SolarEdge Stock: Current Price Misses Structural Opportunity (NASDAQ:SEDG)
SolarEdge shares are down about 80% from their peak but the pain may only be short lived, as management are pointing to a recovery later this year and when the government-incentivised structural growth returns, SolarEdge’s premium multiple will be restored leading to a much higher share price than today.
How We Got Here
It was less than 12 months ago that SolarEdge (NASDAQ:SEDG) was reporting record sales. The combination of the desire for energy independence, reduced energy costs for consumers, low borrowing costs, and government incentives ensured that demand for solar array components — such as SolarEdge’s inverters and power optimizers — remained strong. SolarEdge ramped up production to meet demand and they increased their inventory accordingly. Just as the market turned. SolarEdge was left with excess inventory and significantly fewer people to sell it to. As a result, expectations for growth have been tempered and the extraordinary growth seen recently is no longer being extrapolated into the future. Target prices in excess of $300 (FactSet’s highest consensus target price was $377 in May 2023) are now a distant memory.
SEDG management did not go into great detail about why demand has fallen, only that is has. But almost certainly it is due to the rising cost of living and the rising cost of borrowing. As a capital purchase, solar photovoltaic systems are typically bought on credit, and when credit becomes more expensive, sales fall. This dynamic seems obvious in hindsight, as interest rates had been rising all year, but it was easy to miss when sales kept on growing. In addition, Julian Lin makes a good point in his article from early January, saying “SEDG is a painful reminder that cyclical stocks might not look so cyclical under the favorable guise of zero interest rate policy”.
As a result of the mass cancellation of orders in the third and fourth quarters of 2023, SolarEdge’s inventory will end significantly higher than 12 months ago. At the end of 3Q23, inventory was $1,178m, compared to $561m a year earlier. This is a drain on the company’s cash, and with commentary saying 4Q is likely to be worse, inventory will most likely finish higher again. This will all but ensure operating cash flows for 2023 are negative.
Reducing their workforce by 16%, (900 workers), 500 of whom are employed at SolarEdge’s manufacturing sites.
As a result, in 2024, or at latest 2025, inventory will reduce, which will boost the operating cash flow at the time. This might sound positive, but the downside is that between now and then will be a severe sales crunch and the inventory will only be righted by manufacturing less product, rather than strong selling.
SolarEdge is unlikely to return to the days of being a $200+ stock anytime soon, because a) the elevated sales levels seen in 2022 was, in hindsight, an extraordinary period fueled by cheap debt and geopolitical uncertainty, and these growth rates were being extrapolated too far into the future; and b) the market is unlikely to assign the nosebleed multiples previously given to the company because of lower future growth rates and higher discount rates being used to value the company.
Future Growth Story
So the extraordinary sales seen in 2022 and early 2023 was just that: extraordinary. But does this mean the long term growth thematic is broken? My investment thesis has been built on the increasing global desire to reduce reliance on fossil fuels, the increasing prevalence of electric vehicles, and more recently, the need for energy independence in Europe.
In its May 2023 investor day presentation, SMA Solar (OTCPK:SMTGF) forecast demand for photovoltaic inverter and related energy solutions to double between 2022 and 2026 to around $46bn.
A more recent publication by KBV Research — importantly, one that was published after the demand crunch — backs this up, forecasting the industry to grow to $40.5bn in 2030.
SMA also projected growth in energy storage and electric vehicle charging as ready to explode in the years to 2030. The scenarios are wide, but even if demand lands somewhere in the middle, sales of PV inverters and attached batteries are likely to be materially higher than even the near-term normalized level.
Further, both SMA and SolarEdge have discussed the incentives provided by governments to move towards net zero such as the Inflation Reduction Act in the US and many various programs in Europe that encourage and incentivize households to move to energy independence.
SolarEdge reinforced some of these themes in the recent 3Q23 conference call, with some countries remaining very strong, so it is remaining very country-specific with government incentives and borrowing costs being a large driver of demand.
Consensus Earnings Estimates
2024 is already a write off. After posting non-GAAP EPS of $5.95 in 2022, Seeking Alpha consensus for 2024 is for a mere $0.72. Consensus for 2025 is far more positive, however, with analysts expecting EPS to almost fully rebound to $5.71.
To believe this is possible, one must understand the comments made by CEO Zvi Lando on the 3Q23 conference call.
To summarize, Lando stated that they have taken measures to run down the elevated inventory and have used the sell-through data from the 3Q23 period to estimate what a normal quarter of sales and margin should look like once the inventory correction has completed. This normalized level of $600-$700 million per quarter takes us back to around the same revenues as reported in 2021, highlighting just how extraordinary 2022 was. The last comment suggests that, from the expected fourth quarter 2023 revenue of $300-$350 million, management expect to reach this normalized level after two to three quarters of recovery.
