Solar energy is expected to grow some 6,000% over the next few decades, but that’s not a signal to rush in blind. That growth will come with a lot of huge swings up and a lot of crashes back down to earth.
In this week’s episode of Industry Focus: Energy, host Nick Sciple and Motley Fool contributor Jason Hall tell listeners what they need to know about the solar industry to invest without getting blown away by the volatility. Find out more about yieldcos, installers, manufacturers, and more — along with a few stocks from all those segments that look pretty promising for the long term. Also, the hosts look at recent developments out of OPEC, and explain how they’ll affect the oil industry in the next few years.
A full transcript follows the video.
This video was recorded on Dec. 20, 2018.
Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, December 20th, and we’re discussing energy. I’m your host, Nick Sciple, and today I’m joined by Motley Fool contributor Jason Hall via Skype. How are you doing, Jason?
Jason Hall: Good! It’s been a little while since I was on. I’ve crossed multiple countries since the last time we chatted.
Sciple: Crossed multiple countries. Our two college football loyalties had an epic SEC championship game in Atlanta.
Hall: I’m still wearing a red shirt. I want to point that out. This is not a crimson shirt, this is a Georgia Reds shirt.
Sciple: No judgment here. Who are you going to be rooting for here in the college football playoff coming up in the new year?
Hall: Alabama looks incredible, they really do. Having three weeks off is the best thing that could happen for them to get healthy, get that knee finally at least back to 80%. It’s going to be tough. I think Clemson’s going to absolutely destroy Notre Dame. I’m sure that the college football playoff people don’t like the idea of having 3.0 Clemson Alabama, but I think that’s going to be the final. It’s going to be a really good final. I think the difference between Clemson and Alabama is a lot closer than most people are acknowledging at this point. We’ll see. What about you? I’m pretty sure I know who you’re picking.
Sciple: I’ll tell you who I’m rooting for, it’s Alabama. Probably the best quarterback that’s ever been there in the history of the university. The team is just so deep. I will say, Clemson is definitely a team to watch out for. Their quarterback has really done well in his freshman year. Then, that defensive line is really the heart of the team. Most of their guys could have gone to the NFL last year, could have been first round picks. All came back. Very similar to Georgia last year, bringing back a lot of those seniors who really could have left that junior year. It’s going to be interesting to watch. I’m definitely looking forward to it.
Hall: You hit a key thing there with Clemson. Their entire front seven, but especially their down linemen, are so good, they’re so disruptive. They’re going to be able to control the run game pretty well. If they can disrupt and they can contain Tua. I think Georgia did a really good job with that, but he wasn’t healthy. I think you have to acknowledge that. But nobody really slowed Tua down as much as Georgia did. And Clemson has a much better front. Their down linemen are, like you said, they have three or four guys there that could be playing on Sundays now. That’s going to be the difference in the game. I really do.
Should we talk about investing, too? Should we do the energy thing?
Sciple: Yeah, let’s do that! For listeners who aren’t college football fans, sorry about that. Gotta scratch that itch every once in a while when I’ve got Jason on the show.
Sciple: We’ve got a packed show today, Jason. We’re going to lay out everything investors need to know about jumping into solar investing, all the way from making the panels to the utility providers of energy.
First, let’s catch up on a little bit of news out of the oil markets we’ve had in the past couple of weeks. Probably most significant news has come out of OPEC plus. When we say OPEC plus, we’re talking about OPEC plus Russia and a few others. On December 7th, a recent agreement to cut oil by 1.2 million barrels per day, which was a larger figure than had been anticipated. It’s in the hopes that it’ll stabilize oil prices. We’re down now about 35% off our four-year highs we saw back in October. What are your thoughts about this cut and what it’s going to do to the energy markets, particularly oil, over the next year or so?
Hall: I think it’s just a stopgap move. Even the folks at OPEC and out of Russia — it’s funny, Russia has more influence over OPEC, I think, than half of OPEC’s own members do, which is interesting and strange. But, yeah, I think it’s a stopgap move, and I think they’d tell you the same thing.
It’s remarkable. Oil is down by basically a third since October 1st. It’s a massive, massive drop in a pretty short period of time. I think it is going to provide some stability, especially considering that the biggest source of new production has been the U.S. The Permian Basin has just been pouring new oil out at like a million barrels average annual growth for two or three years now. But we’re at pipeline capacity in that region. That’s going to carry out until late in the third quarter, early in the fourth quarter of next year, before we start seeing pipelines coming on to start bringing more of that oil out.
I think this is going to give the market some of the stability that it needs to see over the next six to nine months. But, there’s a caveat. That caveat is global demand. Between fears of a trade war with China and the U.S. potentially stalling global economic growth, if that weighs on oil demand, if the demand part of the equation changes quickly, the market could get another shock. But if you were to hold a gun to my head, I’d say a year from now, oil is probably going to be where it is now or maybe a little higher. It’s going to move a lot in between now and then. We’ll see what happens. What do you think?
