Sunrun: Industry Risks And Current Difficulties Make It A Sell (NASDAQ:RUN)

Following my articles on Sunnova (NYSE:NOVA) and SunPower (NASDAQ:SPWR), today’s analysis will focus on Sunrun (NASDAQ:NASDAQ:RUN), another company operating in the distributed systems sector. As I have extensively discussed in previous articles, I am particularly bearish about the sector, as it is characterized by companies with high levels of debt, high capital requirements, and enormous difficulties in creating economies of scale. As of Dec ’23, RUN is the industry leader, with a 15% market share of the US market and 933k customers. In FY23, it recorded a record loss of $1.6B, mainly due to $1.1B of goodwill impairment. The high interest rates environment resulted in a decline in revenues, which had always grown at a dizzying pace from its founding until FY22. Despite the increasing number of incentives to support the PV and storage markets, I believe that the specific risks facing the company, combined with the industry risks, represent key red flags to consider before investing in this stock. For these and other reasons, which I outline in the remainder of the article, I currently assign Sunrun a Sell rating. If interested in the world of renewable energy, on EuroEquity Research you’ll find several analyses of companies operating in it.

Business overview

Sunrun provides solar PV and storage systems to the residential segment with 933k customers in the United States (vs. 419k for NOVA), with a total installed capacity of 6,689 MW, as well as 1.3GWh of storage capacity. RUN operates through a network of dealers and partners who carry out the installation of solar panels, battery storage, and other related products, offering different types of services. In fact, the company operates using an Energy-as-a-Service (EAAS) business model, offering installation, maintenance and control of the products it markets through two types of contracts. The first, called Customer Agreement, is nothing more than a PPA contract through which it receives predefined cash flows, with an average 2.5% annual escalator, for a period that can range from 20 to 25 years. It also offers the option of leasing contracts. Moreover, in contrast to SPWR and NOVA which do so only to a small extent, RUN gets about half of its revenues from the direct sale of the systems to its customers, eliminating the risks associated with long-term contracts.

In FY23, the System and Product segment was the main contributor to the decline in revenues, down -19.8%, mainly due to rising interest rates that reduced the borrowing capacity of households. Customer agreements showed greater resilience though, growing by 20.7% compared with FY22. An analysis of the business units shows that in both segments, there was a significant decline in gross margin, probably attributable to increased competition. That is because the companies operating in the sector are lowering prices to increase their market share, with negative effects on operating margins. I believe that both headwinds will continue to characterize the economic performance of RUN in FY24, especially interest rates, which are still at record levels with the first rate cuts expected not before the second half of 2024.

Worth noting on a positive side is the steady quarter-to-quarter increase in storage attachment that came to 45.2% in Q4 2023 (vs. Sunnova’s 15% in FY23) also due to the continued reduction in the price of lithium and consequently batteries.

Brief commentary on economic results

FY23 was RUN’s worst year since its founding, with a 2.7% decrease in revenues. Gross margin dropped to 7.2%, down from 12.9% in FY22 and dropped by 17.6% compared with pre-pandemic values. The goodwill impairment due to a decline in the Company’s stock price, led to a drop in both EBITDA and EBIT margin, even if it does not represent a cash outflow, implies excessive capital spending on past acquisitions and, in my opinion, is a signal of poor cash management. The increase in operating expenses is mainly imputable to the increase in cost of sales (+3.66%) and depreciation (+17.8%), slightly offset by a reduction in marketing expenses (-0.5%). Interest expenses substantially increased as well in FY23 (+46.5%), both due to the increase in debt and the increase in interests expense, as we will see more in details later. I expect further pressure on revenues in FY24, estimated to slightly decrease by 1.3%. Lower interest rates in the second half of the year and a decrease in the cost of solar panels and batteries though, should allow margins to improve, still estimated to be in a negative territory, with an EBITDA margin of -3.1%. FY25 and FY26 are also estimated to register improvements over FY23 results, but without achieving profitability.

Comparative analysis with NOVA and SPWR

The comparative analysis with the two competitors shows RUN’s major limitations in terms of EBITDA margin. As regards net income margin, though, Sunrun performed better than NOVA and SPWR over the analyzed period, except for FY20 and FY23. In terms of revenue growth, Sunrun, partly due to its larger size, recorded lower growth rates than Sunnova in all years considered (except for FY21), while it shows higher growth rates than SunPower over the entire period considered.

Concerns about debt

In my opinion, one of the greatest limitations characterizing this kind of company is the large amount of capital required to finance its business model at time 0, contrasted with cash flows received even 20-25 years later. This aspect generates a very high liquidity requirement and, consequently, a high level of debt. As of Dec ’23, RUN has $10.6B of debt, up from $8.4B in FY22, against $988m of cash & cash equivalents. Although it holds $13B of solar energy systems (tangible assets), these are difficult to liquidate in the event of a cash shortage. In FY23 alone, RUN recorded OCF absorption of $821m and $2.6B of CAPEX, for a liquidity requirement of about $3.4B. Some of this liquidity was obtained by raising about $2.2B in debt, and $1.4B through fund investors (tax equity financing), taking advantage of tax credits such as ITCs allowing about 30% of the invested capital to be regained. The same considerations are the case for FY22, FY21, and earlier years.

