Enphase Stock: I Was Wrong (Rating Downgrade) (NASDAQ:ENPH)

Enphase Energy (NASDAQ:ENPH) recently shocked the market after releasing their latest Q3 earnings. The company reported a decrease in revenue and profit, but the real impact came from slashing their outlook for Q4 2023: they expect their Q4 2023 revenue to be $300-350M. Just as a reference, their Q4 2022 revenue was $725M.

Even though I knew their Q3 results were likely to be bad, I wrote a bullish article about Enphase recently, in which I analyzed the benefits of their main product, the solar microinverter, and tried to estimate its future potential. Enphase’s abysmal outlook has forced me to update my thesis.

Enphase’s results

In a nutshell, Q3 financial results were not good. But this was more or less expected. Although Enphase reported lower revenues, their gross margins remained intact, and their earnings were not that bad either:

Their outlook was however, a negative surprise. Actually, I believe the Q4 outlook was so terrible that I feel the need to recalculate whether the company is still an investment which is likely to lose or to gain value during the coming quarters. Please bear with me and take a look at their expected Q4 metrics pasted from their Q3 financial report (bold text added by author to create emphasis):

• Revenue to be within a range of $300.0 million to $350.0 million, which includes shipments of 80 to 100 megawatt hours of IQ Batteries
• GAAP gross margin to be within a range of 46.0% to 49.0% with net IRA benefit and 38.0% to 41.0% before net IRA benefit
• Non-GAAP gross margin to be within a range of 48.0% to 51.0% with net IRA benefit and 40.0% to 43.0% before net IRA benefit. Non-GAAP gross margin excludes stock-based compensation expense and acquisition related amortization
• Net IRA benefit to be within a range of $26.0 to $28.0 million based on estimated shipments of one million units of U.S. manufactured microinverters
• GAAP operating expenses to be within a range of $142.0 million to $146.0 million
• Non-GAAP operating expenses to be within a range of $85.0 million to $89.0 million, excluding $57.0 million estimated for stock-based compensation expense and acquisition related expenses and amortization
• GAAP and non-GAAP annualized effective tax rate with IRA benefit is expected to be within a range of 21.0% to 23.0%

In the past, Enphase’s outlook has often been relatively conservative, so let us assume their Q4 outlook does not break that trend. Let’s now calculate a worst-case and a best-case scenario based on the metrics they predict:

Click to enlarge

Based on Enphase’s estimates, their Q4 income from operations will likely range between -8M and 29.5M. Of course, they will still need to pay income tax (if applicable) and also have some interest income and expenses (actually Enphase’s interest income has been much higher than their interest expenses in 2023). After this, the company ends up with net earnings, that will likely be between -$0.06 to $0.21 per share. This is actually not bad if we assume that Q4 2023 will be the bottom of the ‘solar cycle’, since the company still makes a (small) profit.

The problem is that nobody knows if this is the bottom. If demand and revenue stay down much longer, which I estimate is not unrealistic, some things are going to hurt Enphase investors on the longer term: their stock compensation program and their convertible debt. Let us take a better look at both of these.

Stock compensation

Enphase reports GAAP and non-GAAP metrics. In their GAAP metrics, stock-based compensations are included as operating expenses. With their quick surge in share price after the company started being profitable in 2019, it is no surprise to see that the total value of their stock-based compensation has shot up dramatically as well:

Since share-based compensation is required to be booked using the fair value (market price) on the date of the grant, awarding a fixed number of stocks will lead to increased dollar-value of stock-based compensation if the share price of a company rises.

The current share-based compensation plan was approved in May 2021 and supplied in the issuance of 9.1 million new shares to use as stock compensation for employees, directors and consultants. Also, 5.3M ‘returning shares’ (not used for a previous program or failure to vest) could be used. At the start of 2023, 6.7 million shares were still available for issuance.

Enphase also has an employee stock purchase plan, with which employees can buy their own companies’ stock at a 15% discount. Enphase’s expenses of this plan were however relatively limited compared to the cost of the share-based compensation plan during the last couple of years.

If we use the average rate of stock-based compensation between May 2021 and now, we can try to calculate the theoretical future costs of stock-based compensation with the current share price if the stock-based compensation would be done using a fixed number of shares. Between May 2021 and now, there were roughly 9 quarters, and the difference between the 9.1M new issued stock and 6.7M still available is 2.4M. The returning shares blur the math here, since returning shares will continue to be added to the equation and they are likely to already be used, which makes the total number of granted shares higher. So the expected expenses we calculate will be a minimum.

2.4M/9 equals roughly 270K shares per quarter, which translates to total expenses of $21.6M with a share price of $80. The total expenses are likely to be higher because of the influence of returning shares and the employee stock repurchase plan, so let’s say that Enphase’s Q4 share-based compensation expenses will be about $25M.

