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Equity Perspectives

Following a boom and bust cycle, the solar energy industry has undergone a dramatic consolidation and lowering of production costs. Meanwhile, demand has strengthened, leading to sharp appreciation in solar stocks.

What do Costco, Johnson & Johnson, and General Motors have in common? Similar to a number of other iconic brands, these giant companies have deployed solar energy on a massive scale in order to help lower operating costs and increase profits—not to mention the considerable intangible benefits these companies realize by using clean energy.1

To understand how a wide variety of publicly traded companies have found the environmental and financial benefits of solar energy attractive on multiple levels, consider Walmart, the world's largest retailer. With more than 10,000 stores in 27 countries,2 the company aims to be powered entirely by renewable energy, and solar power has become an important part of that mix. Walmart plans to continue its investment in solar energy, expanding the number of its locations powered by the sun, and hopes to use its scale to drive down prices for all renewable technologies, one executive said last year.

Solar Economics Optimize
A growing number of utilities and consumers are following suit, which helps explain why solar energy production rose an astounding 500% in 2012, according to the U.S. Energy Information Administration.3 (See Chart 1.) These users know that increasingly affordable solar energy (thanks to sharply lower polysilicon prices; see Chart 2) allows them to reduce their long-term energy costs.


 
Chart 1. Solar Energy Production in the United States Rose 500% in 2012 Alone

Source: Energy Information Administration. Data as of April 30, 2013.

 

 
Chart 2. With a Steep Drop in Silicon Prices, Solar Panels Have Become Cheaper to Produce and to Buy

Source: Bloomberg New Energy Finance. Data as of May 31, 2013.


And now that the gap between supply and demand has narrowed, investors once skittish about the deteriorating economics of solar energy amid fierce competition have returned to the sector with renewed enthusiasm, convinced that Chinese oversupply is not going to be a problem. Shares of two industry leaders, for example, have nearly tripled in the last six months, according to Bloomberg.

The Smart Money Moves In
A number of respected investors recently have taken big stakes in the industry. This likely shocked the market, considering the dire industry forecasts that have led to massive short positions in the solar names.

MidAmerican Energy Holdings announced plans to acquire two huge solar projects on 3,230 acres in California, which together will form the largest permitted solar photovoltaic (PV) power development in the world.4 MidAmerican (a subsidiary of Warren Buffett's Berkshire Hathaway), will reportedly pay $2.0–2.5 billion for the projects, and the renewable energy they produce will go to Southern California Edison under two long-term power purchase contracts. The deal marked Buffett's third investment in solar energy in a little over a year. Another more recent catalyst was a lease-financing agreement between a leading provider of clean energy and Goldman Sachs, which will help users to install solar panels with no upfront investment and lower electricity bills.5

How Solar Investing Has Run Hot and Cold
In the last several years, there have been a number of initial public offerings (IPOs) in the solar industry, both in the United States and China. In the case of one U.S. company that went public in November 2006, the industry at the time was still healthy and growing. Spain, Italy, and Germany all had programs to fuel the growth of solar energy. The company had gone from a small cap to a large cap stock in just one year. (See Chart 3.)


 

Chart 3: Talk about Volatility! One Solar Company Stock's Wild Ride

Source: Bloomberg. Data as of July 24, 2013. For illustrative purposes only and does not reflect any Lord Abbett mutual fund.


But the subsidies would prove unsustainable. As the euro crisis intensified in 2011, the solar subsidies began to disappear. As a result, many investors sold their solar stocks early that year, after which shares of solar companies plunged as Chinese solar companies flooded the market with cheaper alternatives, solar equipment prices tanked, and many industry players fell into red ink.

During this time, the cost of producing solar energy continued to drop at a steady pace, demand rose, and supply started to shrink. By the third quarter of 2012, the company that went public in November 2006 began attracting investors again. Much to their surprise, the company had become a small cap again. The company had rebuilt its business to focus on new markets like South America, where small-scale utility power plants can provide electricity for remote locations like mines in Australia and South Africa, and as a replacement for electricity generated by oil in sun-baked countries such as Saudi Arabia.

Against that backdrop, some analysts began recommending another leading solar company in late 2012, since it appeared to be attractively priced versus its long-term prospects. Nine days later, news that Warren Buffett had chosen that company to build a utility-scale project in Southern California sparked a substantial rally in solar energy stocks as investors refocused on the long-term demand for solar energy in the United States.

During this same time period, a company that makes polysilicon, which is used in the manufacturing of solar panels, also gained favor. The company has also cranked up solar project development, and its shares have more than quintupled in the 52 weeks ended July 31, 2013, according to Bloomberg data.

Solar's Long Shadow
According to the Solar Energy Industries Association (SEIA), the United States has 5,600 solar energy companies across all 50 states and employs more than 100,000 people. In 2012, photovoltaic (PV) installations grew 76% over 2011, with an estimated market value of $11.5 billion as of December 31, 2012. Each market segment (residential, nonresidential, and utility) advanced compared with 2011, while solar markets in most U.S. states also grew.6 (See Chart 4.)


