Sunrun: an innovative business model
Sunrun is an innovative solar company that pioneered the Solar-as-a-service model, where it finances the initial investment of installing solar panels for residential homeowners, and then leases the solar back to the homeowner. Homeowners benefit by getting a cheaper electric bill with no upfront investment. Sunrun benefits by securing long-term (20-25 year) recurring cashflows and tax credits that it can sell to institutional investors.
Since Sunrun is financing the initial cost of installing the solar, the cost of its capital (debt + equity financing) is very important to the sustainability of its business model. Recently, Sunrun has been able to drastically reduce its cost of capital, which will likely lead to strong growth going forward. I discuss the reasons for this in greater detail next.
Reduction in cost of capital leads to faster growth
Since Sunrun needs cash to finance the equipment and labor to install solar for its customers, cheaper capital means that Sunrun can grow faster and more efficiently. During the Q2 Earnings Call, Executive Chairman and Co-founder Ed Fenster disclosed that the company’s cost of capital has declined at an accelerated rate in 2021:
“While our capital costs have been steadily falling since inception, in the last year we've seen an acceleration in these improvements, which have been most pronounced in our non-recourse subordinated debt costs. Today, this market is pricing 175 to 350 basis points below where we've placed comparable loans over the last several years.”
Sunrun is a capital-intensive business with substantial amounts of debt and upfront costs. The recent decline in Sunrun’s cost of capital will lower one of Sunrun’s largest expenses: interest. With less cash going to interest, more cash can be invested in growth. This also allows the company to offer better pricing to customers, further accelerating growth.
The way Sunrun has been able to lower its cost of capital is by selling its long-term recurring cashflow streams to income investors, such as pension funds and other institutional investors. Due to the high collection rates and multiple years of data that span two recessions (2008 and 2020), the market has started to warm up to Sunrun’s financial products (its long-term solar leases) and is paying a premium for these cashflows.
What is significant is that Sunrun now receives more cash from the sale of the long-term leases than it costs to install the leases. This means that Sunrun can finance solar installations for homeowners, and then turn around and sell the contracts for more than the “creation costs”, or the total costs to capture the customer and install the solar systems. This allows Sunrun to quickly realize returns in its solar investments, and to recycle the capital into new growth. This dynamic helps support an acceleration in growth going forward.
Sunrun illustrated this trend in the graphic below: the “Upfront Cash” bar, which is what Sunrun receives for selling its solar leases, is higher than the “Creation Cost” bar. This highlights how Sunrun can generate the necessary cash to fund its growth going forward by selling its solar leases at a higher cash value than its initial cash investment. Co-founder Fenster explained during the Q2 Earnings Call that this dynamic means that Sunrun no longer needs to issue equity financing, which will protect investors from dilution. I also believe that this helps support a premium multiple, as Sunrun should be able to self-sufficiently fund its growth going forward by selling its solar leases.
Source: Sunrun Q2 2021 Presentation
There are some caveats to this model. For example, leases that are “aged” for 5+ years generally receive a higher “Upfront Cash” value, so Sunrun needs to hold onto the leases for a few years before securitizing them. The financing deals are also complex and include tax equity financing, which is based on tax credits for solar installations. These tax credits are scheduled to be reduced in 2024, which I discuss in more detail further below in the risks section.
Sunrun’s financials are better than they seem
As mentioned above, Sunrun is a capital-intensive business, as it frontloads expenses but is paid for these services over multiple years. A quick glance at Sunrun’s income statement and cashflow statement shows a company deeply in the red, hemorrhaging cash. However, GAAP accounting does not properly showcase Sunrun’s business model, in my opinion. For example, the company must expense the majority of installation and marketing expenses upfront, but receives the cashflows over 20-25 years. This mismatch is expense and revenue recognition makes Sunrun’s earlier years appear unprofitable, but will make later years appear highly profitable.
The company can also quickly monetize its solar leases by securitizing them (discussed above), but this is considered a financing activity and is not included in operating cashflows. This is a technicality of GAAP, and the argument can be made that the sale of the leases is similar to selling the solar equipment, which if that were the case, would drastically improve the presentation of Sunrun’s cash flows. As shown in the two charts below, Sunrun’s as-presented FCF is deeply negative as the firm finances the upfront costs of solar installations. In the second chart, if we account for the sale of the long-term solar leases (which are sold as mostly non-recourse debt) as sales of equipment, then Sunrun’s FCF looks more favorable. I believe that classifying the sale of the leases as “sale of equipment” more clearly demonstrates the sustainability of Sunrun’s business model, which is illustrated in Sunrun’s Adjusted Quarterly FCF chart below.
