SolarEdge’s (SEDG) recently announced Q2 results show a company that is back on track after some minor setbacks in the last few quarters. Q2 revenues at $325M exceeded guidance of $310 to $320M. GAAP gross margin of 34.1% also came in above guidance of 32% to 34%. Solar segment outperformed with revenues of $307M compared to the guidance of $290 to $300M. Other products with implied guidance of approximately $20M came in roughly in-line at $18M. Non-solar product gross margin improved from 13.1% in Q1 to 14.9% in Q2 but were low mainly due to weak margins in the SMRE business (expected).
As can be seen, the out-performance in the quarter was entirely due to strong solar segment sales. Management commentary suggests Europe was the primary growth driver for the quarter followed by the US. This is consistent with commentary from Enphase (ENPH) which also claimed strong growth in Europe.
As can be seen from image below, the product strength during the quarter was outstanding. After three flattish quarters, the growth is back to historic levels.
Image from company earnings presentation
While the company had strong sales pick-up in Europe (now 48% of solar revenue and growing), US growth continues to be the chief driver of volumes. However, there is no indication that the US solar market itself is growing as rapidly as the companyâ€™s numbers suggest. Given that the companyâ€™s primary competitor Enphase is also growing well above the general market, the implication is that both of these companies are growing at the expense of competition â€“ most likely the Chinese players.
A few quarters back, there were major concerns raised by short side investors that Huawei would cause considerable damage to SolarEdge and Enphase. Enphase, in particular, was weak and was staring at bankruptcy. But, in less than a year, Huawei has stopped doing solar business in the US due to Trump administrationâ€™s tariffs and due to brand destruction caused by making a state enemy out of Huawei and putting Huawei on a restricted entity list. In addition to Huawei, we suspect that US installers may also be shying away from other Chinese brands for commercial and patriotic reasons. Consequently, instead of market share losses, these companies are now gaining share. It is remarkable how company narratives can change dramatically over a period of a few quarters.
Consequently, from an investor viewpoint, the Chinese competition overhang is now no longer an issue. In particular, Huawei the slayer has been slain. Even if the Trump administration were to reverse the course on Huawei, it will take many quarters, if not years, for Huawei to become a strong player in the space.
Another notable upside for investors is the margin narrative. Investors have been concerned about the failure rates of SolarEdge devices and the hit to margins. That margin trend has reversed in Q1, and has further strengthened in Q2 (image below). Non-GAAP Margins for the solar business, a better historical comparison, were just under 37% – i.e. already above Q2 2018 levels. Note that the company is also seeing about an 80 basis-point hit to margins due to tariffs. If not for the tariffs, the companyâ€™s gross margin would be even higher. The company is now at the margin levels achieved prior to the quality problems.
Image from company earnings presentation
On the downside, the company has guided solar product margin of 33% to 35% for the next quarter. This is below Q2 levels and anemic considering the strong projected revenue growth. Management commented that due to the rapid growth, the company needs to expedite shipments and the expedites will result in a significant hit to the margins. This is expected to create a drag of 250 basis points and last through Q1 of 2020. In addition, the company will continue to incur tariff-related margin headwinds of 80 basis points until Vietnam is fully ramped. We believe the management commentary is credible and we believe that the analyst community will also find the narrative credible. This alleviates past margin concerns raised by quality issues and removes yet another overhang for the stock price.
And, finally, recent market share gains from Enphase have caused investor concern that Enphase may be taking share from SolarEdge. Clearly, the strong above-market growth numbers that SolarEdge delivered do not support such a notion. In addition, management took the time to present data to forcefully refute that Enphase was gaining at SolarEdgeâ€™s expense. We believe management response was effective and removes the third and last major overhand for the stock.
Going forward, the companyâ€™s product line continues to be strong. SolarEdge plans to start mass production of the HD Wave-based inverter and home energy management system in Q3.
The company also plans mass production of a 3-phase storage inverter for low voltage batteries in Q4. This 3-phase inverter is a key product that the company has mentioned for several quarters and has been missing in the companyâ€™s product line up. Management expects that solution to stand out in the market and that should help drive significant product sales in 2020.
The company also expects to have significantly advantaged commercial inverters in the market in 2020 and highly innovative utility scale inverters in 2021.
The companyâ€™s UPS product line is also being revamped and has yet to start contributing and should start delivering results in the upcoming quarters.
Kokam manufacturing plans are also complete with equipment ordering to begin in Q4. Management expects to invest $50M to $60M in Kokam facilities over the next 12 to 18 months to get to 1GW to 1.8GW in battery capacity. This business should drive considerable growth in 2020.
While the removal of three major overhangs is great news, the most stellar part of the earnings release is the guidance. The company guided for Q3 revenues of $395M to $410M with gross margins of 32% to 34%. While the gross margin guidance is a bit light, we already covered the reasons for that earlier and is not an area of concern.
The revenue guidance shows a strong recovery since quality-related setbacks in 2018. At the midpoint, Q3 guidance represents a 24% quarter-to-quarter growth and a 71% year-to-year growth. Solar segment revenue guidance of $375 to $390M suggests that other segments may not grow meaningfully in Q3 despite management’s earlier optimism about some SMRE orders in Q2 or Q3. Management indicated that there could be additional safe harbor sales ahead of ITC expiration but the extent of this is unknown. This could provide further upside to numbers in Q3 and Q4.
Management made it clear that demand visibility is â€śvery, very, very goodâ€ť suggesting that Q3 is essentially in the bag. In anticipation of the growth, the company increased manufacturing capacity by approximately 25% during Q2. Product from the new Vietnam facility, which will not be burdened by tariffs, will start shipping to customers in Q3. As such, the Vietnam plant could meaningfully drive up margins for the company starting Q4. The resulting operating leverage significantly increases the companyâ€™s profitability.
Management commentary suggests the US to be the primary driver of growth and backlog for the second half of the year. While this is clearly driven by ITC step down, the growth commentary should further alleviate any concerns about market share loss to Enphase.
Although SolarEdge’s historic growth rates have been around 50%, growth stagnated a bit in 2018 and the stock valuation has lagged. SolarEdge is once again growing rapidly after product quality hiccups and the companyâ€™s operating leverage is starting to play a significant role in the companyâ€™s earnings beat. The major overhangs holding the stock back in the recent past have now been addressed. This should cause investors to be significantly more bullish about the stock than what we have witnessed in the recent past.
Note: A more extensive version of this article was released to subscribers immediately post earnings.
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Disclosure: I am/we are long SEDG,ENPH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.