Sunedison – more information on our investment
Our recent recommendation to invest in Sunedison has been met with some questions about our strategy.
Firstly, I want to explain that Sunedison is a wonderful business. Unfortunately the management has been a little too eager over the last few years. They have made a few poor decisions and that has led to the extraordinary cheap price available today.
Sunedison is a leader in one of the world’s fastest growing industries. Renewable energy is here today and the falls in price of around 95% in solar cells since 2008 has made it competitive with fossil fuels. Sunedison does have wind installations, however its focus is mainly on solar.
The potential market for Sunedison over the coming decade is beyond our imagination. Solar energy use is still in its infancy compared to fossil fuels. Even with the largest market share in the industry, this only gives them a 2% share. There is a potential growth rate for this business that we will be unlikely to see in most other companies.
Understanding a solar business is quite easy. They build solar installations with large upfront costs and then collect rent from them for the next few decades. What the market has failed to factor in is the growing cash flows from the existing and recently installed sites. These cash flows are growing faster than the debt. So much so that the equity in Sunedison has tripled in just 1 year. Yes, the debt growth of Sunedison has been monumental, but the value of the business is growing much faster. The value is very easy to calculate because we know the amount of their installations.
To quote Mark Twain:
“The reports of my death have been greatly exaggerated”
The media has seen the debts of Sunedison and prematurely concluded that their debt growth will lead straight to bankruptcy next year.
What the media are unaware of is that the structure of Sunedison, whilst complicated, is not as bad as it seems. Most of their debt is nonrecourse. Very little debt matures next year. The media is very likely wrong.
Sunedison set up two companies to take much of the debt away from the parent SUNE. These two hybrid offerings are for eager investors taking large risks for very little upside.
With interest rates at century lows, the desperation for yield leads people to do really dumb things. The search for a Patsy to buy something with a 6% return with all the risk of the shares is not difficult in today’s world. The Australian banks are establishing very similar structures with their hybrids. All of the downside risks with none of the upside. You would think there was a limited market for these types of products. At present, people would much rather get a 6% return with lots of risk than a 3% return with no risk. It will end badly one day for these yield hungry investors.
Funnily enough most people in Australia don’t realise that the Australian banks are far more leveraged than Sunedison, on much riskier assets. With financials (including banks) at 50% of the Australian share market, most other Aussie investors (speculators) are taking enormous risks without realising it. Sunedison in our view is much safer than the Australian banks. The only difference is, with the new Basel rules, the Australian banks have virtually no upside and only enormous downside. Sunedison does have downside if we are wrong, however the upside is many, many times higher from here.
The recent loss of confidence in their complex structure means they will have to find other avenues of finance as they simply cannot transfer assets into their “yieldco” hybrids. With JP Morgan, Macquarie Bank and Goldman Sachs as their key lenders, we are confident that they will continue to have access to financing.
So what has to happen from here for us to make money?
One of two things:
1. The CEO gets fired and Sunedison reigns in their growth plans with a far more conservative outlook. We think this is a very high probability.
2. The company continues to be able to access cheap debt and equity and grows for the next decade at extraordinary rates. (A lower probability, but not zero).
And what has to happen from here for us to lose money?
1. The company loses access to debt markets. (We think this is a very low probability). In this situation, the company will be forced to raise capital to finish off projects. A difficult scenario is a doubling of shares on offer to raise around $1.5 billion. Under this scenario, we value the company at around $7.50, so in time we don’t lose money.
2. The company loses access to debt markets and triples the number of shares on offer. Under this scenario, we estimate the company is worth around $4, so we don’t lose too much money in this scenario, however we don’t make money either.
3. The scenario where we lose money is if the company cannot access debt markets and cannot access equity markets. Under this scenario, all work in progress would stop. The only cashflow available to the company would be from completed projects, which would likely not be enough to keep the business afloat.
The next step of our analysis is to look at the above scenarios and work out what the probabilities are of each. The only scenario where we lose significant money is in scenario 3. We believe the probability of this scenario is very low due to the nature of the business. Installing solar is a boring and predictable business. It has inherent worth and any financier can simply calculate the return on the investment and associated risk with offering them money.
With little debt maturing before 2017, we strongly believe that the tapering of growth ambitions thanks to a less eager CEO will be the outcome. Our upside under this scenario is in the many hundreds of percent return.
Every investment has risk. Berkshire Hathaway is an insurance company. Insurance is simply the calculation of risk on a large scale so that the eventual outcome is on average positive. Berkshire loses money on some of its insurance. It is the averages and probabilities of making money over time on their insurance that keeps them wanting to do business. Investment is exactly the same. If we could find 100 different Sunedison style investments, we believe we will be around 80% right. If our upside is commensurate with our average downside risk adjusted, then our eventual returns will be more than acceptable.
As Warren Buffett Says:
“ Risk comes from not knowing what you are doing”
Those investing in low upside huge downside style investments such as Australian banks don’t know what they are doing. If they continue their investment with such terrible probabilities, then over time, they will lose money.
We strongly feel that we understand the relatively simple economics of the solar industry. High upfront costs followed by long and steady cash flows. Sunedison has some slight complications in their structure, however after careful study, the structure is to the benefit of the company, not to their detriment.
The weakest link in the structure is the hybrids. We would never invest your money with a risky 6% return. We will however invest your money with a more than likely 600% return, even if we are very occasionally wrong on these types of investments.
When looking through the debt structure and consolidating only the recourse debt, the 66% debt to equity is certainly not a stretch for the company. When compared to market darlings like Duet Group (296% debt to equity), Transurban (207% debt to equity) and Aussie banks average (3000% debt to equity), it is not a stretch of the imagination to see that Sunedison is not the certain bankruptcy that the media speculate.
Unfortunately, finding companies that are trading at 2.5 times next years cash flow is a once in a 5 to 10 year opportunity.
We understand if clients do not wish to invest due to fear, however we also point out what Warren Buffett always says:
“Be fearful when others are greedy and greedy when others are fearful”
And to add in another famous quote:
“The best time to buy is at the point of maximum pessimism.” (Sir John Templeton)