Few industries are as interest rate sensitive as the broad renewable energy sector. Most companies are either capital intensive with high financial leverage or the positive cash flows are years into the future. In many cases, both features apply. Although there are other factors at play, there is little doubt that the spike in interest rates is one of the reasons for the massive underperformance of renewable energy stocks over the last years.
In our opinion, maybe the most interest rate sensitive sub-sector in renewables is residential solar where companies sell and install roof top solar systems for households. The finance companies, often referred to as solar service companies, have highly capital-intensive business models. They often outsource the installation job to third parties but finance the solar systems for the buyers through a 10-to-20-year lease or a loan. As interest rates rose, it became more expensive to finance new sales, and more importantly, the value of the existing lease and loan books and net present value of future cash flows declined. In addition, higher interest rates generally lead to less demand for large residential investments like roof top solar systems, which often cost about USD 20 000-30 000.
The higher rates were a triple whammy and the share price of the two largest players, Sunrun (RUN) and Sunnova (NOVA) dropped by 80-90% from late 2021 to the bottom in April this year. The third largest solar service company with a slightly different business model, Sunpower (SPWR), recently filed for bankruptcy.
However, with interest rates about to be cut, there is little doubt that these companies should get some tailwind, and to a certain degree, this is already reflected in the share price as RUN has almost doubled and NOVA has tripled since the bottom in April.
Moreover, there are additional positive factors to consider. First, the guidelines for domestic content tax credits that were detailed in late April exceeded expectations. In total, the installers can obtain a total tax credit in excess of 45%, about 10 percentage points above what the market expected earlier this year. This requires that it is a lease sale with a certain percentage of US manufactured components. As it is relatively easy to monetize the tax credits, this will help them stay on top of repayments of corporate loans and reduce the risk of equity dilution to fund future growth.
Second, as we have noted in several previous monthly reports, retail electricity prices have increased and are likely to continue climbing over the next years as new generation and distribution capacity are needed. As electricity prices rise, the payback time for buyers of residential solar systems will decrease and demand will increase. The potential for residential solar in the US is still vast as penetration is only about 4-5%, compared to about 30% in countries like Germany and Australia.
Third, post-COVID, the cost of equipment and labour surged, further dampening demand for residential solar systems. Today, there are an abundance of small installers fighting for jobs while the cost of solar panels and inverters are declining, although not as much as in international markets.
Fourth, the downturn for the installers coincided with changes to net metering rules in California, by far the largest residential solar market in the US. The new rules sought to incentivise solar systems to include storage, which make sense given the abundance of electricity generation during the day when the sun is shining. Nevertheless, the anticipation of the new regulation pulled demand forward and later led to a significant drop in demand as the market adjusted to less favourable metering rules and higher total costs due to the addition of storage. However, the new metering rules were introduced during the spring of last year and it is expected that California will start growing again next year.
Finally, it also helps the two incumbents, RUN and NOVA, that their largest competitor, SPWR, went bankrupt. Not only is there less competition for signing up residential buyers, but it also improves negotiation power versus the many installers scrambling to keep their workforce employed.
However, despite the favourable conditions, several potential headwinds could offset the tailwinds. First, if interest rate cuts coincide with a recession, the benefits of lower base rates will be diminished as credit spreads widen. Additionally, economic uncertainty during a recession typically causes consumers to postpone large investments, such as rooftop solar systems. As a result, highly leveraged companies generally struggle during recessions, which likely puts further pressure on share prices.
Second, the political risks remain significant. As we have discussed in many previous monthly reports, we doubt that the Inflation Reduction Act (IRA) will be revoked even in a red sweep scenario where former president Trump wins the White House and the republicans’ control both chambers of Congress. Still, there might be smaller changes to the IRA, especially since residential solar does not directly create U.S. manufacturing jobs—a priority for the Republicans. While the IRA is secure if the Democrats retain control of at least one chamber, a Trump-led administration could introduce challenges, such as making it more strident to qualify for domestic content adders. That said, this political risk is widely acknowledged by the market and since the election is still a toss-up, there is already a significant risk premium baked into the share price of RUN and NOVA. This also means there is significant further upside if Vice President Harris should win the election.
Third, the solar service companies’ business model is complex and many question the model and the ability to generate cash when growing the customer base at elevated levels. This is an obstacle many investors face when analysing the financials. However, the introduction of domestic content adders has reduced some of those concerns, but one of the key ideas behind the Inflation Reduction Act is that tax credits will result in more competition and eventually lower prices for end customers. The industry should expect to gradually transfer the value of the credits to the end buyers of roof top solar systems.
There are already signs of increasing competition as leasing companies are entering the business post the publication of the IRA guidelines. Although this in line with our expectation, we note that the incumbents have scale advantages with hundreds of thousands of customers and established service and performance records with thousands of dealers and installers. We believe it will be hard to match this in the short term, even for well-capitalized new entrants. Interestingly, concerns about increased competition are emerging just months after the market questioned the viability of the business model. The fact that new entrants are now pursuing this space suggests to us that they see its long-term potential.
In summary, we like the business model and believe RUN and NOVA will create positive cash flows and value for their shareholders. Although their stock prices have surged 100% and 200% in recent months, respectively, there is still significant upside if rate cuts occur without a recession and if Harris wins the presidency. On the other hand, the downside risks remain substantial in the short term if Trump wins the election or if the U.S. economy slips into a recession. The risk outlook is binary. Although we have increased our exposure over recent months, we have carefully sized the positions and are closely monitoring developments.