Sciple: As always with these global commodity markets, it’s difficult to predict what’s going to happen. We also had some unpredictable developments throughout this year. In Libya, we had some militias shutting down some wells there. Obviously, Venezuela’s collapse has continued to play out. It’s hard to predict those sorts of things. As more pipeline capacity does come on in the Permian, we’re probably going to get more supply coming out of there. As you mentioned, if we see a little bit of a turndown in oil demand, that really could lead to an oversupply problem. The EIA has said that they don’t expect shale production to slow, and that we may see some oversupply going into 2019, barring, as I mentioned, some unplanned outages like we might see out of Libya or Venezuela. It’s difficult to predict, but I think I probably agree with most of what you said there.
Let’s go to this other story out of OPEC. You talked about Russia having more control over what’s going on with that cartel than some of the members. There has been some discontent among membership in OPEC. Qatar most notably, it’s being called #Opexit. They left OPEC after 57 years of membership. Their Energy Minister said when they left that OPEC is an organization managed by a country, in a veiled shot at the Saudis. They really had some conflict with them. Qatar wants to push harder into natural gas.
What do you think about Qatar leaving OPEC? Is it a sign of any instability in that cartel going forward? There are some other countries that have showed some discontent the way things are going. Venezuela, Kuwait, Nigeria, Algeria have all been countries that have mentioned having some friction with the leaders in the cartel.
Hall: I’ll say right out, I don’t think this is any sign that OPEC’s about to break. I don’t think that’s even close to happening. You have to look at the Qatar situation on an island. Qatar has its own problems. Qatar and the Saudis, there are some serious issues. But also, if you look at Qatar, I don’t think a lot of people understand that Qatar is really a natural gas producer. That’s a significant part of what they do. Honestly, I think it’s going to get the benefits of geographically being in that same region with most of OPEC, and OPEC’s actions, and it’s going to have a little more freedom being separate from the cartel, especially in terms of its oil production. But, again, natural gas and natural gas liquids are a bigger part of its business. It’s probably a little more noise than signal, in terms of what it really means for OPEC.
Hall: Sure. Just to mention for our listeners, with Qatar pulling out of OPEC, their oil production is significant, but them not coming along with the cut that OPEC is doing and leaving what the cartel is doing there is not going to significantly impact global demand or really mess up the supply demand dynamics we were talking about earlier.
Hall: Right. Thinking now from an investor perspective, I think this the key thing — if you think about, obviously, from a consumer perspective, how this affects our pocketbook with oil prices, that’s one thing. As an investor, the big takeaway is that if you think about what has happened over the past three or four years across the oil and gas industry, producers of every size, the private companies, the stocks that we invest in — if a company has survived the past three or four years, they’ve done it because they found a way to lower their production costs. They’re drilling cheaper, they’re maintaining wells at lower costs, they’re finding ways to be more efficient with how much they produce. That’s the key. If you find the oil companies that are able to produce… you know, they are looking at $40 for the breakeven — I know that’s a number that ConocoPhillips talks about — understanding how oil prices affect the economics of individual companies is the key thing. If you’re going to invest in the sector, in production, find your low-cost leaders. That’s where you’re going to own a company that’s going to be able to thrive at $50 or $60 oil and is not going to struggle if oil falls back into the $40s or even lower.
Sciple: Related to that, you can look at how hedged companies are to oil prices. The less hedged a company is, the more upside they’re going to capture when oil moves up, but also, the more downside they’re going to have to absorb as prices move. That’s a thing to keep in mind about the risk-reward when you’re looking at these companies.
OK, now, let’s move on to our main topic, which is solar energy. As I’ve mentioned, a few weeks ago, I did a show with Brian Feroldi on residential solar.
Hall: It’s a great show, by the way! That was a great show!
Sciple: We broke down all the things that you need to know about investing in solar for your home, whether it’s appropriate for your home. how to take advantage of the solar investment tax credit — which, as I mentioned on that show and I’ll mention again today, since that solar investment tax credit was put in place in the United States, we’ve seen a 59% compound annual growth rate in solar installation in the U.S., and there are expectations that global solar capacity will increase as much as 6,500% over the next three decades.
Jason, I know you just wrote a very long breakdown of what’s going on in the energy industry. I will drop that in our podcast description for our listeners if they want to go take a look at that.
Those growth rates are really impressive. But when we’re talking about solar, what all goes into that industry? What are the steps in the supply chain to get those panels from manufacturer to your home?
Hall: It’s a relatively complex industry. It’s certainly an international industry, like a lot of other types of manufactured products. A lot of its manufacturing has shifted overseas and is based in China and Southeast Asia.
Essentially, what you have is, you have the solar module, or the panel, as most people think of it. It’s made of solar cells, these individual cells that are grouped together. You have basically two different sizes. You have the size that goes on a house or goes into a commercial installation, maybe on a parking garage on top of a Walmart or a manufacturing facility. Then, you have industrial panels, or utility-scale panels, which are for these giant solar farms that you might see covering acres and acres of land. A utility company might operate those, or they might be buying power from them. So, you have the companies that design the cells and then assemble them into the modules. And, you have companies that do the installation on residential and commercial. These are the companies that are the middleman. They’ll buy the solar panels and they’ll put them on your house. They deal with all the local licensing and local permitting. They work with your utility to tie everything into the grid.
