Why big companies love solar energy investments

Here comes the sun

The Nellis Solar Power Plant in Nevada, deployed by SunPower and financed by MMA Renewable Ventures; the Nellis Air Force Base buys the energy produced under a power purchase agreement (PPA).
Source: Wikipedia, US Air Force

Did you know that Google has a team dedicated to making investments in solar energy projects? I got to meet some people on the group during my time as an intern, and while I found their work to be super exciting, I didn’t think to ask why there would be such a group at Google. As a summer analyst with Credit Suisse this summer, I found that the firm also has a small team dedicated to deploying the bank’s capital to finance renewable energy projects. Making balance sheet investments of this sort is quite rare for a company like CS, so I began connecting the dots. There’s a reason for everything in business, and this principal investment activity is no exception.

Thank you Uncle Sam

The answer comes down to federal incentives around investments in solar projects. Chief among these is the Investment Tax Credit (ITC), which allows a buyer to take a tax credit on 30% of the cost of the solar project. In addition, the buyer can depreciate the investment over five years using the Modified Accelerated Cost Recovery System (MACRS). This is valuable because while under normal circumstances a solar power facility would be depreciated over 30 or more years, the accelerated depreciation creates a large tax shield in just five years. If we look at $100 in depreciation as a tax deduction – which is intrinsically valuable – the time value of money applies to it just as it would to a cash flow. In other words, taking all that depreciation over a shorter period of time creates more value for a company.

Most buyers of solar power systems don’t have a big enough tax liability to take full advantage of the 30% tax credit. Take SolarCity for example, which still has negative operating income: if the company kept and deferred the tax benefits of building its solar systems, it would take years to be able realise any tax shield, by which point its value would be significantly discounted. For a company like Google, which paid nearly $2.3bn in tax last year, the opportunity to earn some tax benefit makes sense.

Most industrial-scale solar projects, then, are primarily funded by a tax equity investor who receives payments from the end consumer. A solar power company like SunPower or Sunrun builds the facility for the investor (e.g. Google, Credit Suisse, or Goldman Sachs to name a few), who then receives payments from the end-user through a lease or power purchase agreement (PPA). If you want to dig a bit deeper into the specific structures used, this article might be helpful.

Solar panels dot the roofs of the GoogleplexSource: Austin McKinley, Wikipedia

Solar panels dot the roofs of the Googleplex
Source: Austin McKinley, Wikipedia

Must all good things end?

In 2016, the federal subsidy on solar power will decline from 30% to 10%. This could have a major effect on the solar industry, as tax equity investors would have a diminished incentive to put money into these projects, raising costs of capital and ultimately making solar energy less attractive to the ultimate buyer. While it’s plausible that the government could extend the higher tax benefit, does anybody want to bet on the government actually doing something?

Wind power might be a good indicator of the future of a reduced-subsidy solar industry might look like. Windmill owners received 2.3 cents per kilowatt-hour produced through the Production Tax Credit (PTC) before it expired in 2013, and investment went from adding over 12,000 megawatts of capacity in 2012 to less than 2,000 in 2013. Congressional debate on renewing the incentive has been blocked by conservative Republicans and Democrats, who are often backed by petroleum companies (there’s something politicians come together over – money!). A proposal to renew subsidies on solar energy might have a similar fate should it find its way into Congress in 2016.

Should these incentives even be in place, though? They distort the market for energy and cultivate an industry heavily dependent on the government. When the incentives are cut back in solar, new projects will likely stall and higher costs of production will be passed on to utilities. Utilities in turn, must seek out the most efficient sources of energy and may end up reverting to coal and other fossil fuels.

It’s hard to consider the implications of subsidised renewables without recognising that fossil fuels are also subsidised. Billions of dollars in state and federal incentives go to oil, gas, and coal each year, and clean energy advocates often point to this data in a push for more “green” subsidies. The reality is that, while fossil fuels receive more subsidies in agreggate, renewables are much more heavily subsidised on a per-unit basis. According to this WSJ opinion piece, coal is subsidised at about 0.05¢ (or $0.0005) per kilowatt-hour, while wind gets 5¢ per kWh and solar gets 77¢ per kWh.

