2023-04-20 12:09:16 ET
Summary
- The California NEM 3.0 has a structural impact on the volume of Power Purchase Agreement, offsetting secular growth tailwinds in solar industry.
- The current high volume of PPA applications is expected to create a pull-forward demand, which may impact the company's top-line growth in the coming quarters.
- Financing operations with high leverage increases liquidity risk for an unprofitable company.
- I remain underweight at the moment as the reduction in price credit and recent macro uncertainties are not price supportive to the high leverage company.
Investment Rationale
Sunrun ( RUN ) is a leader in the US residential rooftop solar and energy storage services market, which is expected to grow at a 15.3% CAGR from 2023 to 2030. The US residential solar is only 4% of market penetration today, presenting significant growth opportunities. However, the California NEM 3.0 will negatively impact volume growth for residential solar installers, as the 75% reduction in price credit could weaken demand and extend homeowner payback period. Despite the stock has dropped almost 40% since December 2022, I maintain underweight as the company's net debt is almost double its market value. This high leverage poses a liquidity risk, particularly in a high interest rate environment.
Company Background
Sunrun, based in San Francisco, California, is a leader in the US residential solar and energy storage service provider. With a mission to create a world powered by the sun, the company offers clean, affordable, and reliable energy solutions directly to consumers or through a network of independent dealers, serving more than 271,000 customers in 22 states, with a total capacity of over 1.5GW. Sunrun takes care of the entire process, from origination and design to installation of solar systems at the customer's home. Revenue segments include Customer Agreements & Incentives, which accounts for 43% of total revenue, and Solar Systems and Product Sales, which accounts for 57% of total revenue. Sunrun is well-positioned to gain market share due to favorable Investment Tax Credit ((ITC)) rules, which provide incentives for solar energy adoption. Sunrun's leading scale in the industry also gives it a competitive advantage, allowing the company to capitalize on economies of scale and drive operational efficiencies.
Power Purchase Agreement and NEM 3.0
One of the key factors that contribute to Sunrun's strong revenue visibility is its long-term customer contracts. Through 20-year leases, power purchase agreements ((PPAs)), or loan contracts, Sunrun establishes enduring relationships with its customers, providing a stable source of revenue for the company. Additionally, these contracts allow customers to avoid upfront payments associated with installing solar systems, making solar energy more accessible and affordable. Through net metering programs, customers can connect their solar systems to the grid and receive price credit for any unused solar power they collect during the day. This can be achieved by sending the unused power back to the grid, which can then be sold to other homes in the area.
As of December 31, 2022, more than 40% of Sunrun's solar systems were deployed in California. However, the company now faces headwinds due to the California NEM 3.0 proposal, which took effect on April 15, 2023. Under this new rule, the price credit for solar installations has been reduced by 75%, from a 1:1 full price credit of 25-30 cents per kilowatt to only 8 cents per kilowatt. While existing program participants who signed up before the April 15th deadline are not affected, the high volume of pull-forward demand created by this deadline will impact solar installers' top-line growth in the coming quarters.
Financial Leverage
The company's net debt of $8 billion as of Q4 FY2022 is higher than its current market cap of $4.2 billion. According to the 10-K FY2022 , page 102, The debt facilities are secured by net cash flows from Customer Agreements less some expenses. While more than 80% of its total debt is non-recourse, a potential slowdown in new Customer Agreements due to the reduction in price credit could still pose a liquidity risk. I believe that the recent 40% retracement from the December high may have priced in this risk. The stock has underperformed the benchmark by 14% (04/14/2023).
It's important to note that high interest expenses can weigh heavily on the company's bottom-line, particularly in a high inflation environment. The interest expense of $446 million in FY 2022, which represents a 36% YoY increase, is a concern given the company's high leverage. Despite the US inflation continues heading south from the peak, the recent March CPI is still running 5% YoY, which is still higher than the 2% target rate. Additionally, while the company has been able to increase its cash balance through borrowing, the fact that net cash provided by financing activities was almost $3 billion suggests that the company is not generating enough cash from its operations to fund its growth, and that it is relying heavily on debt financing. This creates a significant liquidity risk for the company, particularly if top-line growth slows down.
4Q FY2022 Earnings
Despite better-than-expected revenue and earnings, the company expects the core KPI, Solar Energy Capacity Installed growth, to be in a range of 10% to 15% in FY 2023, decelerating from 25% YoY in FY 2022. In 1Q FY 2023, Solar Energy Capacity Installed growth is expected to be in a range of 215 to 225MW, implying only 5% growth YoY. During earnings call , The CFO, Danny Abajian, says, "Even with the tremendous sales activities we are currently seeing, our conservative stance is influenced by the mid-April transition to the new net billing tariff in California, extended cycle times of higher storage mix timing uncertainty with the implementation of ITC adders and our ongoing pricing adjustments and go-to-market optimization efforts". I believe that the current strong demand for solar panels is primarily driven by homeowners seeking to lock in the full price credit agreement prior to April 15th. This rush to take advantage of the full price credit is likely creating a pull-forward demand that could have a negative impact on volume growth later in the year. It is important to keep in mind that the current demand surge may not be indicative of sustained growth in the long term. Therefore, I doubt that the company is able to muddle through and achieve the guidance outlook in later this year.
Valuation
RUN's current trading multiple of 6.7x EV/Revenue FY23 (as of 04/06/2023) is slightly higher than the industry average of 6x. While this may not pose significant issues compared to NOVA 's higher multiple of 11.7x, it is important to note that the company's low-quality nature, including its high leverage and negative free cash flow, could potentially lead to a lower multiple. This is evident when comparing Sunrun's multiple to that of other solar companies such as First Solar ( FSLR ) and SolarEdge ( SEDG ), which are trading at 5.6x and 3.6x respectively, despite posting significant year-to-date gains. Therefore, the higher multiple makes it more volatile in a late-cycle environment.
Conclusion
In sum, I remain cautious on Sunrun due to the potential impact of new policies that may structurally reduce net metering program additions. Although the company benefits from long-term secular growth tailwinds and holds a market leader status, I'm more concerned about the balance sheet, as the company is heavily reliant on borrowing to maintain operations, resulting in significant interest expense. As a result, I would recommend a wait-and-see approach over the next several quarters to assess the impact of the price credit reduction before becoming more bullish on the stock.
For further details see:
Sunrun: 75% Reduction In Price Credit Will Create Growth Headwinds