Friday, October 2, 2015
Sun Edison - some comments and a way forward
Until about a week ago we were showing (small) profits on the position. Then it took yet another leg down. I know the cliche about trying to catch falling knives - but we think this is a quite good bet - and would be a better bet if the board took decisive action to fix immediate and pressing problems.
Sun Edison develops huge and highly capital intensive solar and wind project where the power is largely pre-sold and where separate financing is developed for each project. These projects are then sold to [“dropped down to”] semi-captive yield companies sold to mostly to yield sensitive investors.
There are several issues. Big solar projects are massively capital intensive – think of utility scale power generation where you have to pay for the next 25 years of fuel upfront. The projects have huge debt but also reliable high margin cash flow.
Secondly there is a pretty obvious conflict of interest in the “yield co” drop-downs. We have successfully shorted a few companies where we think that overpriced assets were being sold to captive vehicles. In the end they these were good shorts - if you can't treat the investors in the drop-down vehicle fairly you will eventually wind up with fewer investors, less access to capital and less underlying profitability.
Thirdly, because of the related parties and the copious amounts of different types of debt these companies have complex and even scary accounts. At Bronte we are quite good at getting to the bottom of complex accounts. But we have a problem with these.
In a meaningful fashion Sun Edison is a “trust me” story.
Whatever, the problems Sun Edison and its yield cos have been smashed. Once fairly obscure solar developers have become a major topic of discussion on Wall Street.
It took us a while to understand why they have fallen so hard. The argument comes down to complex accounts, lots of debt and a peculiar acquisition of door to door marketing company(Vivint).
But there is also more than the usual amount of rumour and innuendo. On Twitter there are arguments we know to be wrong and arguments that are simple fear-mongering (calling Sun Edison “Sun Enron” is one such appeal). Sure the company is highly levered and complex but it is almost certain that the past deals have been good deals. Any solar farm deal you put in place 3-5 years ago has worked out. Both solar panel prices and interest rates are lower than you would have baked into your cash flow models. We would be enormously surprised if the past deals of Sun Edison did not work out.
Whether the future deals work out is however an open question. Low solar panel prices and low interest rates are not exactly a secret – and the funding cost for solar panel farms has risen with this panic. Bluntly we think unless the company repairs its relationship with capital markets it is unlikely to be able to generate good deals in the future and it will wind up in run-off.
There is a deeper problem with the way these companies [yield cos and their parents] see themselves and communicate with investors. That comes down to the fact that many have their roots in semiconductors where operating leverage is everything. You disclose your costs, your variable versus fixed, capacity expansion and so forth because if you make solar modules, wafers or chips that stuff matters a very great deal to your business. Investors use and demand that information because simply put, it matters and drives the profitability of the business.
A yield-co is a completely different business – it is a non-bank financial company.
Non-bank financials “blow up” for one of three reasons, (i) credit risk, (ii) duration mismatches and (iii) and unstable funding. If you want to assess TerraForm Power (Sun Edison’s yield co) you need to assess whether the credit risk on the projects (the counter-party) is okay, how the contract and funding is (eg floating/fixed etc) and all the ways in which project development funding is able
to roll into long-dated funding.
A friend put this to a yieldco and the management balked at providing that level of project detail. My friend's response: “well, are you Northern Rock?”
And that is the guts of the issue and the market fear. We have gone to considerable effort to convince ourselves Sun Edison is not Northern Rock with solar panels. We have talked to several people who have organised funding for these things and it seems okay to us. Specifically all construction finance automatically can be termed out as project finance (over the life of the project and linked to the project) when the construction is done.
If this is true the market fear for this company cannot cause insolvency. Given that the company is priced as if insolvency is likely this stock should produce a good return from here.
Alas we could be wrong here. We can’t see all the funding (the disclosure is complex) but the bits we have seen have this character. We checked through several sources and we don't think the company can have a “run on the bank”. The Northern Rock outcome is unlikely.