 

Chart 4. U.S. Photovoltaic Installations and Global Market Share

Source: SEIA/GTM Research, "U.S. Solar Market Insight: 2012 Year in Review."
Note: The annual installed figures cover only grid-connected capacity. DC stands for direct current, the type of power output by photovoltaic cells and modules. Data as of December 31, 2012.


The industry remains rather fragmented. However, several weaker companies have gone bust or been acquired, leaving the strongest players in the position to benefit from the significant increases in residential, nonresidential, and utility-scale installations. (See Chart 5.) In fact, leading U.S. solar companies are being contacted to take over projects originally expected to be fulfilled by Chinese module providers.


 

Chart 5. U.S. Photovoltaic Installations by Market Segment

First quarter 2010–First quarter 2013

Source: SEIA/GTM Research. "U.S. Solar Market Insight: 2012 Year in Review."


Residential solar installations have increased in part because one industry player has implemented an innovative financing mechanism whereby buyers can lease systems at attractive rates over, say, a 20-year period, which dramatically lowers the upfront capital investment, which for years was a major hurdle for prospective purchasers. Now some states are providing rebates and tax credits for people who lease. Federal tax credits would still go to the solar leasing companies who purchase the solar energy equipment.

Commercial solar installations have advanced as developers have focused on improving equipment performance, reduced investment costs, increasing government incentives, and the near-certainty of future price hikes for nonrenewable energy. "Solar is a more viable alternative than ever," said Jones Lang LaSalle (JLL), a global commercial real estate services and investment management firm.

According to JLL, there are several different options for commercial real estate developers when considering solar as an energy source. One is to obtain solar power through a power purchase agreement from a third-party provider that owns, installs, and maintains a solar system on a developer's property. (Renting large flat-roof spaces, such as warehouse roofs, to an outside solar developer would be one example.) A second option JLL cites is outright ownership of a solar energy system that can be installed in a variety of locations such as building rooftops, parking lot shade structures, mass transit waiting areas, even unused land.

The recent growth in utility-scale solar projects is especially noteworthy. "This category was all but nonexistent only five years ago, when the residential and commercial sectors accounted for nearly all of the photovoltaic7 [PV] installations," according to the U.S. Energy Information Administration. "While a residential PV system might comprise only a few solar panels and 5 to 20 kilowatts of capacity, utility-scale plants have capacities of 1 megawatt (MW) and above. Utility-scale PV capacity grew from just 70 MW in 2008 to 1,052 MW in 2011. In fact, prior to 2011, the majority of utility-scale solar capacity was concentrating solar technology,8 and not photovoltaic." According to the SEIA, the United States installed 723 megawatts of solar energy in the first quarter of 2013, which accounted for more than 48% of all new electric capacity in the United States the previous quarter. Those installations marked the best first quarter ever for the industry.

Glenn McIsaac, Lord Abbett Research Analyst, U.S. Large and Mid Cap Equity, thinks utility-scale solar (especially PV) will continue to grow in the United States, driven by declining panel prices, a federal tax credit program that remains in place until at least 2016, and state renewable portfolio standards. Even so, solar will likely remain only a small part of the total generation mix, he added.

The Solar Horizon
From an investment perspective, we would caution that the industry remains in the early stages of a recovery, and, therefore, this is still a fragile situation. Demand needs to grow and supply needs not to expand too fast. As concerns the latter, one wild card is the question of how long it will take the Chinese market to rebalance.

The bottom line is that we will continue to own solar companies as the recovery ensues and the economics of the business remain healthy.


1 According to the SEIA, the top 20 companies (in terms of on-site solar capacity deployed) are: Walmart, Costco, Kohl's Department Stores, IKEA, Macy's, McGraw-Hill, Johnson & Johnson, Staples, Campbell's Soup, Walgreens, Bed, Bath & Beyond, Toys 'R' Us, General Motors, FedEx, White Rose Foods, Dow Jones, Snyder's of Hanover, ProLogis, Hartz Mountain Industries, and Crayola. Other companies that are significant users of solar include Apple, Bloomberg LP, Del Monte Foods, GE, Google, Intel, JC Penney, Kaiser Permanente, Lackland Storage, Lord & Taylor, L'Oreal USA, Mars Snackfood, US Foods, Stop and Shop, Merck, REI, SAS Institute Inc., and Tiffany & Co.
2 Source: corporate.walmart.com.
3 SEIA, September 12, 2012.
4 "Buffett Holding Makes Big Solar Purchase," CNN, January 3, 2013.
5 "SolarCity and Goldman Sachs Create Largest U.S. Rooftop Solar Lease Finance Program," BusinessWire, May 16, 2013.
6 SEIA, "U.S. Solar Market Insight, 2012 Year in Review."
7 Solar power uses photovoltaic (PV) cells to convert sunlight directly into electricity. When sunlight strikes a PV cell, electrons are dislodged, creating an electrical current.
8 Concentrating solar power (CSP) is a utility-scale renewable energy option for generating electricity that is receiving considerable attention in the southwestern United States and other sunbelts worldwide, according to the U.S. Energy Information Administration. Although many people think of photovoltaic (PV) cells when thinking about solar power, CSP technologies that concentrate sunlight to create heat that can be used to generate electricity are also becoming more popular, the EIA says.

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