Summary

• SolarEdge closed 2017 with another blowout quarter: strong market share gains, stable ASPs, and continuous cost initiatives resulted in record sales, profitability, and cash generation.
• During the earnings conference call Q&A session, a detailed outlook was given on future geographic and segment mix. The positive implications on growth are analyzed.
• We estimate the value of the assets and of the business earnings power.
• We find that SolarEdge is trading at an insufficient premium over Earnings Power Value in light of its first-class return on capital and expectations for significant revenue growth.

SolarEdge Technologies (SEDG) designs, develops, and sells direct current optimized inverter systems for solar photovoltaic (PV) installations worldwide. The company's systems include power optimizers, inverters, and cloud-based monitoring software and are used in a range of solar market segments, including residential, commercial, and small utility-scale solar installations.

SolarEdge was founded in 2006 in Israel. It revolutionized the way power is harvested in residential solar installations with an intelligent solution that optimizes the DC voltage at the individual PV module level while performing the DC-to-AC conversion in a centralized inverter. This architecture maximizes power generation, even in the presence of shadows or irregular roof geometries, while lowering system costs. It also allows for real-time safety and monitoring capabilities.

Since its foundation, the company has expanded both geographically and across market segments. Longer term, it is aiming squarely at becoming the leading provider of inverter solutions across all solar PV market segments.

The common stock trades in Nasdaq since 2015 and is in our market-beating portfolio since August of that year. We added aggressively to our long position during the sell-off in 2016 and are now sitting on triple-digit returns.

Q4 2017 results and guidance for Q1 2018

For its more recent quarter, the company reported 70% Y/Y revenue growth and 129% Y/Y operating income growth, thanks to a 250 bp gross margin expansion and operating leverage.

For Q1 2018, SolarEdge is guiding to revenues of $205 million (implying 78% Y/Y growth) and flat gross margins of 37% at the midpoint.

It should be noted, however, that those comps are against Q4 2016 and Q1 2017, which were unusually weak due to the effects of the last-minute extension of the Solar Investment Tax Credit Extension on US demand for solar PV systems. On a TTM basis, Q4 2017 revenue increased 24% Y/Y, and Q1 2018 guidance calls for 45% growth.

Implications of geographic and segment mix outlook on growth

SolarEdge does not provide specific guidance beyond the next quarter.

However, during the Q4 2017 earnings call Q&A session, management provided a detailed outlook on the geographic and segment mix shifts expected during the next 3 years.

Here, we derive the minimum growth assumptions implicit in that outlook.

CEO Guy Sella provided the following guidance on geographic mix, on a MW (megawatt) basis:

As I mentioned in the past, on a yearly basis, I believe that in 2018, we'll end the year where 50% or a little bit less coming from the North America and probably around 45%, 45% to 50% coming from North America where the rest is coming from Europe and rest of the word. For our longer term model, probably for 2019, '20, it will be 33% from North America, 33% from Europe and 33% from Asia.

In Q4 2017, the mix was 60% North America and 40% rest of the world. Hence, even assuming no growth in North America for the next three years, the following growth rates are implicit on the mix shift:

• 25% growth in 2018 to get to a 48% North America/52% rest of the world mix.
• 22% CAGR through 2020 to get to a 33% North America/67% rest of the world mix in 2020.

Furthermore, Mr. Sella stated:

We would like to get on a megawatt basis by the end of the year to 50-50 percent between commercial and residential.

Non-residential represented 33.1% of MW shipments in Q4 2017. To get to a 50-50% mix in 12 months, and assuming no growth in residential, non-residential shipments would need to increase 34%.

The price of a commercial MW is lower than that of a residential, so dollar growth would be somewhat lower. Also, some price erosion is expected in the upcoming years, particularly in commercial systems.

But this growth rate assumes zero growth in residential in 2018 (very conservative), just as the 22% CAGR through 2020 assumes zero growth in North America during the next three years (again, very conservative).

A more realistic 3-year revenue CAGR is probably in the vicinity of 30%, with revenues doubling in the next three years.