In between, you have companies that are more specialized. Maybe they manufacture mounting hardware to make it easier to install those panels on your roof, so it’s faster for the installers. So, their labor costs go down, and they can pass the savings along to you. Then, they can be a little more profitable, they can do more installs in a given amount of time.
The industry is also becoming smarter in terms of getting the most efficient production, measuring it, making sure that you’re getting the best production based on how the system’s installed. You’re seeing a lot more of the electronics in between the panels, which produce DC energy, which is what your car battery uses. And then, there are electronics called inverters that convert it to AC energy, which is the energy that your lights in your house and your dishwasher and all of those devices use. It does that conversion. And you’re seeing those devices get smarter and better, more efficient. More of the sunlight that hits the panel makes it all the way through back to the grid to power your house. Improves the costs, makes it more cost effective. There are a few companies that are really interesting in the middle that make that part.
And now, you have batteries. That’s been one of the big problems that we’ll talk about in a little bit, is making sure that solar production matches up with when the grid is able to produce and when actual energy consumers are consuming. So, batteries are becoming a big deal, being able to store and tap the solar energy when it’s most needed.
Then, on the back end, you have even more companies involved. The utility companies of the solar business. You have what they call yieldcos, which are companies that build these utility-scale projects. Maybe they make an investment in a really big one with other yieldcos. Then, they sell the power to the utility companies, or in some places, directly to large industrial users on long-term contracts. These are really good dividend investments.
Whether you’re looking for growth, a value opportunity, a niche special situation company, if you’re an income investor, there’s something for everybody in this space. But it’s really dynamic. There’s still a ton of consolidation going on. It’s heavily cyclical. You can see demand go up and down in 30% or 40% demand swings over a year or two. Even though we’re talking 6,000% growth over the next 30 years, there are really big cyclical swings that can happen from one year to the next that have significantly impacted solar investors. You need to understand that before you go in. You can see big losses in a very short period of time that you may have to hold through to come out of the other side before the profitability shows up.
Sciple: Yeah. Let’s talk about the segment of the market that probably has suffered the most from that cyclicality. That’s the solar panel makers and manufacturers. Earlier this year, we saw President Trump put in place a 30% tariff on imported total solar panels. However, even in spite of that, taking a lot of this imported supply, making it more expensive, we’ve still seen solar panel prices decline significantly over this past year as demand has fallen. Do you want to talk a little bit about what’s going on with that over the past year or so?
Hall: Initially, at least in theory, the way it was presented was that the idea behind the panel tariffs that were put in was that it was supposed to create incentive to bring solar manufacturing to the U.S. Frankly, that hasn’t happened. There were a few projects that were announced. I know that First Solar (NASDAQ:FSLR) is making a big expansion, but they’re expanding a facility where they were already doing some domestic manufacturing. Ironically, their solar panels are excluded from the tariffs anyway, because the thin film technology they use is not the same monocrystalline multicrystalline technology that’s where the tariffs are.
Hanwha Q CELLS announced a big plant in Florida that was supposed to add like a thousand jobs. It was going to be a huge deal. After multiple revisions, what they’re saying now is, it’s going to create 50 or 100 jobs, and it’s going to be completely assembly. They’re taking cells that are still being manufactured overseas, shipping them into the United States and assembling them into panels.
Frankly, the tariffs haven’t generated anything like what was purported to be the job creation and bringing solar panel manufacturing to the U.S. Now, a couple of reasons why that’s happened. Probably the biggest short-term reason is the U.S. announced these tariffs early in the year. Close to the middle of the year, China made some substantial changes to its domestic distributed solar policy, which absolutely cratered demand for panels. Panel prices have plummeted since then because you have this massive overcapacity. It’s like oil. OPEC has announced this cut of oil because there’s too much oil. The idea is, that should restore some supply and demand. Essentially overnight, we had a massive oversupply of solar panels. Solar panel prices in the U.S. have actually fallen more than the amount of the tariffs because of this massive cut in China’s domestic program to add distributed solar. You could actually buy solar panels in the U.S. today for your house, theoretically, for cheaper than you could have a year ago. [laughs] That’s where we are.
The end result is, you think about an industry that’s already a fairly commodity product, companies like Canadian Solar, Jinko Solar, who by revenue are two of the biggest solar panel manufacturers, and the vast majority of their manufacturing happens in Southeast Asia. They sell a commodity panel. It’s a low efficiency panel and they lead on price. They’ve had to slash their prices because demand has evaporated in China.
Sciple: It’s kind of a funny coincidence, the U.S. comes out with a 30% tariff and then magically, demand plummets to where it doesn’t affect China in a meaningful way. I don’t know if that’s a coincidence or not. [laughs] You mentioned First Solar getting an exclusion from tariffs as a result of their technology being a little bit more unique relative to the commodity panel makers. Can you talk a little bit about the dynamic between the tech-focused cutting-edge panel manufacturers vs. what you’re seeing from some of the more commodity-focused manufacturers like Junko Solar? What should investors think about when deciding where they should allocate their cash between those two broad categories of panel makers?
