases-loans/
  • Management previously gave investors the heads up on a soft Q1 due to a pull forward in demand related to changes in AZ policy, caution around tax policy and tariffs, etc. - the deployments being down wasn’t a surprise
  • However, the company stopped disclosing MW booked and MW deployed saying that the two were converging.  Maybe, or maybe they don’t want investors looking at the order book if it gets weaker?
  • MW deployed were down YoY but FCF was worse as discussed above
  • Leased MW deployed was down more than total
• With interest rates rising, funding costs are likely to go up, and the company’s returns at the gross margin level are below the cost of debt before any rate increase

Miscellaneous

• Executive/Board Turnover (might not be anything but two President/COO figures in two years, a GC this past month, and a member of audit committee)
• Mina Kim, General Counsel and Secretary - resigned Apr 2018
• Jameson McJunkin, Board Member on audit committee - resigned Mar 2017
• Paul Winnowski, President and Chief Operating Officer - retired Dec 2017, no new job?
• Tom Holland, President - retired Dec 2015, only with company two years, went on sabbatical after leaving (aka left without a job lined up)
• Teamwork makes the dream work!
  • Former CS analyst covering RUN was hired to head IR.  New CS team initiated with extremely bullish report a couple of months ago

Valuation

• I think that RUN will go bankrupt at some point
• Some really quick and dirty math for triangulation
• Invested Capital = ~$3b x 0.5x MOIC (earns well below cost of capital at gross margin level...) = $1.5b
• Panel business = $320m in LTM sales x 5% assumed EBIT margin for retail/distribution business x 8x multiple = $130m
• Net debt = $1.2b
• Minorities (i.e. financing vehicles) = $490m

Upside Risks / Bull Case

• High short interest
  • Counter: uh huh...
• Price can remain irrational
  • Counter: at some point fundamentals still matter, size appropriately
• Will take leasing share as SCTY reduces leasing
  • Counter: let them, when ROIC
• Solar panel costs will fall
  • 80% of the industry is imports.  5 suppliers = $185m in RUN purchases vs. COGS of $239m last year  
  • For 2016 contracted minimum of 120MW and up to 150MW from REC, which manufactures in Singapore Link
    • A Chinese co bought REC Solar in "a move that may help circumvent trade disputes in the U.S. and Europe." Link
  • Up to 135MW from Hanwha Q Cells, which is based in Korea and manufacturers in Malaysia and Korea Link
• Canadian Solar supply of 112MW in 2016 Link
  • Counter: panel costs have already fallen and the efficiency and price is not changing that rapidly anymore.  If panels were such a large component then tariffs would be a killer (see suppliers below). Reality is most of the cost is manual labor of delivery and install and sales/marketing

Catalyst

Continued cash burn, rising rates, PPA economics change, tighter capital markets