The ITC for solar power is extremely generous at 30%, and I wouldn’t count on the federal government moving to keep it that high past 2016. So, what will happen to tax equity investing? Google’s last wind power investment was in December of 2013 – just before the 2.3¢ per kWh incentive ran out. A 10% tax credit for solar investments may not be enough for large corporate players like Google and Credit Suisse to stay involved in this space. Independent financing companies may fill some of the void, and securitisation of renewable energy receivables may create a deeper capital market for this type of liability.

Companies investing in large-scale renewable energy projects have had an important role in the development of alternatives to fossil fuels. Without the ITC for solar and PTC for wind, renewables might still be prohibitively expensive in the US. It remains to be seen how solar project finance evolves post-2016.


The Business of Gambling: Part 2

The gaming industry is facing a few major shifts that could spell big change for some companies. This piece examines these opportunities and the positions taken by major US-based casino operators. The coming years may cement the positions of heavyweights like Las Vegas Sands, but it could also be a chance for a company like MGM Resorts International to globalise and come out ahead.

Online Gambling

One of the biggest issues facing gaming companies in the US market is the issue of legalised online gambling. This is a major opportunity and threat to the brick-and-mortar casino business, and the issue has divided the major players. Las Vegas Sands head Sheldon Adelson has been a vocal opponent of legalisation, promising to spend “whatever it takes” to stop this from becoming a reality. He has spearheaded a “six-figure advertising campaign” through his advocacy group, the Coalition to Stop Internet Gambling, according to FT and the Associated Press. Mr. Adelson has the tacit support of Steve Wynn, who has been lukewarm on online gaming for some time. MGM and Caesars have taken the opposite approach, advocating for legalisation through the American Gaming Association (AGA). These companies both sorely need a growth-driving market, and they may sense an opportunity to gain an edge on their larger, more Asian-focused rivals.

So, which is the right course of action for casino operators? This strikes me as a case of Pascal’s Wager. Caesars and MGM are investing in infrastructure to prepare for the possibility of widespread online gaming (Caesars already operates a few websites in New Jersey). If this becomes a widespread reality, they will be in a favourable competitive position to capture a sizeable share of the market and benefit from its growth opportunities. If online gaming is not legalised widely, the companies will have some sunk costs. Think of it like a long call option – the downside has a floor (the amount of money the company invests in online gaming), while the upside is limitless, so to speak (see Fig. 1). Wynn and LVS, on the other hand, are avoiding investment in online gaming – the equivalent of no position, so no upside or downside. If it is legalised, they will be forced to choose either to pour money into an online presence or to miss out on the market altogether. Either way, they lose. As second-movers in such competitive business, they would capture smaller market shares, and missing online gaming completely would be like Microsoft not investing in mobile technology. Mr. Adelson and his cohort is taking a big risk by opposing online gaming.

The lobby against betting online claims that online gaming should be blocked because it could be used by criminal organisations to launder money. This is disingenuous. Messrs. Adelson and Wynn are concerned that online gaming will harm business for their casinos in Las Vegas and throughout the US. Most research does not seem to corroborate this fear. A recent article in Businessweek cites an Econsult Solutions report suggesting that online gambling in Pennsylvania could collect about $110 million in taxes per year through online gambling, “largely without cannibalising casinos’ existing businesses.” This sentiment is echoed in other consultancy reports that I (unfortunately) cannot cite in this article.

