• SolarEdge stock has plunged some 20% after Q2 earnings.
• Q2 financials were within expectations, and guidance for Q3 a bit soft, but not enough to justify the selloff.
• We argue that market reaction is more related to impending competition from Huawei in the residential solar market.
• We look at Huawei's and SolarEdge's strengths, estimate SolarEdge's value on a zero-growth basis and close with key investor takeaways.

For Q2 2018, SolarEdge Technologies (SEDG) reported a performance broadly in line with our expectations. Q3 revenue guidance was a bit weak, but nothing by itself concerning.

The stock, however, has plunged some 20% after earnings, coming down to the $45 level that it reached after reporting Q1 results.

In this piece, we explore the most likely reason behind the selloff: the impending competition from Huawei.

We start by reviewing Q2 numbers, comment on the relevance of Huawei entering Western markets with a residential solar solution similar to SolarEdge's, highlight SolarEdge strengths to counter the threat, update on valuation and close with investor takeaways. Throughout the article, we also touch on all the main topics discussed during the Q2 earnings conference call.

As a reminder: SolarEdge is a core holding of the market-beating IW Portfolio since August 2015. In February 2018, we presented the long thesis to the investment community. For an introduction to this wonderful company and to understand the valuation methodology employed in this article, we recommend you to have a look at the original long-term thesis before moving on.

Quarterly financials

The numbers

Revenues of $227 million were above guidance and up 67% YoY on the back of a soft Q2 last year. Gross margin of 36.1% came in at the lower end of guidance (36 to 38%).

Q3 guidance calls for revenues of $235 million and gross margins within the usual 36 to 38% range. The revenue outlook represents 41% YoY growth (on the back of 30% YoY growth last year) and 3.5% sequentially.

The 3.5% sequential top-line growth guidance for Q3 was the weakest part of the report. It compares negatively to QoQ revenue growth of 8.2% in Q2 and 10.9% in Q1. Still, compounding QoQ growth rates for the first three quarters of the year (Q1, Q2, and guidance for Q3) brings YTD growth to 24%, in line with our expectation for 20%+ annual growth in the coming years.

To filter out quarterly noise, we like to look at financials on a twelve-trailing-month (TTM) basis. Doing that, we see that Q2 TTM revenue was up 61% YoY with 36.7% gross margin. And Q3 guidance calls for 63% YoY TTM revenue growth and 37% gross margin (assuming  Q3 gross margin comes in at 36.5%, below the midpoint of guidance).

Moreover, on a TTM basis, the company increased operating leverage by 50 bps QoQ and 200 bps YoY.

If there are reasons for concern, they do not yet show in the numbers.

The underlying dynamics

But valuation is about future cash flows, so let us have a few words about ongoing market dynamics.

In 2018, SolarEdge is navigating a flattish solar market in North America, which is responsible for about half of the revenues. This was partially offset by company strength in Europe. And the US residential market is expected to get back to growth next year.

As already mentioned, gross margins fell towards the lower end of the 36-38% target range. To a large extent, we believe that the soft margins were due to temporary headwinds, including Euro depreciation against the US dollar, capacity increases not yet matched by full capacity and a meaningful percentage of product deliveries still being air-shipped. Hence, we wouldn't read too much here and expect gross margins to trend back towards 37% in coming quarters.

For readers not familiar with the company's gross margin trajectory, some perspective: in fiscal 2014, the first full year before the IPO, gross margin was 16.5%. Since then, economies of scale, R&D cost-cutting initiatives and manufacturing automation have more than offset ASP erosion to bring the gross margin to the company's target range of 36 to 38%, a milestone first achieved in Q4 2017.

In the future, the company will pass further cost-cutting achievements to its customers in the form of lower prices, rather than letting gross margins creep up higher. This provides the company with ammunition to fight entrants (mainly Huawei) and keep taking market share from incumbent competitors (Enphase Energy ENPH, ABB, SMA, Fronius).

Huawei headquarters in Shenzhen, China (ZDNet)

Huawei

Competition from Huawei in the residential solar market looms large on the horizon for over two years. Now, after a delay of about one year, it seems to be finally arriving.

The Chinese telecom and IT giant, which also happens to be the world's largest manufacturer of utility-scale solar inverters, introduced its residential solar power electronics solution in Australia and Germany earlier this year and is in the process of entering the US market.

Huawei's residential solar solution is inspired by SolarEdge's. It consists of module-level DC optimizers, a multi-level inverter and a cloud monitoring and management solution, and offers support for battery and smart home integration.

In the past two months, SolarEdge has filed a lawsuit for patent infringement against Huawei and its German distributor in the regional court of Mannheim, Germany.

SolarEdge claims that Huawei's products infringe on three patents related to SolarEdge's power optimizer and HD Wave inverter technologies. The Israeli company is seeking damages, an injunction and a recall of Huawei products from the German market. Huawei has rejected the charges and will fight the claims.

To an analyst question about IP protection in the US, CEO Guy Sella stated that "the total portfolio of patents [..] in the US is dramatically stronger than [..] in Germany".

Now, we have no edge on the most likely outcome of this and other potential legal cases. 

What we know is that the CEO has reported not having seen the sightless loss of market share to Huawei as of August 2018.