Valuation

While Wall Street calculates target stock prices based on complex discounted cash flow models that rely on a number of highly uncertain predictions about the future, at Investment Works, we calculate intrinsic value starting from what we know with relative certainty (asset value), and only then moving progressively, but with full awareness, toward more uncertain components of value (the value of current earnings and the value of growth, if any).

Rather than wasting effort on putting precise numbers to variables such as cash flows, capex, changes in working capital or interest rates several years into the future, we assess where the company is today, and devote that effort to build an understanding of the intricacies of the company's competitive environment, for it is that competitive position and its durability that determine whether the company can sustain excess returns or realize value-generating growth.

Net asset value

The book value of stockholders equity is $397 million as of end of 2017. The balance sheet does not call for significant adjustments beyond the addition of the value of intangible assets including the product and IP portfolio, technology development platforms, manufacturing know-how, supplier and distribution channel relations and customer reputation.

We estimate that a potential entrant would need to spend 3 full years of R&D expenses, 2 years of S&M expenses, and a year of G&A expenses to reproduce SolarEdge's intangibles. This assumption brings the net asset value to $656 million, $338 million of which is comprised of distributable cash and marketable securities, that is, not related to the generation of operating earnings. Net operating assets are estimated at $318 million (656-338).

Earnings Power Value

The figure below provides our estimation of TTM revenues and after tax operating margin, had the company decided not to invest in future growth. This is what value investors often refer to as "earnings power" or "current earning power".

SolarEdge Revenues and Profit Margin from 2015 to 2018 SolarEdge TTM revenue (million USD) and adjusted after-tax earnings margin (source: Investment Works)

The assumptions and adjustments for the calculation of zero-growth after-tax operating margin include:

• The use of estimated maintenance capex (or capex required to maintain ongoing revenues, without growth) in lieu of GAAP depreciation charges.
• The capitalization of R&D and S&M expenses, linearly amortized over 3 and 2 years, respectively. This is done to differentiate the expenses required to maintain the ongoing level of earnings from the investment in future growth.
• Stock-based compensation is considered a recurrent expense.
• A tax of 20% is assumed. This is conservative, considering that SolarEdge currently enjoys a tax holiday on profits in Israel (ending beginning of 2019), after which the rate stays at 12%, and a 21% tax rate in US.

For the calculation of Earnings Power Value (EPV), of the present value of current earnings assuming no future growth, we use:

• Annual revenues equal to 4 times Q4 2017 revenues or $757 million.
• After tax operating margin remains constant at 14%. This is likely to prove conservative since the company has guided to flat G&A expenses going forward and flat gross margins in the 37% ballpark. Moreover, management has played down fears of competition from Huawei, noting that it has successfully out-competed established competitors such as SMA, Fronius, or Enphase Energy (ENPH) for many years and that Huawei's product introduction in Australia is inferior and more expensive. The easing of component shortages in the back half of the year should also help sustain margins.
• A discount rate of 8%.

Current earnings power is estimated at $106 million (0.14*757), and EPV, at $1,325 million (106/0.08), or $28.27/share using 46.876 diluted shares outstanding.

Besides the value of current earnings, the company has $388 million ($7.20/share) in distributable cash and marketable securities and no debt.

Adding that to the value of earnings, the EPV to equity holders is estimated at $1,663 million or $35.5/share.

Takeaways and future coverage

SolarEdge stock is trading at an all-time high in the mid $40s, following a 20% gain after the earnings and guidance surprise.

At $45, the stock trades at a 27% premium over our conservatively calculated EPV.

But this is a business generating 30%+ returns on capital ($106 earnings power on $318 net operating assets). Assuming a cost of capital of 8%, that means that this is a business that transforms a dollar of investment into $1.20, every year (1.30/1.08).

And with expected sales CAGR near 30% through 2020 within segments in which the company operates at a competitive advantage (hence the excess return on capital), there will be no lack of investment opportunities.

These two ingredients together, abnormal returns on capital and vast investment opportunities within an established franchise, result on wonderful shareholder value creation. And as of today, there is no competitor in sight likely to erode that competitive position.

Hence, in our opinion, the value of that growth is likely to exceed the current stock price premium over EPV by a large margin.

We recommend investors to maintain or add to their long positions.

This research piece was originally published in invworks.com