The Smarter Bet On Solar

Count me a “distech” skeptic. So-called disruptive technologies never fail to grab headlines. Those who bet on them, however, usually wind up with empty wallets.

Remember Vonage Holdings (NYSE: VG)? Eight years ago, that company was touted as the distech Internet phone provider on the verge of turning the communications sector on its ear.

As it turned out, its voice over Internet protocol (VOIP) technology is now the industry standard. The company, however, is an afterthought with a microscopic market share, moribund revenue and declining profits.

As for the stock, Vonage is down roughly 80 percent from the May 2006 initial public offering price. That’s a sore subject for customers who bit on the IPO. Even the company’s founder Jeffrey Citron has been feverishly selling shares in recent months.

Distributed solar is to this year what VOIP was in 2006. Industry cheerleaders have forecast mass defections from regulated electricity service as businesses and consumers install rooftop solar and other technologies. The poster child: SolarCity Corp (NSDQ: SCTY), a stock that’s risen 407 percent over the past 12 months.

SolarCity has yet to book its first dollar of earnings, and it won’t in 2014 or 2015. In fact, surging sales to date have been accompanied by shrinking profit margins. And the company has taken to raising cash by securitizing revenue, with a target market of retail investors.

You’re not going to do much disrupting in a major industry if you’re only making money for stock promoters. Solar power, on the other hand, does have considerable promise.

As an energy source, it’s still a rounding error in the US energy mix. But the construction of more than 200 utility-scale plants is about to put it on the map. Output of facilities like NRG Energy’s (NYSE: NRG) Ivanpah in California will be sold under long-term contracts to regulated utilities. Developers have only to build to grow earnings.

Not Disruptive, But Enriching

Distributed solar energy potentially has equally strong economics. Developers absorb the cost of installing equipment for willing consumers and businesses in return for signing them to long-term contracts. The result is basically a utility-like stream of cash flow.

Under the most optimistic credible forecasts, distributed solar will grow at a compound annual rate of 22 percent between now and the end of 2020. Those assumptions depend on continued government subsidies, availability of cheap components from China and popularity of “green” consumer preferences.

None of those are sure bets. The example of Germany’s increasingly dysfunctional power system has stirred considerable backlash to solar subsidies. Arizona became the first state to impose a new fee on consumers and businesses that go rooftop, forcing them to bear grid costs.

The glut of solar components that’s driven down prices recently is already showing signs of abating. And while green is popular with many consumers, the vast majority of Americans are a lot more concerned with prices—which even distributed solar’s advocates admit won’t be competitive with natural gas until 2025.

A change in any of these factors would shift solar economics for the worse. But assuming they hold, distributed solar will account for 4.5 gigawatts of capacity by 2020.

Put in perspective, that’s equivalent to roughly 0.4 percent of total US generating capacity. And because the sun doesn’t always shine, actual electricity produced would be a fraction of what an equivalent sized natural gas plant would produce, and therefore the electricity America will need by then.

Those are scarcely numbers capable of real disruption. Growth, however, is significant enough to create an opportunity for robust growth and powerful investment returns. And because cash flows are based on contracts, they’ll hold up even if solar economics shift.

The Retail Option

The question is who will dominate rooftop solar? Wall Street obviously can’t get enough of SolarCity at this point. And it won’t take much to disappoint expectations baked into a price of nearly 30 times sales, even if keeps growing.

Utilities themselves are now are moving aggressively into the business. California’s Edison International (NYSE: EIX) purchased SoCore Energy LLC last year. Even utilities ramping up natural gas capabilities have gotten into the game, such as Dominion Resources (NYE: D) and Southern Company (NYSE: SO).

Utilities have massive advantages in the rooftop race. Those include deep pockets but also total access to every customer in their territories. The problem for investors is they’re also huge. Overall prospects are very solid for earnings and dividend growth. But distributed solar’s contribution will be marginal even in a best case.

That’s why I prefer a third alternative: Retail providers of electricity and natural gas operating in 15 US states and District of Columbia that have deregulated power and gas. In these states, the grid remains a regulated monopoly, but power generation and marketing are competitive businesses.

Retail marketers basically compete for customers, for who they procure energy by either buying or producing. Their profits depend on controlling exposure to energy costs, while retaining and attracting customers.

To be sure, this has been a very tough business to date. Most retail marketers melted down in the crash of 2001-02, following the implosion of Enron. The rest have survived by utilizing a combination of tight cost controls and adding scale. But the challenges they face today are severe as ever, as low gas and power prices have made it difficult to attract and keep customers.

The four companies in the table are therefore all survivors: Centrica Plc’s (London: CNA, OTC: CPYYY) Direct Energy, Just Energy (TSX: JE, NYSE: JE), New Jersey Resources (NYSE: NGR) and NRG Energy (NYSE: NRG).

Now, however, they’re seeing their first strong growth since the 1990s: “Green” energy offerings. The actual electrons used by consumers and businesses aren’t necessarily generated by renewable energy. But the effect on overall grid generation is the same, as companies purchase output from renewable sources.

Rooftop solar is a natural extension of this business. And retail marketers have the customer connections, regulatory knowledge and experience, scale and financial power to carry it through.

Just Energy’s distributed solar business is conducted through Hudson Energy Solar, which installs systems on residential and commercial sites in New Jersey, Pennsylvania and Massachusetts.

Solar cash flow during the fiscal 2014 second quarter (end September 30) was a little less than $1 million, or about 2.3 percent of the company’s overall total. That was up from a loss a year ago, however, indicating the company realizing scale advantages.

Just Energy cut its dividend last year, the result of high debt and cash flow lagging acquisition costs. This year’s day of reckoning will be on or about February 7, with the announcement of fiscal 2014 third quarter cash flows.

The stock has risen by close to 40 percent since late summer. A good number for distribution coverage would add to those gains. An unexpectedly good number for solar growth could put the large number of short positions against the stock into a full-blown squeeze.

Those who don’t want that much excitement will do well with the other three on my list. Centrica Plc has been a major aggregator of retail marketers in North America and Europe recently, buying cheaply and boosting profits with efficiencies and scale.

Like most UK-based companies, it only pays a dividend twice annually. But investors can get on board for the next one by buying in before February 20. The company has been raising dividends between 6 and 8 percent annually, a rate it should maintain with ease this year and beyond.

NRG Energy is a leading unregulated generator that’s already made its mark in utility-scale solar generation. The company’s CEO David Crane has been very vocal about the advantages of distributed solar energy and the company’s pursuit of opportunities.

NRG’s retail customer base has to date been more of a hindrance to growth. But with operations in such markets as Texas, there’s a lot of opportunity to sell solar when it makes sense to.

New Jersey Resources, meanwhile, has been installing rooftop solar and locking in customers to long-term contracts for several years. That’s a natural offshoot of the regulated natural gas utility business, as well as related businesses in energy services, gas storage for utilities and renewable energy projects under its Clean Energy Ventures unit.

The company’s overall record is one of rock-solid stability. And 5 percent annual dividend growth looks set going forward.

Each of these companies is doing something neither SolarCity nor regulated utilities are: Making money in the distributed solar business. They’re also proven quantities, having survived very tough times in their industry.

Unlike SolarCity, they’re not getting a lot of airtime. But ultimately, profits will prove a lot more important to returns than popularity. And if Wall Street does eventually catch on, look out above!