Now of course we have not seen and understood all of the finance deals. Only the ones we can find. But that is sufficient to know we are probably right. And that is the case for buying. The old projects are good and they should run off at an attractive clip.
The Vivint Acquisition
That said this company does not behave like a financial institution, they have been rash and callous in their treatment of capital markets. This is dumb. Capital (not solar equipment) is the main input in this business. And capital is cheaper if people trust you.
Moreover management did a really foolhardy acquisition and explained it badly.
Vivint (the target) is a door to door marketing scheme selling solar systems. Some suggest multi-level marketing scheme characteristics but I cannot find the contractual terms that indicate it is an MLM. [Contra: friends have done research on the numbers of complaints at State agencies concerning Vivint.]
Moreover the product it is selling door-to-door (financed solar systems) is not a bad deal for customers. Customers put the solar panels on their roof and their power bills go down. Whether the solar system is owned by the household or some corporate structure what is effectively going on is a loan to the householder where the householder will repay the loan by splitting the utility bill saving with the solar company. Things can go wrong in this deal – but those things are not very likely.
That said, there are good reasons why roof top solar is less attractive than utility scale solar farms. The main one is that rooftop solar gets under-priced use of the grid. The grid is essential here – unwanted solar is sold to the grid and the grid provides electricity when the sun doesn’t shine. My business partner was once a utility CEO. He has an instinctive skepticism of rooftop solar. He thinks – correctly – that people with rooftop solar underpay for grid services.
In Northern California this is becoming explicit. Pacific Gas and Electric is proposing changes which explicitly charge households with solar panels more to access the grid. Whilst we have no view on the size of the charge the direction is probably right. This will become a trend and make roof top solar less attractive in the future.
The Vivint acquisition - which looks strange - was poorly explained and was bundled with a few details that indicated that the margins on projects dropped down to the captive yeild-cos are declining caused a run on the stock. Moreover there were lots of hedge funds who had oversized positions in Sun Edison before the collapse. There clearly was a rush to the exits.
And in capital market terms those can be self-fulfilling. The equity and debt cost for Sun Edison has risen substantially and this seriously impedes the economics of the company. Its that strange thing about financials that lower prices for equity and debt reduce the future cash flows.
The current situation and the way forward
Sun Edison has lost about 80 percent of its value without the slightest hint from the management team that there is a problem. The credit default swaps have moved against them and it will be far more difficult to grow whilst the situation is like this.
There really is one issue here. Can they find and develop new solar plants and drop them down into project financed bankruptcy remote vehicles and (a) make a profit and (b) ensure the new owners of those vehicles make enough return to keep them coming back for the next vehicle? [At the moment there is a fairly strong private market for solar projects - people like large pension plans - but the same concern applies to them too. They got to trust you.]
If they can't develop and sell either growth stops dead or the company becomes a ponzi.
Alas with market distrust it becomes unlikely that future projects can meet the required return hurdles. The private market for completed projects will also have the same concerns about the management.
The best case here is that the company has become a melting ice-cube. It is worth something (I think a fair bit more than the current price) but every drip of cash that comes off in the end goes either for debt repayment or is returned to shareholders.
The whole project development team - the raison d'être of the company - ceases to have any use. They should all be fired. Yes - all of them. [If you work for Sun Edison it is your job too. And that will eventually include the board. Them are the stakes. If the current board doesn't do something about this it is eventually your job.]
There is an alternative - an alternative I think the company should take. They should pay their contrition to the market - and give the market what the market wants.
What the market wants here is a clear vision of financial control and responsibility. They want to know that Sun Edison is not Sun Enron.
Stocks don't just fall 80 percent in a vacuum. Someone has to be held responsible - and the board needs to ensure that happens to ensure Sun Edison has a future.
That person is the CEO.
Ahmad R. Chatila
Ahmad R. Chatila (Sun Edison's CEO) is a visionary. Indeed Mr Chatila is the reason for Sun Edison's success to date. I have heard managers describe him in glowing terms - amongst the best CEOs in America.