It is not difficult to calculate how consensus gets to its estimate of $2.15bn for 2024: if we assume gradual improvement from $300-$350m in 4Q23 to $400, in 1Q24, $500m in 2Q24, $600m in 3Q24, and $650m in 4Q24, the total for the year would be $2.15bn. This seems very like a very reasonable assumption to me. And if the company can continue to hit $700m per quarter in 2025, again, the imagination does not need stretching to see that revenue would return to $2.8 billion (SA consensus is for $2.88bn).
You can see all the consensus numbers on the Seeking Alpha Earnings Estimates Page.
2021 GAAP net income margin was 8.6%. If the company can achieve this in 2025, the company will produce $240m in net income, which is EPS of $4.22. This is lower than the SA consensus estimate of $5.71, however, consensus may be taking into account further buybacks, which would give EPS a boost.
The multiple assigned to SEDG is clearly depressed compared to its own history and to peers. But more than that, it is now being priced on depressed earnings. In my opinion this is giving an artificially low share price that could rebound once the market believes the tide is turning. To be sure, there is no evidence of that yet – save for management’s projection that it is likely to occur gradually throughout 2024. But, if you believe it is likely that the SolarEdge business (and that of peers) is not broken and can look through 12 to 18 months of earnings disruption, today’s price of around $73 could turn out to be a bargain. Let’s put some numbers around it.
If we start with the estimated 2025 EPS figure of $4.22 from above, what is an appropriate multiple to value SEDG on? Since its IPO in 2015, SEDG’s average P/E has been 36x. However, there are two very clear periods of time in this chart. From November 2015 to November 2019, the average forward P/E was 16x. But from November 2019 (when the P/E began to noticeably expand) to June 2023 (the month before weakness was first noted by management), SEDG’s average P/E was 61x. I’m not sure either of these are helpful because neither represents the likely environment SolarEdge will operate in over the next few years.
Instead, we could look at a peer set of companies in the solar industry, which includes the likes of Enphase Energy (ENPH), Canadian Solar (CSIQ), and First Solar (FSLR). The average of this peer set is 15x, below SolarEdge’s current forward P/E. Because the entire industry is experiencing the same disruptions and depressed multiples, what might be more appropriate is to use the industry multiple of before the disruption but after industry market P/E’s had somewhat normalized. I took a snapshot in May 2023 and the average forward P/E rating for a set of solar peers was 24.7x. For a company growing strongly – and there is plenty of reason to believe that the industry will return to growth post-2024 – 25x (24.7x rounded) seems like a reasonable multiple.
As another point of reference, the S&P500 traded at 20x 1 year forward earnings in May 2023 and is currently at 22.7x. A growing company such as SolarEdge (post-2024) could be expected to be assigned a multiple of at least the market multiple. In fact, Since IPO, SEDG has traded at a 1.78x premium to the S&P500 forward P/E. My comments regarding SEDG’s historic average P/E notwithstanding, applying this P/E premium to the current market multiple implies a P/E of 40x (22.7 current multiple times 1.78 equals 40.3). I am not going to sit here saying SEDG should trade on 40x, but I think the answer most likely lies somewhere between the 24x multiple discussed above and the 40x market premium P/E.
A 25x multiple of $4.22 per share implies a share price of $105.50, but because this is two years forward, we need to discount this to bring it back to the present value. I am using a WACC-based discount rate of 9.5%, which gives a valuation of $96.35. Because there is much uncertainty involved in estimating what shares could trade at in 12-18 months in this manner, a sensitivity analysis will be highly informative. The following matrix shows what SEDG could trade at in various scenarios. (Note, all values are discounted back one year at 9.5% to account for the time value of money).
The low end of my highlighted range, i.e. 2025 EPS recovering to $3.72 and the P/E of 25x, is still above today’s share price whereas the most bullish case, where the company achieves the consensus forecasts and recovers to 40x P/E sees SEDG almost triple.
The Main Risk: Expectations
The biggest risk facing investors today is that it takes longer for SolarEdge to work through their elevated inventory as a result of prolonged demand weakness. The consensus numbers discussed above clearly show the market is pricing SEDG to begin recovering late 2024 with 2025 being a return to their growth trajectory. Any delay in this occurring will lead to downgrades and the share price will follow.
The entire case for a buy scenario is that earnings recover in 2025. If this occurs, SolarEdge shares are materially undervalued as the P/E valuation scenario analysis above shows. Investors who can look through the coming difficult period for SEDG with a view that sales, growth and margins all return could be well rewarded for their patience.