(Note: Q4 2020 Adj. Qtrly FCF was impacted by an acquisition completed during the year. If we include acquired cash of $537 million, then Q4 adj. Qtrly FCF would be an inflow of $309 million during the quarter)
Co-founder Ed Fenster stated during the Q2 Earnings Call that “under this financing strategy, over several quarters and especially next year, the cash flow generation of the business should be substantial.” The company has over $4.5 billion of net earning assets on its balance sheet, which represent the cash value Sunrun would receive today if it sold all of its leases. With $4.5 billion in available capital on its balance sheet, and lower costs of capital, Sunrun is becoming a more efficient company. We can see this in recent results, which have started to accelerate.
Recent results start to accelerate while funding costs continue to decline
Sunrun reports Q3 results on November 4th, so the following numbers are based on Q2 results. Notably, Q2 results accelerated from the prior quarter. For example, Q2 sales grew 20% QoQ, up from the 4% sequential growth in Q1. While Q2 sales typically accelerate relative to Q1 due to seasonal trends, this represented the fastest Q2 sequential growth rate in the last four years. Moreover, Q2 orders increased 25% QoQ, which outpaced the 10% QoQ increase in installations, signaling that demand has outpaced installations. The outsized growth in orders also supports a continued acceleration in sales going forward. Pro-forma customer count also accelerated, and grew 19% YoY in Q2 to 600,000 customers, an acceleration from the 18% YoY growth in Q1. The acceleration in Sunrun’s business led management to increase their 2021 sales outlook to 30% YoY growth (up from 25%-30%).
Sunrun reported that capital costs have come down even more since the close of Q2 which is a harbinger that growth will likely continue to accelerate. For instance, on 10/11/21, Sunrun announced its non-recourse lending facility increased by $1 billion (to $1.8 billion) while interest costs also fell by 50 bps. The non-recourse lending facility is used as a bridge to finance solar installations and are paid off once the solar leases are aged and can be securitized. The large increase in the lending facility coupled with the lower interest rates highlights how the bond market believes that Sunrun’s business model is sustainable. The increase in cheap capital should also drive strong growth going forward.
Sunrun also announced that its most recent securitization deal was at the lowest cost of capital and highest advance rates in the company’s history. What this means is that Sunrun’s growth is becoming cheaper and more efficient. Sunrun’s Co-founder Ed Fenster added that “these financings highlight that Sunrun can not only fund growth but also generate cash, despite incurring billions in capital expenditures and operating cost.” Looking forward, Sunrun’s cheap capital and unique financing model positions the company well to grow rapidly with the solar market.
Trends driving the adoption of solar
Climate change, the adoption of EVs and cheaper electric bills are all tailwinds that will drive the adoption of solar going forward. Recent surveys have shown that owners of electric vehicles are often adopters of solar. With the expected ramp in EVs going forward, solar adoption will likely follow. Sunrun’s CEO Lynn Jurich explained during the Q2 Earnings Call that around 40% of EV owners have adopted or are installing solar now. Deloitte forecasts that EVs will gain significant market share in the future, which will likely be a tailwind to solar adoption going forward
There are also tax incentives for adopting solar. For instance, the federal government currently offers an investment tax credit (ITC) for the installation of solar power facilities. Since Sunrun is the owner of the solar systems it installs, the company can claim these ITC benefits and receive a cash grant for them from the U.S. Treasury, or they can sell the ITCs to investors. The federal government also offers a personal income tax credit for solar installed by residential taxpayers who purchase the solar system outright as opposed to leasing them. These tax credits have supported demand for solar, and were recently extended by two years.
Another key benefit driving the adoption of solar is net metering, which allows solar powered homes to sell their excess power back to the grid, which lowers their electric bill. Sunrun states that upon solar installation, homeowners often realize a 10% reduction in their electric bills, which can be realized with no upfront costs. However, utilities are fighting to remove net metering, which I discuss in more detail next.