Hall: There’s three legs to this stool. You have the companies that are focusing more on the commodity. They’re really focusing on driving down the cost per watt as much as they can. You have two panels, they’re the same size physically, their power production qualities can be very, very different. For example, let’s say you have a SunPower (NASDAQ:SPWR) panel. SunPower makes some of the most efficient panels that, per square inch of space, they generate the most electricity, in terms of output on the backside. Then, you take a Canadian solar panel or a Jinko solar panel, they may only be operating at 16% or 17% efficiency. So, you think about the difference between 16% efficiency and 21%, that 21% panel actually generates about 20% to 24% more electricity. So, for the same size, you’re getting a quarter more power. So, when you’re actually pricing them out, you look at the cost per watt, which normalizes based on actually how much power you’re getting from it.
Companies like First Solar, which makes the thin film panels, which work really well in temperature variations like high heat or colder area. They tend to produce a more consistent amount of power. Then, SunPower, which is super high efficiency.
Then, on the other hand, you have the commodity panel manufacturers. What you have to look at with these companies is, look at their cost per watt. How much does it cost them to manufacture a panel on a per wattage basis? When you’re looking at them as an investor, that’s something you really want to understand about their business.
The next part of it is, you want to think about balance sheet management. This is an excellent year, but demand can shift substantially from one year to the next. You have to look at how financially well-built the company is in terms of being able to ride that out. On the best-case scenario is definitely First Solar. This a company that has a little over $2 billion in cash on its balance sheet right now. We’re heading into 2019, which is not expected to be a particularly good year for the solar industry. It’s going to be a little more stable than 2018, but it’s not going to be a particularly booming year. First Solar is going to invest somewhere between $650 million and $750 million in adding to its manufacturing capacity, to its Series 6 panels, which are its newest, most efficient panels. It’s still going to generate roughly $300 million in positive cash flows over what’s going to be a bad year, and it’s going to be making substantial investments.
Most of its competitors are going to spend 2019 just trying to make it through. You’re not going to see them being able to make these big investments because most of these companies don’t carry anything like the amounts of cash that First Solar has. Also, they tend to carry substantially more debt as a portion of their total net value.
That’s the reason for me. When it comes to investing in a panel maker, SunPower is one that’s always at the top of my list. If you look at how much it stock price has fallen this year, now’s a great time to be looking closely at SunPower.
Sciple: SunPower, not First Solar?
Hall: Oh, sorry! I was looking at SunPower on my screen. [laughs] First Solar. Thank you for catching that! Yeah, First Solar is absolutely at the top of my list and generally always stays there, especially the price it’s at right now. I think it represents a pretty good value.
Sciple: It sounds like it’s very similar to what we talk to our listeners about with oil and natural gas businesses. You really need to have a strong balance sheet to be able to ride what goes on in the cycle and be able to make investments not whenever it works for you, but whenever the market justifies it.
Hall: Probably the best industry to compare it to, in terms of the cyclicality, is the steel industry. Think about steelmakers. It’s an industry where the shifts in demand can be very sudden and very large. But these are very capital-intensive businesses with high fixed costs. You can quickly swing from losses to profits in a very short period of time. A company we’ve talked about before, First Solar is kind of like a Nucor of the solar industry. It doesn’t pay a dividend, it’s a newer company, but in terms of that balance sheet, management that does a really good job of allocating capital, that’s a good comparison for me.
Sciple: Let’s move on into the installers. We mentioned a little bit with the falling demand out of China that we’ve seen panel prices really fall in a significant way, enough to even make up the 30% tariff that was put in place earlier this year. In a year that looked like, when the tariffs first dropped, it might be tough times to be a panel manufacturer as your input costs rise and it’s more expensive for folks to hire you to install solar on their homes, it’s actually turned out to be not that bad of a year for them. What are you thinking about this space with the installers this year?
Hall: It’s been surprisingly good, it really has. I’ll tell you, a year ago, I was pretty negative on companies like Sunrun, Vivint Solar. Those are the two largest pure play publicly traded solar installers. I was pretty negative on them because of the looming tariffs and how that was likely to impact demand domestically. But, I’ll tell you, especially for Vivint, it’s been a good year. I think stock is still up something like double over the past year, which is really good. The company’s also built up a pretty good book of recurring revenues that it’s going to own.
I’ll talk really quickly about how these companies work and how they make a living. Essentially, they do two things. They sell you a solar system and install it, and they make a profit on that sale. Then, they can make recurring income over time for maintenance and support that thing. The other way that they make money is, if you don’t want to buy or finance, take out a loan, to acquire a solar system, there are solar leases and there are PPAs, or power purchase agreements. These are long-term like 20, 25-year contracts. What happens with these is, the solar installer maintains ownership generally. Sometimes they sell it to a third party, but generally, they maintain ownership of that asset and it goes on their books. Then, they have a source of recurring revenue that they can make a living from over time.
I think Vivint Solar has something like $8.10 per share on its books in present value of the long-term contracts that it holds. The benefit for you as a consumer of doing one of these PPAs or lease agreements is that you get a fixed payment based on whatever your usage is going to be. And generally, you can reduce vs. your energy bill because your energy bill basically goes away. You may pay a little bit to your electric utility, but you can save 20-30% off of what you would normally pay your utility. You don’t have to make a major financial outlay or take out a loan to buy the solar system. And you know that the installer is going to take care of maintenance and repairs and keeping the system up and working.
