A Graham Exercise: SolarCity versus SolarWinds
We don't have many regrets in our investing career, but certainly at the top of any such list would be never attending any of Benjamin Graham's classes at Columbia Business School. His ability to describe and demonstrate the core components of value investing gave many of today's more famous value investors their foundational education in the field.
One of Graham's well-known techniques was to pick to two stocks next to each other in the stock listings and compare them. This seemingly random process (one of the more important learnings from this process was getting your ticker symbol right) was a great tool in practicing the steps necessary for quality security analysis. When reading a recent article on GuruFocus ("SolarCity in Tight Spot", Jan. 11, 2015) we noticed the name of the article's subject (SolarCity - SCTY) was remarkably similar to one on our watch list - SolarWinds (SWI, Financial). In the spirit of Graham, we thought it would be interesting to see how these two companies compare in a value investment analysis.
A few things before we get started. First, Nintai has no position - long or short - with either of these companies. Second, one of these companies (SCTY, Financial) would never make it as an investment candidate in our search process while the second (SWI, Financial) remains a top opportunity on our watch list. Last, one of these companies is in a darling of Wall Street industry (solar) and recently announced a joint venture with a leader of Wall Street (JP Morgan) while the other quietly runs its business with little to no stock coverage or glamour.
The Companies
SolarCity (SCTY, Financial) is engaged in designing, sales, engineering, installation, monitoring, maintenance and financing of solar energy systems to residential and commercial customers, and sale of electricity generated by solar energy systems to customers.
SolarWinds (SWI, Financial) designs, develops, markets, sells and supports enterprise-class IT infrastructure management software to IT professionals. Its product offerings range from individual software tools to more comprehensive software products.
While the companies share "Solar" in their respective names, they are quite different in their industries, products, and services.
Revenue Growth
SolarCity receives a Financial grade of 5 and a Profitability/Growth grade of 2 on GuruFocus. Revenue has grown in the past five years from $33M in 2009 to $231M in 2014. Revenue per share has grown at a -1.5% for the past 5 years. EBITA growth has been -10.2% annually since 2009. Shares outstanding have increased from 8.4M in 2009 to 99.4M in 2014.
SolarWinds receives a Financial grade of 9 and a Profitability/Growth grade of 8 on GuruFocus. Revenue has grown in the past five years from $116M in 2009 to $407M in 2014. Revenue per share has grown at a 22.8% for the past 5 years. EBITA growth has been 26.6% annually since 2009. Shares outstanding have increased from 56.8M in 2009 to 76.5M in 2014.
Profitability
SolarCity has averaged a Return on Equity of -72% over the past two years and a Return on Assets of -6.4% in the same period. The company has averaged a -17.3% Return on Capital since 2010. Gross margins have ranged from 5.4% in 2009 to 24% in 2014. Net margins have ranged from -81% in 2009 to -34.1% in 2014. In 2014 the company produced –$1.11B in free cash flow with a 5 year FCF growth rate of -10.3%.
SolarWinds has averaged a Return on Equity of 48% over the past five years and a Return on Assets of 18% in the same period. The company has averaged a 51% Return on Capital since 2010. Gross margins have ranged from 95.8% in 2009 to 89.8% in 2014. Net margins have ranged from 25.3% in 2009 to 26.8% in 2014. In 2014, the company produced $178.6M in free cash flow with a 5 year FCF growth rate of 28.6%.
Financial Strength
SolarCity has $733.5M in cash and marketable securities on the balance sheet. The company has $1.4B of long-term debt with an Asset/Equity ratio of 0.18.
SolarWinds has $209.5M in cash and marketable securities on the balance sheet. The company has no short or long-term debt with an Asset/Equity ratio of 0.71.
