How Not to Invest in Green Energy

The prospect of a greener and more sustainable energy industry has been the dream of many a modern energy executive, including your correspondent, who has spent more than a decade analyzing green energy policies, business and development initiatives for investors, energy utilities and consulting clients.

Today, much like 10 years ago, there is a lot of talk about utility disruption and green revolutions, and it might be easy for investors to get caught up in the hyperbole, the sky-high stock valuations, and the heady promise of an investment that can possibly save the world.

It is my hope, with this column, to help investors keep their heads and their wallets when evaluating such investments, by advocating a no-nonsense, analytical investment approach that demands results.

This would seem intuitive, but too often investors have been swayed by the story to only find that a company’s prospects were pure fiction, time and time again. I’m also concerned that even as there are some promising new energy tech companies, there are also a lot of firms that offer more risk than reward. And the so-called forecast of the demise of the utilities industry has been overdone.

As we have noted in previous reports, although we do see the potential for industry disruption, the industry has yet to respond to the existential threat. And we would urge extreme caution when evaluating alternative energy investments in general, as it is still far from clear how the industry will evolve and which technologies or firms will be dominant.

The Wild, Wild West of Green Tech

My knowledge was gained the hard way: I witnessed the swift rise and sudden collapse of the last green energy bubble. In the early 2000s, when I was a young, idealistic junior securities analyst for a top investment bank, I was tasked with helping analyze the wave of green energy companies that were going public amid that era’s tech boom.

In those days, my boss, who had been designated an “All-Star Analyst” by The Wall Street Journal, believed that electric deregulation and green energy tech were going to produce a new breed of energy company that would displace staid utilities. He thought fuel-cell technology, in addition to wind and solar, energy trading and independent power companies would emerge to replace the old-line utilities industry, which would become wires companies and fade away.

And he was far from alone in making such predictions. Numerous banks and consultants were touting a new energy paradigm, where consumers could choose their electric supplier, competition between utilities would lead to lower prices, and the adoption of a carbon-pricing regime would spur a new energy revolution.

Today, many believe that solar and renewable battery technology will be the next killer application. And it is similarly predicted that utilities will be relegated to managing the wires once the bulk of companies are forced to reorganize due to huge, unsustainable infrastructure costs.

Moreover, utilities, many have said, will no longer be able to collect income on billions of uneconomic or shuttered power plants that have been disrupted by these new green energy technologies. In fact, Goldman Sachs, in a report issued in late March, forecasted that prices for solar panels and battery storage will decline to such levels that by 2033 homeowners will no longer need to be on the grid.

Of course, such bold predictions hearken back to what I heard during the last green energy wave. At the time, I admittedly drank the Kool-Aid. After all, who wouldn’t want to be part of something that was going to change the world for the better by producing cleaner, cheaper energy?

Unfortunately, that dream was not supported by reality. Electric competition was only realized in a few regions of the country, utilities’ costs were still significantly cheaper than the new technologies, and the independent power producers overbuilt, took on gargantuan amounts of debt and largely found themselves in bankruptcy.

Part of the problem was that many of these new green energy companies were commercialized too early, and much like their dot-com brethren had no income, and similar cash-burn rates.

In the old days, a company had to produce years of steady earnings before banks would even consider helping it go public. However, that all changed during the Internet bubble, when investors would snap up each public offering as if it were the next Microsoft, certain that metrics such as sticky eyeballs or page views suggested eventual financial success.

And just like their dot-com peers, many of these green energy companies would regularly miss forecasts for earnings, production, sales, or technology development.

Under normal circumstances, when a public company fails to meet goals set by management or falls short of earnings forecasts, it suffers the wrath of investors. But for a time at least, investors who bought the story about green technology were willing to look past these disappointments and push share prices to dizzying heights.