The benefit for them is, typically, these can be a little more profitable for them than just selling you a system. That’s part of the trade, too. They can make a little bit more money on these deals, and they can capture recurring cash flows for the length of that contract.
As an investor, if you’re looking at these businesses, you want to understand, what is their mix of business? Can they sell systems profitably? And can they profitably do these solar leases and PPA agreements? Especially as interest rates are going up, that’s going to put a little bit of a squeeze on them to continue making the same margins. They have to get money to pay for those systems still, and it’s typically debt that they take out. You have to understand that.
Sciple: I mentioned with Brian when we talked about residential solar panels a few weeks ago about the solar investment tax credit that’s going to be rolling off after the end of 2019. That’s going to impact demand from individuals if they want to install solar on their home. Unless I’m mistaken, it’s going to impact whether these installers, when they do these lease agreements, can get that tax credit on their investment to purchase the panels. As that tax credit rolls off, of course there’s a chance that Congress could reup it.
Hall: That’s already happened once. We saw that a couple of years ago when it was set to expire. Congress extended it for a couple of years. It doesn’t just go away. There’s like a few years where it drops down a little bit each year. That’ll play a role as well. There’s a number of factors that are going to come into play. It’s hard to say. The reality is, the industry is a lot healthier now. We’ve already seen a lot of consolidation. We’re going to see more consolidation over the next couple of years. Where those credits have a bigger impact is on the utility-scale side. In general, these companies are budgeting three years, five years out for some of these types of investments when they’re looking to add capacity. Maybe they have a coal power plant that’s coming that’s 40 years old, and they’re going to need to start replacing the power that it produces. So, they’re starting to look at adding renewables to replace that capacity.
And if they’re setting their budget for investments they’re going to make in 2020, and they’re finalizing those budgets in 2019, and there’s no clear path from Congress that they’re going to increase or extend, they have to build their budgets based on what they know. That’s where this can have a bigger impact on forecasting demand. This is what creates those big cyclical swings more than anything, is the utility demand from year to year. That’s what we saw last time, when Congress extended the taxes. It happened so late in the budgeting cycle for the utilities that there wasn’t a lot of upside the next year that it happened. It was a year later before we really saw it.
But what we did see happen was, a lot of companies pulled forward deals. First Solar, for example, and SunPower as well, they pulled a lot of business forward because companies wanted to get it done before the tariffs expired. Maybe we see a little bit of a bump toward the end of next year if it looks like the tariffs are definitely going to not get renewed. If companies can find the money in their budgets to do some of these commercial or utility-scale projects, they can really move the needle in terms of affecting the big numbers for the panel makers.
But, for the residential guys like Sunrun and Vivint, it’s really residential solar that moves the needle for them. They’re built where they can ride out the changing economic environment with the incentives set to start declining. A good way to see that is that panel makers have had to drop their prices 30% on average this year, and we’re not hearing about a bunch of panel makers going out of business. That’s the big thing. The input costs for them are set to continue through as the incentives get changed.
Sciple: Yeah, definitely something for investors to watch in this next year in this space. Let’s go into the solar component accessory manufacturers. This is something that gets me the most excited. These are the folks that make inverters, as you mentioned off the top of the show, they make some panel mounting racks, but the really exciting stuff in addition to the inverters is what’s going on with the energy storage systems. If solar is going to be a larger and larger segment of our energy production over the long-term, we’re going to have to find a way to store some of that energy produced during the day when the sun is out for use at night.
What are we seeing with these component manufacturers? What’s really driving the story for these companies right now?
Hall: The big needle-moving thing right now is definitely the shift to module-level power electronics. MLPE is the acronym that you’ll hear. Historically, the way a solar system has worked is, you get the panels on the roof, then you have an inverter in your garage that converts DC from the panels to AC from all of them and sends it to the grid or sends it into your house for you to consume. The problem with that is, it’s a single point of failure. If the inverter goes out, you are no longer getting any solar at all. Those panels are just sitting up there on your roof soaking up heat.
There’s been a move to shift to actually having inverters and power optimizers on each individual panel. A couple of things that this going to do is, it’s going to, No. 1, if you have an inverter go out, it only affects the panel that it’s attached to. You’re still getting power production from the rest of your system. Also, since it’s taking the power from each panel, it’s more effective at managing. You have power optimizers and also inverters on there, and they’re managing the power. For example, if you have a tree that shades part of your solar system for part of the day, then it moves across, you get more efficient production because it’s managing the power at the panel level. It’s a much more efficient way to do it, in terms of getting power output. That could mean you need less panels to generate the same amount of power. It’s a more efficient way to do it.
Two companies that are really well positioned in this are SolarEdge (NASDAQ:SEDG) and Enphase (NASDAQ:ENPH). They’re two of the big leaders in this. That’s big step change, going to the module-level power electronics. Electric Code is calling for that change. Beginning it in about three weeks, January 1st, they’re going to have to make this shift. They’ve already started to make it. What’s happened is, SolarEdge and Enphase have started signing supply deals with the panel makers. They’re working directly with the panel makers under long-term contracts, so they have some stability in knowing what they can project for the revenues. It gives them some competitive edge, some protection. It’s a niche industry that I don’t think you’re going to see the panel makers try to move into.