We also know that the threat of Huawei should not be downplayed, as Western telecom companies Siemens, Alcatel, Nokia, Motorola, and Ericsson, which have competed against Huawei in the network infrastructure market in recent decades, know too well. In those instances, Huawei was able to navigate the incumbent's patent portfolio on its way to the top of the market.

Established in Shenzhen in 1987 by Ren Zhengfei, Huawei has grown from a small importer of office telecom equipment into one of the world's biggest telecom and IT equipment vendors (some readers may be familiar with its line of smartphones). Incessant innovation in cost-cutting and customization, as well as scale advantages owed to the size of its local Chinese market, make of Huawei a formidable competitor. At over $90 billions in annual revenue, Huawei is China's largest exporter and a role model for Chinese companies looking to leverage their local strengths beyond national borders.

SolarEdge weapons

Having acknowledged Huawei's credentials, we need to put them into the context of SolarEdge's strengths.

The first, already mentioned, is its intellectual property portfolio.

The second is a pristine balance sheet free of debt of $430 million ($8.6 per share) in distributable cash equivalents and hefty margins.

In third place, it should be mentioned that SolarEdge is used to compete against companies many times its size. In fact, it has been gaining market share from much larger competitors since its foundations.

Moreover, SolarEdge has a relatively well-diversified customer base across geographies (US, Europe, and APAC) and product categories (residential and commercial).

The company has gained and continues to gain market share from competitors on a steady basis, both in commercial and in its original bread-and-butter residential sectors. As said before, SolarEdge will forego further gross margin expansion going forward, which increases its ammunition to fight competitors with lower prices. Also of note: in mid to end 2019, 3-phase commercial inverters will be migrated to SolarEdge's award-winning HD-Wave topology, which will bring significantly lower costs, as has been already the case in residential.

Future US tariffs on inverters and optimizers originating from China was another topic of discussion during the conference call. SolarEdge indicated that any financial impact would only be transitory (a few quarters), while the company ramps up manufacturing in Romania and Hungary to serve the US from Europe while using China capacity to serve European markets. We would anticipate Huawei to be more strongly impacted by US tariffs on Chinese imports. Yet, while a slight negative on an absolute basis, the tariffs could be seen as a positive in the context of competition with Huawei in the US market.

Moreover, the company has a pipeline with several new product categories (solar and non-solar) that could drive meaningful growth in the coming years.

These include:

Utility-scale solar

SolarEdge's strategy has been to start with residential-scale systems and build its way into higher-power systems over time. In Q2, the commercial was already responsible for some 43% of sales on an MW basis, and the next horizontal expansion will be into utility-scale solar. A 27 MW ground-mounted installation is already under commissioning in India, but the inflection point will come during the next 1.5 years with the introduction of 4 new products designed from the ground-up for utility-scale installations. The company wants 20% of deliveries to be utility-scale "in a few years".

Incidentally, SolarEdge's strategy is the reverse of Huawei's. The Chinese company got started with utility-scale string inverters, and later expanded to commercial and now residential scale. So while Huawei challenges SolarEdge's supremacy in residential, SolarEdge will be eating into Huawei's business in utility-scale solar.

Uninterruptible Power Supply (UPS) solutions

Following the purchase of assets from Gamatronic closed on 1 July 2018. Although the impact of the acquisition in 2018 will be negligible, the company expects a dramatic increase in profitability within 4 quarters.

For details on the purchase, we refer readers to our previous research piece on SolarEdge.

Other categories adjacent to solar

Adjacent categories include power electronics for residential stationary storage systems (StorEdge), electric vehicle charger inverters and virtual power plant solutions. The latter would extend the monetization of inverter systems sold in the past at lofty margins.

Valuation

As of Q2, we estimate SolarEdge's steady-state TTM earnings power at $145 million, or $2.93/share. Our adjusts reported financials to zero-growth (steady state) based on certain assumptions, described in the original research piece we shared in February this year.

Using an 8% discount rate (12.5x multiple), that puts earnings power value (EPV) at $36.6/share. Adding the $8.6/share of distributable cash brings the total value to equity-holders to $45.2/share, or about the current stock price.

Investor takeaways

At $45/share, SolarEdge stock can be bought today at 1x EPV, using a discount rate of 8%.

What that means is that if the company restricted future investments to those necessary to preserve its current earnings power and succeeded in the attempt, investors at today's price would realize 8% annualized returns.

It also means that investors should expect annualized returns in excess of 8% if earnings grow in the future as a result of investments at returns above the cost of capital.

And on the contrary, that if future earnings decline or if the company is forced to ramp up investments aggressively to protect earnings, annual shareholder returns would fall under 8%.

So the investment thesis boils down to the strength of the company and its future avenues of growth relative to the competitive threat of Huawei.

Our view is that, at 1x EPV, the positives outweigh the negatives. We have trust in this management team and believe that the company has ample resources at its disposal to navigate the challenges.

So we are maintaining SolarEdge in the IW Portfolio and believe that investors can benefit from initiating a long position at today's price.

Investors wishing to participate in SolarEdge's growth story but wary of Huawei can devise partially hedged strategies, such as long SolarEdge short Enphase, on the rationale that if Huawei hurts SolarEdge, it is likely to kill Enphase (much weaker balance sheet and competitive position, and no presence in the commercial sector). We are not recommending to short Enphase as we have not researched it in any depth, but we wanted to mention the idea for readers who may want to take it from there.