And I don't disagree.
Except that he should be fired. Pronto. Now.
Sun Edison - through the vision and drive of Mr Chatila has become a financial institution. One with a lot of run-off value. One which I think has improved the world a great deal.
Vision, drive and competence are usually great things for a CEO.
Not in this case.
I am an old fashioned kind of guy. I do not think visionaries should run financial institutions.
Visionaries running financial institutions end in disaster.
Mr Chatila has built an institution for which he is profoundly unsuitable to run. The market has made that abundantly clear.
Pay him out
I have mostly been unsympathetic to firing executives and leaving them with a big payout. Mr Chatila is an exception.
Mr Chatila has not done much that is wrong. He has created - from very little - a worthwhile, valid and large business. He has achieved much.
He has not done very much that is wrong except create a business which he personally is a woefully inadequate CEO for. For this he should be rewarded: as recognition of (a) what he has truly created and (b) for going quietly and constructively.
Calculate his payout, add thirty percent and fire him.
Who to appoint?
There is a core criteria on picking the new CEO.
They need to be boring and from a control culture. The idea CEO would be someone from (say) the risk management department of Goldman Sachs. What you want is a dull suit occupied by someone whose job it is to pull wings off butterflies. Someone whose job it is to ensure - and be seen to ensure - that bad projects are not funded.
The market wants someone who will get on an earnings call and talk about asset liability matching, FX risk mitigation and basically sounds like the CEO of a mortgage REIT, not a semiconductor visionary.
You want risk aversion above all other things.
And you want it for another reason. Mr Chatila has populated the senior ranks of Sun Edison with people like himself. Ambitious go-getters - people who get things done. It is notable that all of the ex Goldman hires at Sun Edison come from the banking and advisory side. They are deal people. Deal people do deals and are not happy if they are not doing deals.
The people Mr Chatila have hired have got things done. Alas if you are going to have people like this in a financial institution (and Goldman Sachs is full of such people) then you need a counter-balance. Someone who stops you doing silly things and has the intellectual horsepower to work out what is silly and what is not. There are plenty of such people around and if Sunedison can poach deal centric Goldmanites then perhaps it can pick up a few slighly more salty risk managers too.
There is an alternative of course. But that is harder. You could keep Mr Chatila. Have a visionary running your financial institution - but then you need to beef up the risk management culture of the place to an extraordinary degree. You need to sack the CFO, half the board need to resign (and be replaced by hard-headed financial types) and you need to remove about half the go-getters that Mr Chatila has installed.
Easy and difficult routes to dullness
This company has got to become dull and predictable and it has to get there fast. Anything short of dull and predictable will end badly.
There is a fast route to dull and predictable (the one I prefer). Start at the top. Sack Mr Chatila. Appoint someone who will embody the new (and boring) Sun Edison. And this guy is going to give the market the sort of information they need - that is
(a). Power purchase agreements and their counter-parties (the analog of credit risk for a non-bank financial institution),
(b). Contract terms for the above PPAs - eg fixed, floating, renewal terms and also for the debt for the projects (the analog of whether there are mismatches in funding), and
(c). The funding details (to ensure that there are not mismatches in the duration of funding).
There is the second route to dull and predictable. That is to leave Mr Chatila in place but sack half the people around him and replace them with people who will control his ambition. This is - in this case - a worthwhile option as Mr Chatila really is a visionary - someone who really has created value.
Whether you can keep the good parts of Mr Chatila (vision, drive) and also keep the market happy has yet to be seen. I have my doubts.
The third way to dull and predictable - and one which will be forced upon the company shortly if the board does not react sensibly is just to put this into a form of run-off. Fire everyone in project development. Just do it. My guess is that they have to start firing now - but a few is not going to do. In runoff they have to fire all the interesting people, leave a skeleton maintenance staff and send us (now suffering) shareholders lots of cash.
My guess is that the board will settle on the first option or Carl Icahn or some equivalently effective activist investor will buy a big stake and force the third option on them.
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