Risks and valuation
Sunrun’s main competitors are utility companies and utilities are fighting to change net metering policies. Sunrun disclosed in its 10K that it relies on net metering policies to offer competitive pricing, and changes to these policies may reduce demand for its solar offerings. Net metering is available in 39 states, but changes are on the horizon. Louisiana recently gutted its net metering policies, which is expected to lower the amount of savings homeowners will realize from adopting solar. California is also expected to change its net metering program in 2022, which is significant as 40% of all of Sunrun’s solar installations have been in California. While these risks are outside the control of management, there are some offsets that should dampen the impact from changes in net metering policies.
For instance, management disclosed that battery installations have dramatically increased in regions with unfavorable net metering policies. CEO Jurich explained on the Q2 call that battery adoption in the Bay area is almost 100%, and “some of the changes in California, around rates and [net metering] will be even more encouragement for batteries”. Sunrun reported that battery installations increased over 100% in Q2 to a record high. CEO Jurich added that Sunrun can “network these batteries together to form virtual power plants, providing incremental recurring revenue and offering an enhanced customer value proposition. This further differentiates Sunrun from companies that lack the scale, network density and technical capabilities to serve this market.”
Furthermore, California passed a bill that went into effect in 2020 that requires all new residential builds (three stories or less) to have solar installed. There is also a bill that is expected to be implemented in California that would require commercial buildings to install solar. These new mandates may help offset any demand loss from potential changes in net metering policies in 2022
Another key risk to Sunrun’s business model is changes to tax incentives. The US government currently offers favorable tax benefits, which were recently extended for another two years. The expected phase out of tax benefits may reduce demand for solar, which would be a headwind to growth for Sunrun. However, there are stipulations in the tax codes that allow the tax benefits to be accrued throughout 2026, which should provide enough time for Sunrun to continue to scale its business. Furthermore, efficiencies are driving down the costs of solar and batteries, which should help offset the need for government incentives in the future. While it is impossible to predict if incentives will be extended further, the global drive to reduce greenhouse gas emissions should motivate governments to incentivize solar going forward.
Lastly, supply chain issues present a risk in the near term to Sunrun’s ability to accelerate sales. Data gathered from S&P Global found that US solar panel imports fell in Q3 2021, possibly due to supply chain bottlenecks. This issue could lead to an increase in prices in the near term, which may cause a near term headwind to demand.
While there are many risks, Sunrun should be able to overcome them going forward. Looking at its valuation, Sunrun trades at an 8x P/S multiple, which is above its three and five -year median of 3x and 2x, respectively. The higher multiple relative to historical valuations is likely a reflection of the company’s improving financials, as the firm is now able to generate excess cash by securitizing its solar leases. Looking forward, Sunrun trades at a 6x fwd P/S multiple, which is slightly below the peer median of 7x. Sunrun appears reasonably valued relative to other solar-related peers.
Another way to value Sunrun is to look at the company’s net earnings assets, which represent the present-value of future cashflows of its leases (less cost and debt) and is similar to book value. Since Sunrun is in the business of originating long-term loans and securitizing them, this is similar to wholesale mortgage lenders, which are commonly valued at Price to Book value multiples. Below are Price to BV multiples for some mortgage originators along with Sunrun, a solar lease originator. Mortgage originators have Fannie Mae backstopping their loans with implicit guarantees, which likely awards them higher multiples. Nonetheless, the business models of these companies are somewhat similar to Sunrun’s, however Sunrun trades at a substantial discount.
In conclusion, Sunrun pioneered a unique business model that allows residential homeowners to capture the benefits of solar without the large upfront investment. Sunrun has been able to securitize the long-term leases it signs with homeowners and is now in a position where it is receiving more upfront cash from the sale of these leases then it costs to capture the customer and install the equipment, making Sunrun self-efficient and no longer reliant on dilutive equity financing.
The company’s cost of capital, the main barrier to growth, has rapidly improved in 2021, and the improvement has continued into Q4. This improvement makes Sunrun more efficient and allows the company to accelerate growth going forward. While we have seen an acceleration in growth in Q2, the decrease in the company’s cost of capital and tailwinds from the adoption of solar should support strong growth going forward. While there are risks, such as changes to net metering policies and tax codes, there are offsets to these risks that should benefit the company going forward. The company also appears reasonably valued relative to peers.
Disclosure: Bradley Cipriano and the I/O Fund may own shares in Sunrun and may change their respective positions within the next 72 hours. You can access the I/O Fund’s positions herehere. The above article expresses the opinions of the author, and the author did not receive compensation from any of the discussed companies