Real Goods Solar ( Nasdaq - RSOL ) -- Speculative Turnaround

Real Goods Solar (RSOL $0.85) appears on track to report unexceptional Q4 results.  New management was brought in during the third quarter.  The company's two largest shareholders each contributed $1.0 million in debt financing, as well, to tide things over while operations were straightened out.  Overdue receivables were collected, reinforcing cash flow.  Middle management was streamlined.  New marketing techniques have been developed.  And better supply arrangements were negotiated.  Still, the overhang from earlier mistakes almost certainly kept sales below potential.  Margins probably remained below normal, as well.  Another sizable loss is anticipated.

The solar installation industry is thriving, though.  If Real Goods Solar's new management team can restore operations to normal, profitability could reverse course in a meaningful way.  The company is a leading provider of solar systems for residential (50% of sales) and commercial (50%) customers.  The latter business was added early in 2012 via an acquisition.  The underlying business remains solid but too much bureaucracy was created by the merger.  Most residential contracts provide homeowners with electricity at prices below local utility costs with no upfront investment.  Real Goods Solar engineers and builds the systems, and then sells them to investors who benefit from a raft of tax benefits.  Homeowners either lease the systems and pay a fixed monthly amount.  Or they pay for the electricity they use, subject to a monthly minimum.  The format usually depends on what kind of buy-and-sell deals are available with the local utility.

U.S. tax credits offset 30% of a system's cost.  The law actually allows higher credits based on a "market value" formula, although that approach has been subject to abuse and now is being investigated by the government to identify possible fraud.  State and local governments provide additional payments.  And many utilities are forced to offer incentives of their own.  On top of that the I.R.S. permits 60% first year depreciation, and 100% after five years.  Low interest rates facilitate financing options further.  As a result installation companies like Real Goods Solar can sell systems at a hefty mark-up to the financing companies. The trick is to keep marketing, management, and regulatory costs to a minimum.

A large debt payment comes due next April.  Sales expansion is likely to be held back until that obligation is refinanced.  The bank is sure to require evidence that margins are returning to normal.  Despite that constraint on selling expense, sales promise to improve at an above average rate.  Panel costs continue to fall.  Installation methods have become increasingly efficient.  And the tax incentives will remain in place until 2016, if they aren't extended.  Climate change has been identified as a top priority by President Obama as he begins his second term.  Additional boosts could emerge.

We estimate Real Goods Solar will return to profitability this year.  In 2-3 years sales could reach $150-$200 million.  At 5% pretax margins fully taxed income could attain $.15-$.20 a share.  Higher margins appear possible, especially if the regulatory climate is simplified.  Obtaining permits and hook-ups now accounts for 25%-40% of a deal's total cost.  Aligning local utility interests with the solar industry could yield further benefits.  New solar technologies are in the pipeline which could double price performance of the panels themselves in 2-3 years.  That rate of improvement could be sustained for several iterations, making solar a mainstream technology.

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Real Goods Solar (RSOL) -- Delivering the Goods

Real Goods Solar_­ (Nasdaq: RSOL $1.15) is a leader in solar energy engineering, procurement and construction (“EPC”). The company designs and installs residential and commercial solar arrays, using photovoltaic equipment from top manufacturers. This equipment is purchased directly from the manufacturers, unlike many of Real Goods’ competitors, which buy from third-party dealers at a higher cost. In addition, the company offers several other services, including obtaining permits, grid connection, and helping customers to find financing for a project.

The company’s residential and commercial installations normally generate between three kilowatts (“kW”) and one megawatt (“MW”) of electricity. If bought outright, a residential array costs between $10,000 and $30,000. It’s a substantial investment up front, but the system will generate power for 10%-30% less than what fossil fuel utilities charge. Certain customers also qualify for financing or system loans to ease the cost of installation.

Sales are hampered by the struggling economy. There is a lot of interest in solar energy, but potential customers are reluctant to carry through with a solar project because of economic uncertainty. Demand for solar looks like it should increase in the next few years, though. Half of United States power plants are 30 years or older, and many plants run at or near capacity during peak hours. The increased demand and aging infrastructure translate to higher costs for consumers. Utility companies will have to build new plants to reach the rising demand, which could further drive up prices. Coal reserves are estimated to last about another 100 years, but higher demand will burn resources more quickly. Also, coal may be the cheapest fossil fuel, but it’s also the worst for the environment. Real Goods and other solar installers can’t overlook natural gas, though, which is cheaper than solar and much cleaner than coal. 

Real Goods installs only in the United States, primarily in California and New Jersey, with the remainder in other Northeast states and Colorado. Sales are achieved through the company’s reputation and by word-of-mouth referrals from previous customers. Once a potential customer is identified, company sales representatives engage in thorough telephone interviews to decide the optimum setup for a customer. Customers range from 30 to 65 years old, and tend to be just as interested in the environmental benefits of solar power as they are in cost reduction. Once a contract is signed, the process takes 60 to 90 days to complete, with installation taking only two or three days. The rest of the time is spent obtaining buildings permits and have building sites inspected. 

Like most solar companies, Real Goods’ sales fluctuate seasonally. The first quarter is the slowest, because the systems can’t be installed in winter or other unfavorable weather conditions. Real Goods’ highest sales historically have come in quarters three and four. Revenue grew 70% from 2009 ($64.3 million) to 2011 ($109.3 million), but earnings haven’t followed suit. Shares earned $.08 in 2010, but the company has posted losses every other year. We estimate shares will lose $.05 in 2012, despite a projected 19% revenue gain to $130 million for the year. However, an EPS in the range of $.10 and revenues around $180 million seems reasonable for 2013. Tax credits in the United States were extended through 2016, and there is no longer a $2,000 credit cap. A handful of states have legislation that makes solar even more appealing, which could lead to other states adopting similar strategies and giving the company more potential customers. On June 25, Real Goods announced a deal with Canadian Solar (Nasdaq: CSIQ) for the former to use up to 40 MW worth of the latter’s PV panels in installations. Real Goods also buys panels from Kyocera, Sharp, SunTech, and SunPower. Inverters are purchased from Enphase, SMA and others.

The company’s main competition comes from smaller, privately-held installation companies. Solar City is believed to be the largest.  Others include Sungevity, REC Solar, Verengo, and Namaste Solar Electric. Some of the smaller companies can charge customers less, but Real Goods has a strong reputation and 30 years’ experience in solar installations. 

Real Goods is located in Louisville, Colorado.

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