I was so scarred by their subsequent crash that when I heard a portfolio manager rhapsodizing about the recent performance of Plug Power Inc (NSDQ: PLUG), Fuelcell Energy Inc (NSDQ: FCEL) and Capstone Turbine Corp (NSDQ: CPST), I could scarcely believe it. These were names that I had not heard in years, names that many investors would like to forget. Indeed, even with the recent run-up in their share prices, the value of these firms today is just a small fraction of what it was back then.

Chart A: Will the Green Energy Boom End as in the 2000s?

2014-03-27-U&I-Chart A

Created with YCharts

What happened to them? The dot-com bubble burst, the recession hit, fundamentals changed, and investors realized that these companies’ technologies, though promising, weren’t quite ready for primetime.

In fact, a similar scenario occurred two decades prior, when the green technology industry was still in its infancy. Ironically, even as disaster loomed once more, my boss, who covered green energy companies in the 1970s, would reminisce about his own disappointment when wind energy’s potential failed to meet investor expectations during that decade.

As everyone now knows, it would be more than three decades before substantial progress would be made in this area. Now that wind is an energy technology that’s ubiquitous, one can only guess when fuel cells will eventually follow suit.

Is Past Prologue?

Perhaps it will be different this time. But after so many false starts, it’s hard to know whether the so-called revolution in green energy is truly at the beginning of the beginning–or whether investors will be burned once again by overhyped technologies, just as they were in the 1970s and early 2000s.

Certainly, the economics have improved, as wind and solar power are now cheaper and more efficient than they were previously. And if the cost to produce solar power declines by 3 percent per year over the next two decades, as some analysts forecast, while storage costs came down, then these two trends could very well disrupt the utilities industry.

Still, there is much debate as to how many customers would be willing to unplug from the grid and adopt new technologies without a utility back-up. And as we’ve written previously, it’s not clear how utilities will respond to these challenges.

As such, it’s too soon to conclude that green energy firms will supplant utilities, since the latter have successfully countered such existential threats in the past.

Meanwhile, on the legislative front, there does seem to be more momentum for green energy legislation than we’ve seen in past years. Various congressmen recently attempted to revive climate legislation that would establish a carbon price.

And the Environmental Protection Agency is set to unveil new greenhouse gas emissions (GHG) standards in early June. These will affect 1,000 existing power plants, the bulk of which burn coal to generate electricity.

Although these developments bode well for the sector, there is still concern that it is overvalued. First Solar Inc (NSDQ: FSLR), SunEdison Inc (NYSE: SUNE), and even electric car company Tesla Motors Inc (NSDQ: TSLA), to name a few, have seen stellar appreciation in their stock values.

Chart B: Another Green Energy Bubble in 2014?

2014-03-27-U&I-Chart B

Created with YCharts

But their business fundamentals have yet to align with their market valuations. Tesla hasn’t posted a single profitable year since going public, and the last 12 quarters’ return on equity has been negative, by double and triple digits.

Even First Solar and SunEdison, which have rallied from their lows by 138 percent and 359 percent, respectively, still trade about 77 percent below their all-time highs.

First Solar’s profits have been choppy over the trailing year, swinging up or down by $50 million. And SunEdison hasn’t seen a profitable year since 2010.

Over the last few years, some of the weakest solar-power companies have crumbled, including the infamous Solyndra, which received a $535 million loan guarantee from the Department of Energy in September 2009 and subsequently declared bankruptcy in 2011. Then there’s Evergreen Solar, a high-flyer that traded for over $103 per share in late 2007, but later filed for bankruptcy in 2011.

In the battery storage space, lithium-ion battery developer A123 Systems filed for bankruptcy in 2012, followed by utility-scale battery maker Extreme Power, which filed for bankruptcy in 2014.

Though chastened by my past experience, I’m still optimistic about wind and solar power, as well as battery storage. When conducting investment research, however, investors should maintain a laser-like focus on green energy companies’ financials and keep their money on the sidelines until these firms show real performance. Whatever you do, don’t believe the hype.

Utility Forecaster subscribers get to read the full update, which includes our analysis of the few green energy stocks that are actually worthwhile.