But wait, didn’t Enphase state in their Q4 outlook that their Q4 ‘stock-based compensation expense and acquisition related expenses and amortization’ costs will likely be $57M? This means that the company will actually sharply increase the number of shares they allocate to this program in Q4, since the total value of stock-based compensation seems to be quite stable (stock-based compensation explains the bulk of the difference between their GAAP and non-GAAP operating expenses). I am surprised to see that the company increases the number of shares being used for their compensation program as their share price drops, which increases dilution for shareholders. Also, most stock-based compensation programs are supposed to reward performance, and current financial indicators do not seem in line with this.

Expenses like stock-based compensation do not directly influence the bottom line of the company, but they do influence shareholder returns indirectly. As a result of these stock-based compensation, Enphase’s share count will increase which will dilute existing shareholders, unless the company buys back its shares.

Enphase was quite active with buying back its own shares in Q2 and Q3 this year. They used $110M in Q3 (average share price of $129.92) and $200M in Q2 (average share price of $159.42) for this. Of course, considering the share price drop since then, these repurchases can be considered to be very badly-timed in hindsight. But fact is that after their Q3 repurchases, the company can still buy back shares under its current repurchase program for $890M until July 2026.

With dramatically lower sales, revenue, and profits, stock-based compensation will have a relatively stronger effect. Coupled with some (in hindsight) badly-timed share repurchase decisions in Q2 and Q3 this year, these share compensation and repurchase decisions of Enphase do have some negative influence on investors. Annual stock-based compensations of four times $50M on a total market capitalization of $10B amounts to an annual dilution of 2%, which is not insignificant.

Convertible notes

Enphase issued a couple of convertible notes during the last years:

$575.0 million aggregate principal amount of the Notes due 2028;

$632.5 million aggregate principal amount of the Notes due 2026;

$102.2 million aggregate principal amount of the Notes due 2025;

These convertible notes were all issued at times when the stock conversion price was higher than the current stock price. This means that these notes will likely have to be refinanced in the future. These notes were issued with very attractive rates: all but the 2025 notes have zero interest, while the 2025 only carry 0.25%. Issuing these kinds of notes will likely not be possible anymore for Enphase during this higher-rate environment, which will significantly increase financing costs for the company in the future.

If Enphase wants to refinance this debt, which amounts to a total of $1,309.7M, the company needs to take into account that the FED rates are currently 5.25-5.5. This likely means that the annual costs for Enphase will go up with at least 6% on their debt, which amounts to an annual $78.6M. If their earnings allow for this, Enphase could choose to pay off some of this debt, but this annual increase in costs could push the delicate balance of their ‘just-about’ profitability in Q4 2023 into negative territory if revenue does not increase.

What can we learn from the Enphase debacle?

Sometimes, one factor has so much influence on the performance of a company that it dominates all others. For Enphase, this factor is demand, which has been influenced by rapidly increasing interest rates lately. I grossly underestimated the effects rising interest rates would have on the demand for solar PV systems, and I wrongly assumed that other factors would be able to soften this blow. Also, I did not factor in that energy prices have calmed down compared to 2022. Electricity has become cheaper again (albeit at a higher level than before), and uncertainty has partially waned. As such, people have much less incentive to install PV systems than compared to 1-1,5 years ago.

At this moment, demand is everything, and if demand for solar microinverters starts growing rapidly again, Enphase will likely be fine. If demand stays depressed for a longer time, Enphase’s investors will likely not only suffer because of non-increasing sales, but also because of annual dilution from stock-based compensation programs and increased interest expenses. But, if demand picks up again, these two will likely be non-issues.

Demand for (residential) solar panels and microinverters has experienced a boom during 2022 and the first part of 2023. A combination of much higher electricity prices (especially in Europe) and a low-rate environment led to a huge surge of PV system sales. For instance, the Netherlands already has more than 1KW of solar PV capacity per inhabitant. The current calming of the electricity markets is sometimes accompanied by tougher permitting procedures, lower subsidies or even a ‘sun tax‘ in some countries like Australia. As such, there seem to be some roadblocks on the way to new explosive growth. Annual solar PV installations in Europe are only expected to grow at an annual 4% during the next couple of years. In the US, annual installation of residential solar is expected to grow at an average annual rate of 6% until 2030.

I am still holding Enphase shares, and my investment is down 40% at the moment. I will however continue to hold the shares, since Enphase seems to have has all the pieces on the board to become very profitable again as soon as demand picks up again. Demand does not need to explode, but if the company can stick to its margins and grow by a healthy annual percentage, this is enough for Enphase to be a good investment.

Enphase needs a turnaround for share price recovery. And whether 2024 can provide a turnaround for the company likely depends on factors outside of its own circle of control. When reading expectations for annual growth of residential solar installations, coupled with the current interest rate environment, it seems unlikely that Enphase’s revenue will return to previous levels quickly. For this recovery to speed up, slowly dropping interest rates or increases of electricity prices seem to be essential. I feel it is impossible to put a fair value on the shares of Enphase for this reason. This is why I have to change my rating for Enphase to ‘hold’.