Sciple: Yeah. It seems to be a little bit more consolidated than what we’re seeing from the panel makers. Fewer players. When we’re talking about these shifts in supply and demand, with a smaller number of operators, the potential for irrationalities may be a little bit less. And, again, as solar becomes a bigger segment, we’re going to see more pushing into the storage business. Enphase is starting to roll that out. Tesla (NASDAQ:TSLA) has some operations there with their Powerwall, which they partner with, we talked about a minute ago with installers with their Solar City part of their business. There’s some big opportunities there.
I want to call out, on the MLPE stuff, it gets you a significant boost in efficiency. The Department of Energy said you can reduce energy losses just from partial shading of your solar panels by 20-35%. That’s a significant bump up. Additionally, there’s some safety factors. If an individual panel fails, it can start overheating, all these sorts of issues. You can cut off that individual panel while still getting some solar production from the rest of your operation. Really, some exciting stuff going on there. It’s an interesting industry to follow.
Hall: Very much so. The battery business is really interesting. Of the companies that are in this space, I’m most excited about Enphase. You’re a big fan of Enphase as well, if I’m not speaking out of turn.
It’s worth mentioning Tesla, too. I think we should bring Tesla into this conversation. Tesla acquired Solar City a year and a half or so ago. It’s substantially backed down on its focus of residential installations. It was the biggest residential installer in the U.S. by a wide margin. It’s gone way back on that. It’s more focusing on the manufacturing side now. They’re working on the roof, the solar tiles as an actual solar roof. That’s slowly starting to roll out on the industrial and utility side, in addition to the residential side. The Powerwall that you talked about, with their deal with Panasonic. They’re definitely a big player in this.
I don’t think you can invest in Tesla based on it solar business. Its auto business is still by far the biggest part of it. But it is an interesting part of Tesla’s business to follow.
Sciple: It definitely is, Jason. Assuming they can get it all up and running, there are some synergies between what they’re doing on the solar side and what they’re doing with the EV side. If they ever get everything firing on all cylinders, it really does seem like a compelling synergy between those two parts of the business.
Hall: And not run out of money in between now and then.
Sciple: Right. We mentioned the cyclicality and all those sorts of things.
Let’s talk about the last segment that we want to mention, which is these independent power producers, the yieldcos, as you mentioned off the top. These are similar to traditional utilities, but they do own and operate some solar systems. We’re not seeing any yieldcos that are pure plays right now. Most of these businesses have significant investments in other types of renewable energy, whether that’s wind, hydroelectric, things like that.
What are you seeing with the yieldcos? Are there any companies that stand out as particularly attractive to you?
Hall: If you go back a couple of years ago, there were a couple of pure plays. SunPower and First Solar had 8point3, which was their combined yieldco. I think the challenge is that if you’re a power producer, you really want to be flexible. You want to be able to invest where you’re going to get the best cash on cash return you can capture. And solar isn’t always that. These businesses were too limited if they were strictly solar-focused.
There’s been a lot of consolidation. You talk about companies that do a lot of things, NextEra Energy Partners is really interesting. It’s a big electric owner, owns a little bit of wind. It also owns a lot of natural gas distribution. It’s tied to NextEra Energy, the big utility that owns Florida Power & Light. It’s really interesting. I think it’s worth following closely because it’s going to be adding a lot more renewables over time, especially a lot of solar.
Brookfield Renewable (NYSE:BEP), the majority of its cash flows come from hydroelectric. The whole Brookfield Asset Management (NYSE:BAM) family of companies, Brookfield Renewable owns around two-thirds of TerraForm Power, which is a third solar, two-thirds wind. It’s a really interesting growth story that Brookfield Renewable is using as a way to drive its growth in solar and wind. I really like Brookfield Renewable a lot. It’s down like 25% from its high close to the beginning of the year. Its yield is almost 8%, which I think is an absolute steal.
I also like Pattern Energy. Today, all of their cash flows come from wind. It’s starting to look closely at solar, and it will be making solar investments in the coming years. That’s more of a risk-reward play right now because it’s paying out a ton of cash flows to support its dividend. Those cash flows are starting to grow, so it’s closing that gap, but there’s a little more risk right there. Basically, the way they make money is, they invest in or build these big renewable projects. They find a utility. They know who’s going to be buying their power usually before they even build these projects out. Then they sell on 10 and 20-year contracts a power purchase agreement to sell the power capacity. They can pretty much project what their cash flows are going to be for the next decade based on what they already own. They take out debt, generally at a relatively low cost over long, fixed terms to finance those projects. Then, the spread of the cash flows that they generate vs. what their debt costs and their operating costs are, they generally pay the rest out in dividends, retaining a small amount to reinvest in growing the business.
If you’re looking for really good dividends and dividend growth opportunities, that’s what I really like about the yieldcos. That big 6,000% growth in solar that you talked about, these are going to be a massive owner of a lot of that growth. These companies are going to see their cash flows growing on a per share basis. They should grow pretty substantially over the next 20 or 30 years. These are really good dividend growth investments. Maybe my favorite part of solar to invest in, is the yieldcos.
