Niche Opportunities in Solar Energy and Biofuels Despite Sector Headwinds
TWST: You’ve recently become slightly more positive on solar. Please tell us why. Also, which companies do you believe are the best plays on solar?
Mr. Molchanov: The reality that the solar manufacturing arena is facing structural and severe oversupply has actually not changed at all in the last six to 12 months. Whether it got worse or is about the same, I suppose, is debatable, but it remains an extremely tough market. Unfortunately, for investors, most of the publicly traded companies in the solar value chain are the manufacturers — in other words, the very companies that are facing significant oversupply — and as a result, persistent margin pressures — and in many cases, negative earnings and even negative cash flow.
The most interesting dynamics in the solar value chain are happening outside of the manufacturing arena and specifically on the downstream of the value chain — in other words, financing, installation, marketing and customer engagement. The problem is that these are overwhelmingly privately held companies.
There is one public company, very small, that is a pure play on the demand side of the equation rather than the supply side. Real Goods Solar (RSOL) is a solar installer for residential and small business customers headquartered in Colorado but operating in California and throughout the United States. Again, a very small company with limited share liquidity. So for many investors it may be difficult to buy the stock, but it is, for the time being, just about the only U.S.-traded pure play of its kind.
There should eventually be an IPO of a company called SolarCity. SolarCity is the largest solar installer in the United States, and Real Goods is the second largest. SolarCity has said that they are aiming to go public. We don't know when, of course, and we also don't know what the financial metrics look like, but I think the SolarCity story could be quite interesting for a lot of investors, precisely because it will be another pure play on the downstream of the value chain.
Going back to manufacturing, like I said, most of the publicly traded companies are commodity manufacturers — that is to say, companies that make the wafers, the cells or the finished products, the modules. That's precisely where the oversupply and the margin pressures are.
There are a few exceptions to that — in other words, manufacturers that do not produce a commodity product. One good example that actually went public just in March is Enphase Energy (ENPH). Enphase is a unique pure play on microinverters. What is a microinverter? It is a replacement to a traditional solar inverter, and just about every installed PV system has to have an inverter of one kind or another to take DC power and convert it into AC power for the grid. Microinverters are a cutting-edge product that brings smart grid functionality and advanced communications into the solar arena. Microinverters boost power output of PV systems and improve project IRRs by between 1% and 2%.
The target market is residential and small commercial systems — in other words, this is not for large solar farms. Because microinverters are a very new technology with a narrow set of competitors, Enphase is emphatically not a commodity company. In fact, it is the world's only major producer of microinverters. There are other companies developing this product, and a few have started selling commercially, but Enphase is really the only major one. That's why in the context of declining industry margins and flat to down revenue, Enphase in 2012 is poised to grow top line by about 60%, and perhaps, even more impressively, should improve its gross margin by several percentage points.
TWST: In your recent industry report, you wrote it is important to debunk the myth that a temporary period of depressed oil prices marks the death knell for these emerging technologies. Would you elaborate? What do you believe will be the impact of oil prices on alternative fuel companies?
Mr. Molchanov: When looking at renewable fuel companies that are public, we can differentiate between two types. One is commercial-scale producers, and generally this will be in the ethanol and biodiesel arenas. The second category comprises the early stage advanced, or second-generation, biofuel developers that are not yet in commercial production. It goes without saying that for companies that are producing large volumes of product currently, declining oil prices certainly do not help. Again, that's true of ethanol and biodiesel. For companies that are early stage, lower oil prices also do not help in terms of investor sentiment, but when it comes to the underlying business, oil price swings actually have very little effect.
Let’s look at some of the specific publicly traded companies. KiOR (KIOR) has zero revenue for the time being. Its first commercial plant is expected to start up late in the year. Gevo (GEVO) just started up its first commercial plant in June and is selling small quantities into the chemical market. Solazyme (SZYM) has limited revenue, currently producing mainly cosmetics from renewable feedstocks. Amyris (AMRS) also has limited revenue for the time being, as it's producing specialty chemicals, such as flavors and fragrances. To be clear, none of these companies are producing fuel on a large scale yet.
Then, there is Codexis (CDXS), which is not a biofuel producer on its own, but more of a derivative. Codexis has sizable product sales, but they come from its pharmaceutical business. For now, Codexis is an enzyme provider for the pharmaceutical industry and eventually for cellulosic biofuels.
The most recent IPO in the space is Ceres (CERE), which is an energy crop company. It is also a derivative on biofuels in terms of providing seeds for energy crops, like sweet sorghum. It has a small amount of sales in Brazil, but again its economics are not directly linked to the price of oil.
In the context of the Raymond James' energy group’s view on oil prices, which is to say our belief that prices will not bottom until mid-2013, we don’t think the advanced biofuel stocks are problematic. To be clear, these stocks are speculative and risky by their nature as early-stage companies, but near-term oil price weakness is not a major issue for them because they have so little current production to begin with.
TWST: Last time we spoke, you said you expected several IPOs in the biofuel and biochemical sector. Has that come to fruition and what is the resulting impact for the sector as a whole?
Mr. Molchanov: We certainly think that there will be additional IPOs in the space, and in fact, there are a number of companies that have filed to go public and whose IPOs are still pending. The challenge right now is that the overall stock market is very risk averse, jittery and short-term focused. The reason it's become that way, especially in the last 12 months, is mainly a function of the macroeconomic concerns — the debt crisis in Europe, the slowdown in China, and the U.S. election and possible policy changes emerging from that. For speculative, early-stage companies, this is not an optimal environment for IPOs.