Even if 90% of the debt is non-recourse and related to the various vehicles created by the company, it has come to have a high value and significant riskiness. This is also evidenced by the interest rates charged, fluctuating in the range of 7% to 9%, compared to the 6% rate used by RUN to discount the $14.2B of net earning assets, represented by the future expected cash flows from its clients. Moreover, going deeper, in FY25 the company has maturities of $2.5B, implying a large amount of debt that will need to be refinanced, just a few months before the maturity of the $397m convertible notes in February 2026. A high-interest rate environment in FY25 could put severe pressure on the solvency of the debt, and I believe it is the biggest risk factor associated with the stock. Finally, in the event of difficulty in raising new financing, management could be forced to undertake stock issuance with dilutive effects on capital.

Others risks being considered

On top of the one just discussed, I believe that Sunrun is subject to an additional set of risks that can lead to a serious negative impact on its financial results/assets and are among the main reasons behind my bearish view on the stock:

One of the main risks already implicitly pointed out is the intense competition in the distributed solar systems market, where companies operating in the sector seek to gain market share at the expense of margins. Such activity can have destructive effects on such companies, even if it ultimately benefits consumers.

The industry in which RUN operates is characterized by a high level of regulation and various tax incentives. Changes to these regulations can have a relevant impact on economic performance.

In contrast to utility-scale systems, distributed systems have higher installation costs and significantly higher maintenance costs. Also, by relying on third-party installers, it has little control over customer relations with its clients, evidencing high dissatisfaction rates as shown by ratings on Yelp.

Any tariffs imposed by the U.S. government on Chinese products may have an inflationary effect on solar panels, batteries, and other industry-related components. Quoting from the financial statement FY23:

We have historically benefited from declining costs in our industry, and our business and financial results may be harmed as a result of recent and any continued increases in costs associated with our solar service offerings and any failure of these costs to continue declining as we currently expect. If we do not reduce our cost structure in the future, our ability to continue to be profitable may be impaired.

45% of company-owned facilities are in California. Extraordinary weather events or lower solar irradiation in the state can result in a huge cost to the company in economic terms. That is because Sunrun, in the event of electricity output below the average estimated within the contract, agrees to pay the difference to its customer.

Main opportunities

Despite there are many risks associated with the investment, there are also a range of opportunities that could help improve Sunrun’s economic and financial situation:

A reduction in interest rates between H2 ’24 and FY25 could help RUN to refinance its debt at lower rates compared to current rates, reducing interest expenses, and boosting its profitability.

Increased storage attachment allows more value to be derived from each individual customer, reducing the percentage incidence of external partner installation costs, with a positive impact on operating results.

The Inflation Reduction Act will boost demand for distributed PV systems outside California as well, reducing the geographic concentration of revenues. An opening to international markets is not excluded in the future, but at least for the moment it looks complicated. The European distributed systems market, for example, is characterized by greater fragmentation and could be an excellent growth environment for RUN.

Finally, the lower price of solar panels due to increased Chinese supply could be a positive factor for the company’s financial performance. The same for lithium price, which decreased significantly from 2022 and 2023 prices.

Valuation

I was not able to conduct a multiples analysis or Discounted Cash Flow (DCF) due to RUN’s negative estimates of EBIT and EBITDA. However, the EV/Sales ratio analysis shows a valuation in line with the average of the two peers included in the article. Considering RUN lower operating margins than NOVA, as evidenced by the previous comparative analysis, suggest that Sunrun’s current valuation is slightly lower than Sunnova’s. As a result, market shows a premium valuation for Sunnova compared to Sunrun.

The Quant Rating provided by Seeking Alpha shows a valuation of 2.58 corresponding to Hold, despite being at lower levels for several periods of time in the past. The most negative ratings are Growth, Profitability and Momentum, two of which are deteriorated from 3 months ago. The F attributed to Profitability confirms my concerns that, given the current market dynamics, RUN seems unable to turn its installations into profits. Moreover, Momentum downgrade by 2 notches (from B- 3 months ago to current D-) highlights the difficulties of the stock, resulting from a new increase in US long-dated rates due to a possible reschedule of the rate cut, confirming the thesis previously discussed in the section on debt.

Although both competitors present worse Quant Ratings, 1.23 for NOVA and 1.27 for SPWR, the result of RUN remains, in my opinion, negative enough to lead me to stay away from this investment before any noticeable improvement.

Conclusion

Sunrun operates in an extremely competitive industry, characterized by strong headwinds due to high interest rates, increasing industry competition and growing customer dissatisfaction. FY23 was an extremely negative year, characterized for the first time by a decline in revenues, in contrast to competitors such as Sunnova continuing their growth trend. I expect an improvement in economic results and margins in both FY24 and FY25, but which will not yet turn into profits. In light of the various issues discussed in the article, I currently assign Sunrun a Sell rating.