Sciple: If our listeners are maybe a little squeamish about these shifts in demand volatility, this a good way to get exposure to solar and renewables in general without being quite as exposed to the roller coaster ride that you might see from some of these other businesses.
Sciple: Let’s end — [laughs] we’ve been going for a good minute. Let’s talk about some of the challenges that we’re going to see in solar over time. The first thing I want to call out is called the duck curve. Traditionally, what we see with power generation is that it starts to tick up after the sun rises, folks go to work. It rises throughout the day while people are at work, then reaches a peak right after folks go home, say, six, seven. Folks are home making dinner, turn on the air conditioning, all those sorts of things. The duck curve is that middle of the day where we start to see a surge or increase in energy demand. Once you get a certain amount of solar into your grid, you start to see demand from your traditional energy sources, whether it’s hydrocarbons or otherwise, really start going down. The sun goes up during the day, you reach your peak of solar production, so you don’t need to use another energy source.
Where it becomes an issue is when the sun goes down and that solar power rolls off the grid, you really have to ramp up very quickly your hydrocarbon or other energy-producing sources to meet that demand. It’s led to some complications for utilities navigating how to shift between those demands, particularly with energy sources, say, like coal, that are really difficult to bring on quickly intraday.
Hall: Yeah, especially coal. These baseload power generation facilities, these legacy facilities, were never intended to be able to handle these really quick surges like that. They just weren’t built to be able to do that. This has been a major challenge, it really has.
The thing with the duck curve that’s interesting is that, if you go back four or five years ago when this first started becoming a major concern, especially where I live here in California where we have a massive amount of solar, huge populations, so it’s really the perfect environment for something like the duck curve to happen and to be a problem, batteries weren’t even really on the radar as a long-term solution. But the technology has improved as global scale of manufacturing batteries has grown and the costs have come down. It’s really become an interesting potential solution. Energy storage, great big batteries, as Elon Musk has called it, has an amazing amount of power to fill this need.
I think it’s gotten to a point now where you have utilities that are even looking at using battery storage as a solution instead of building a peaker plant. So, instead of building a small natural gas plant that can quickly surge to meet those quick peak demands, bringing in a battery storage system that’s capturing power even from carbon sources, maybe getting power from a coal plant that’s charging batteries during the day, if that just happens to be your cheapest incremental source of electricity. Then, using those batteries instead of a peaker natural gas plant to meet that surge demand. It’s really interesting what we’re seeing.
So, think about battery storage. In the near-term, you may see battery storage getting rolled out that’s not even connected to renewables. It may be connected in the short-term, pulling power from the natural gas plant to meet those peak periods in demand. Over time, obviously, the long-term goal from a carbon reduction perspective is to tie it into solar and wind and capturing those resources that aren’t on all the time, to meet those surges in demand. Watch the battery space really closely.
Sciple: Yeah, batteries are going to be very important to store that production we have during the day. Then, you mentioned the peaker plants for natural gas. That’s one of those things where, as that gap filler fuel, natural gas serves a good role there because it’s really easy to turn on, get production quickly, and turn your production off quickly. With coal, it’s not economic unless you run it 24/7. You could say the same for nuclear. Bullish for both batteries and natural gas having a continued role in energy production over the long-term.
Sciple: As we’re going away, let’s talk about some regulatory issues that we’ve seen. You mentioned living in California. California is pushing heavily into solar. Beginning in 2020, every new home constructed in California will be required to have residential solar installed there. California is the most populous states in the country, one of the most populated locations in the world by concentration of people. So, this is going to be a significant increase in energy demand as those start to come online. What do you think about that as a potential new demand source going forward?
Hall: The thing that I’m really interested to see is who are going to be the winners in that space. If you look, a lot of the top 10 home builders that operate in California already have partnerships with some of the installers and some of the panel makers. Seeing how that plays out is going to be really interesting.
In general, this is probably going to be one of those rising tides that lifts all boats to a certain extent. Homebuilding is another one of those cyclical industries. We have to consider, from one year to the next, how demand is. I’d be really careful about using this as a key piece for anybody’s thesis for any company. At the end of the day, some of the biggest winners are probably going to be some of the local panel makers, simply because if I’m building a 100-house development, my cheapest source for panel installation may be the guy that operates in that Tri-County area. That might be the best place for me to meet that legal requirement. We have to be careful about assuming anybody like Vivint Solar is going to be a big winner. That may not be the case. That’s where you have to be careful. Any time that there’s a specific legislation or regulatory deal, be careful about baking it too heavily into your thesis. As we’ve seen, other things can change that can completely blow it up in a one-year period.
Sciple: Sure. It’s definitely something to watch. If other states start to follow California’s lead, that definitely could be a bullish sign for the industry, but not something to hang your entire investment thesis on. But, it’s something to be aware of.