Valuation
SolarCity currently has a market cap of $5.12B. The stock has returned 321% over the past 5 years. According to the GuruFocus, the company’s intrinsic value (please note: a considerable amount of good news was required to get us to a positive DCF valuation. We settled on positive earnings of $0.25 with a growth rate of 15% and discount rate of 12%) is estimated to be $19.50/share. This is considerably less than its current price of $48.50 as of January 12, 2015.
SolarWinds currently has a market cap of $3.77B. The stock has returned 125% over the past 5 years. According to the GuruFocus, the company’s intrinsic value (utilizing historical 5 YR FCF and discount rate of 12%) is estimated to be $48.75/share or roughly in line where it is currently trading today (as of January 12, 2015).
The Evaluation
Many of my fellow readers will point out (quite correctly) that these two companies are involved in two entirely different industries and business models. And – indeed – they are. Yet this is the beauty of such an exercise. These two specific tickers tell the story of very, very different businesses – one speculative in nature and the second a solid business growing at a steady and very profitable manner. In essence, this exercise shows us that compared to each other, the clear choice here is between speculation and investing.
When we complete any such evaluation like this, we look to answer several core questions that get us to go/no go when it comes to further investigation. Let's use these in this instance and see what conclusions can be reached.
1. Does the company’s return on capital exceed its cost of capital in the long term?
The answer to this one is quite clear. SolarCity clearly does not and SolarWinds absolutely does. Any business will find it very difficult to succeed as a going concern when your cost of capital exceeds return on capital in the long term.
2. Does the company grow revenue, earnings and free cash flow in a consistent manner?
While every business can go though a period of sudden downturns (like 2008-2009) or bursts of growth (2002-2004), great businesses generally grow all aspects of their business at a steady and upward manner. For instance, SolarWinds saw their EPS grow solidly from 2009-2014, while SolarCity’s EPS growth was far more sporadic.
3. Are management good allocators of capital?
Strong and steady growth are great, but we want management to be thinking as astute business leaders. It is immensely frustrating to see company leadership allocating capital through acquisitions, share repurchases, etc. that produces low or even possibly negative returns on capital. SolarCity’s numbers reflect the latter.
4. Does the company have a competitive advantage?
Having a true competitive advantage – or moat – can make your life as a manager and investor all that much easier. Signs of competitive advantages are reflected across the financial statements of a company - high ROA, high ROE, revenue growth, margins, etc. SolarWind and SolarCity stock tell a very different story about their competitive advantages. We would humbly predict SolarWind’s would have a much greater shot at eating competitive market share versus SolarCity.
5. Is the company’s valuation respective of its history and future?
By this question we want to understand whether the investors in this company purchase it as an investment or for speculation. Does price – in general – follow the core business in its ups and downs? In the case of SolarCity we believe investors are not always taking into account the fundamental business behind the stock. A 321% return over the past 5 years are indicative of that in our eyes.
6. Does the company have the financial strength to withstand a 2008 scenario?
A famous public finance minister once said “it’s a lot harder to go bankrupt if you don’t have any debt”. One thing the Great Recession taught us is that things can get a helluva lot worse than you think in a lot less time than you could possibly imagine. We believe SolarWind’s balance sheet gives it the security to weather an event that can certainly happen more than once in a million years. Or so we are told by Wall Street.
Conversely, SolarCity’s financials leave it little – or no margin – for a catastrophic event such as 2008. As we’ve said before: if a security such as SolarWinds shaves a couple of points off of our returns we are quite comfortable paying that price.
Conclusions
By running through such an exercise such as this on a regular basis, we believe it strengthens Nintai’s core investment knowledge. We get to see stocks and industries we rarely analyze and constantly adjust/test our inherent biases. In addition, we create a pool of potential investment opportunities we can review on a monthly or quarterly basis. Most importantly, we get to walk in the shoes of an extraordinary individual who has so much to teach us. If nothing else, remembering Benjamin Graham, his methodologies, and his words of advice give us a much better chance to improve our investment returns. And that is time very well spent in our eyes.
As always we look forward to your thoughts and comments.