So what can turn this around? Two things: One is within each individual company's control, and one is not. The thing that's within these companies' control is for them to achieve commercialization milestones that provide validation of their underlying business. This includes bringing online commercial-scale facilities, signing up additional strategic partners, and so on. What these milestones do is help derisk the story in the eyes of investors, so even if the overall market backdrop stays as it is right now, companies that have a less risky story to tell will find a more receptive audience.
Alongside that, of course, if and when the macro headwinds are lifted in relation to Europe, China and Washington, that should create a better overall backdrop for IPOs not just in renewable fuels but in clean tech and other fairly speculative companies more broadly. For the time being, the vast majority of the pending IPOs in clean tech are in the renewable fuel and chemical arena. So by definition, anything that makes the broader market more risk tolerant would be very helpful to this space.
It's worth noting that even though the IPO window right now is shut for these companies, many have been able to raise money from private sources, both venture capital firms and strategic partners. So just because the IPO window is closed does not mean that these businesses are not able to develop, though obviously it makes scaleup more difficult.
TWST: Which two segments of the alternative energy sector would you direct investors to pay the most attention to at the moment and why?
Mr. Molchanov: Well, as challenging — and indeed, downright brutal — as conditions in solar manufacturing are, the fact remains that in terms of market cap, this is still the biggest subsector of clean tech. That makes it hard to ignore that space altogether, even though right now we're recommending very few stocks there.
The biofuel — more specifically, the advanced biofuel and renewable chemical — arena is certainly one that has seen a disproportionate share of IPO activity over the past 12 to 24 months. It is becoming more investable, and compared to solar, it is clearly an area where there is no overcapacity, because it's an early-stage industry.
China is not a source of competitive pressures for biofuels the way it is in solar or batteries. There is also less policy risk with biofuels. With solar, so much of the day-to-day trading has been driven by policy news out of Europe, particularly Germany and Italy. By comparison, biofuels and chemicals is not an industry that depends on subsidies the way solar has traditionally depended. So that certainly adds to the appeal of the overall concept, but again, the risk is that these are overwhelmingly early-stage companies. It's really in 2012, 2013 that the first tangible commercialization milestones are going to be achieved.
Looking at other areas of clean tech, unfortunately there is not much that's publicly traded in the U.S. For example, there are lots of companies that participate in the wind market, but they are usually embedded within a much larger business, like General Electric (GE) or Siemens (SI).
As for smart grid, it's a similar story. Many smart grid companies have been acquired by large industrial or technology companies. In fact, just last month, one of the biggest smart meter makers, Elster Group, was acquired by a British private equity firm. So again, not a lot of public pure plays.
One that I would mention that is actually a very interesting story is Echelon (ELON). Echelon has two sets of customers — utility customers plus commercial customers in the building automation market. Both of these areas represent different plays on the smart grid concept — in other words, the crossroads of communications and energy. Echelon is not currently profitable but it is definitely not an early-stage business. Last year, it generated over $150 million of revenue and had EBITDA that was essentially breakeven.
The stock is down year to date in large part because of headwinds from Europe. Although the Europe risk is real, Echelon has been making good strides in expanding its footprint into Brazil and China, both of which have not been large smart grid markets historically, but are heading in that direction.
TWST: What do you believe are some common misconceptions or little-known facts about any segment within alternative energy that a savvy investor would want to make an effort to understand more thoroughly?
Mr. Molchanov: Well, in relation to solar, like I said, the problems right now are in the manufacturing part of the value chain — not the installation or marketing or financing part of the value chain, where by and large companies are actually doing quite well. Let’s keep in mind that those very pressures in pricing and margins that have crushed profitability so much for the manufacturers are actually creating pretty favorable industry conditions for the companies on the downstream end. By definition, cheap solar panels are good for customers, and therefore they drive the volume of business.
TWST: Which three individual stocks would your recommend as the best ways to get exposure to alternative energy at the moment and why?
Mr. Molchanov: I already mentioned Enphase Energy, the world's leading provider of microinverters, a cutting-edge product with very little competition right now and for the foreseeable future. It's not currently a profitable company, but we think Enphase will turn cash flow positive about a year from now. Last year’s revenue was $150 million. This year, we are projecting more than $220 million. So it is a well-established company in the solar inverter arena that is growing and taking market share despite a difficult market environment.
Another one is Gevo, which I mentioned in the biofuel discussion. Gevo is an early-stage company that is developing a product called isobutanol. Isobutanol in Gevo’s case is made from corn, much like traditional ethanol, but the difference is that isobutanol has higher energy density than ethanol. In other words, a gallon of isobutanol has about 20% more energy than a gallon of ethanol, which gives it a higher value and opens the door to sales in the chemical industry and not just the fuel market. Because of that, Gevo's current focus is not on fuel but rather on chemicals. Gevo just recently started shipping product to one of its core customers, a large chemical company called Sasol (SSL). Gevo's first commercial plant just opened up in June, so it's going to take some time before it scales up to full production.
I would also point out that Gevo shares took a big hit last month when the company raised equity in the public market. In fact, the stock from the time of the offering’s launch is down about 50%, so I think it provides a great entry point, a classic buy on the dip opportunity that I would encourage investors to take a look at.
TWST: Thank you. (MES)
Note: Opinions and recommendations are as of 07/16/12.
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