We have another regulatory question from our listener Brendan, who send us an email at email@example.com. He’s asking about House Bill 7173, it’s the Energy Innovation & Carbon Dividend Act. What the bill is going to do is put a price on carbon and distribute it to American households. Similar legislation has been passed in Canada and would give a carbon dividend as a result of the fees they’re charging there. He asked, “Now that we’re seeing that a price on carbon appears to be getting closer, are there any investing takeaways or things to take note of in the energy space as a result of this bill and things like it? And, are there any impacts from it with regards to the Green New Deal that has been discussed over the past year?”
What are your thoughts on this piece of legislation, Jason, and what impact it may have on energy, particularly solar energy?
Hall: If you look out a decade from now, maybe it’s more likely that we see some of these carbon tax, carbon incentives happen in the U.S. that you’re starting to see in Europe and recently in Canada. But, to be as blunt as possible, this this a non-starter. It’s not going to happen under the current White House administration. It’s not going to happen with a split Congress. A lot of this is about political points as we move toward 2020 and the next presidential election. Just to be pragmatic and look at this as what it is, it’s political posturing to a certain extent. Whether or not it’s good legislation, I don’t think we should even get into that on the show.
For investors, it’s just noise in the background. It’s not really worth thinking about in terms of the near-term, in terms of investing in solar. If you think about the typical supply side, demand-side parts of the business, think about the companies that have the best balance sheets to ride out those cyclical shifts. And take a grain of salt with any projections about solar demand any one given year, because there are other material regulatory things, as we saw with China and with the U.S. over 2018, that can change things in the blink of an eye. But I don’t think this is legislation that’s even going to get to a vote in the next two years.
Sciple: I agree with you, Jason. If this becomes a big sticking point for 2020 and a candidate gets elected on the backing of this kind of program, maybe it’ll have a significant impact. But in the near-term, we’re not going to see anything concrete come out of this legislation.
Hall: If it were to get to a point where it was actually codified, obviously it would be a tailwind for any carbon-reducing, carbon-neutral, solar, wind, any of those power sources, it would be good. But I think we’re far politically away from it even being considered, I’m not even considering it as part of any thesis I have for any renewable or carbon investment at this point.
Sciple: Sure. For our investors, going away, we mentioned in the panel space, Jason really likes First Solar, their strong balance sheet, their ability to ride downturns in the cycle. On the yieldco side, Brookfield. Across anything in the infrastructure space, Brookfield really seems to be well positioned and able to ride cycles and make strong investments. One thing to note with them is, they are an MLP, so consult your tax advisor on how that may affect your tax liability.
On the component space, we both really like what Enphase is doing with their inverters and things like that. That’s definitely a company to watch in that space. It’s the space for me in solar that I’m most excited about. What do you think, Jason?
Hall: I tend to agree. As much as Enphase has rocked it this year, it’s still a double for most investors that bought late last year, early this year. Huge catalysts with the with the MLPE, as you were talking about. Also, its step into battery storage is a smart move. It’s going to give them some diversity and it’s the right move.
The one thing I will say on Brookfield, like you said, it’s a limited partnership. If you look at all of Brookfield’s limited partnership investing notes, they make a point to say that they don’t pay UBTI, which is the thing that makes them bad for retirement accounts. But, there’s still the risk that that could change. Definitely, buyer beware. Definitely talk to your tax expert before you pull the trigger there.
If you’re really concerned about that, look at TerraForm Power. It’s a standard corporation. It’s now run by the Brookfield family. It’s a good alternative if you’re concerned about that limited partner tax risk and your retirement accounts.
Sciple: Sure, and it gets you that same trust that you can have in Brookfield’s management while also getting you a little bit overweight exposure into solar relative to the Brookfield Renewable core platform. As we mentioned, that’s majority hydroelectric. Things to think about when you’re looking at investing in the solar yieldco space.
Listeners, a brief programming note. We have Christmas coming around the corner next week. The holidays are in full swing. We’re going to be taking a step away from Industry Focus for the next two weeks. Next week, you’ll hear our roundtable show with all the hosts of Industry Focus, we came together to discuss the year that was in 2018 and what we need to watch going into 2019. On January 3rd, you’ll hear our 2019 energy trends look-ahead show we recorded back in October with Jason, Matt Dilallo, and Tyler Crowe during FoolCon. On January 10th, we’re going to come back, Jason and I, and we’re going to talk about all the things we got wrong on that show.
Hall: Oh, boy!
Sciple: Yeah, tell me about it. So, listeners, tune in, and send us all the angry emails you want in that week beforehand. We’ll answer any questions that you have. If there’s any other news that you want to cover, or things that you’re looking forward to in 2019 you’d like us to cover, we’ll try to hit those on the show, as well. You can send questions our way on Twitter @MFIndustryFocus. I’m @NWSGator on Twitter if you want to get in touch with me. And, you can email us, firstname.lastname@example.org. I want to wish everyone a happy, safe and restful holiday season. We’ll be looking forward to talking to you again in the New Year. Thanks for coming on, Jason! I really enjoyed it!
Hall: Thanks, Nick! Happy holidays to you, buddy! Happy holidays to everybody out there!
Sciple: Happy holidays to you, Jason, and to all our listeners as well! Hope you have a happy, safe restful holiday!
As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don’t buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. For Jason Hall, I’m Nick Sciple. Thanks for listening and Fool on!