Mr. Adelson’s stand against online gaming leaves a bad taste in my mouth. He has spent millions lobbying politicians under the flimsy premise of protecting Americans. On a Bloomberg News video on YouTube, Mr. Adelson insists that money is “not the consideration,” talking instead about how children would gamble online and compares legalisation of online gambling to legalising heroin. The casino magnate has even allied himself with conservative Christian groups opposed to gambling to push his agenda. The whole ordeal makes Mr. Adelson seem untrustworthy. As we say in Mexico, mañoso – slick, tricky, or cheating are the closest translations I can think of.

Next Stop Japan

Japan presents an opportunity for the ‘next Macau’ to take shape. The government seems poised to adopt legislation legalising gambling ahead of the 2020 Summer Olympics, and licences will likely be awarded in Tokyo and Osaka. This untapped market is expected to be worth more than Singapore and could surpass Nevada to become the world’s number two gaming market. This makes Japan a massive opportunity for whichever company nabs a licence. The large, affluent domestic market makes this a solid case of “build it, and they will come.” While some high-roller Japanese gamblers are currently travelling to Korea, Macau, or Singapore to gamble, thousands more would be compelled to spend money if the casino were a short train ride away. Bloomberg also notes that Abenomics has weakened the Yen, making overseas vacations more expensive for Japanese citizens (see Fig. 2).

Source: Bloomberg Fig. 2

Source: Bloomberg
Fig. 2: The Yen has weakened against the US Dollar

If MGM or Caesars can secure financing, building a resort in Japan might be a grand power-play to expand in Asia. Caesars appears to be making plans for a potential development in Tokyo, while MGM has drawn up proposals for a resort in Osaka. The potential growth of such a market would markedly improve these companies’ competitive positions. Caesars has no properties in Asia, while MGM has just one casino in Macau. Unfortunately, neither of these players is equipped to be competitive in the fight for licences that will inevitably play out if gaming legislation passes. Japanese officials have shown a desire to work with casino operators that have experience with integrated resorts of the kind found in Singapore. Integrated resorts are designed to cater to a wider demographic, featuring a spa or theme park in addition to casino facilities. This means Las Vegas Sands and Genting Singapore – owners of the two resorts in Singapore – may have an advantage in courting the Japanese government for licences. The risks for MGM and Caesars could be compounded by the financing hurdles of such a project, which could bind them under unfavourable debt arrangement and eat into profits. Both companies are highly-levered, and more debt would present a major credit risk. Nonetheless, owning a property in a major market like Japan could make a huge difference for these companies.

Of course, Las Vegas Sands is making bold moves to secure the favour of Japanese officials. Mr. Adelson has pledged to spend $10 billion on the market, hoping to secure a licence in Tokyo. This may be theatre: Reuters cites a recent Morgan Stanley report predicting that a resort costing over $5 billion would “offer a return on investment of below 20 percent due to rising costs and a struggle to attract enough high-rolling Chinese VIP customers.” Regardless of how much money winds up being spent, it is clear that Las Vegas Sands has a major advantage in Japan. Less-sophisticated companies may be left with fewer licences to battle over.

Casinos in the US: Beating a Dead Sick Horse

Here’s an idea I don’t like as much: opening resorts in every one-horse town from Pennsylvania to Oregon and hoping more gamblers will materialise and deepen the US market. The Sands Bethlehem (in Pennsylvania), the MGM Grand Detroit, and plans for a Wynn resort in Everett, Massachusetts – these are all fine ideas, but the market won’t define companies the way Macau did. At some point, gamblers may have so many local options that they will avoid Las Vegas altogether. Some observers have suggested that the market is saturated – looking at revenue per casino does not support this assertion outright, but it does seem that growth in revenue per casino is levelling out. The number of casinos in the US has only grown about 2% since 2005, and revenue per casino has increased a solid 12% since then. Again, growth does seem to be decelerating, but saturation may be some years off. As resorts get more expensive and return get smaller, though, I would opine that casinos in the US market won’t be a very attractive market in the next few years. There are plenty of struggling casinos to illustrate that point: Atlantic City has been in decline for some time, and this article highlights casino troubles in a number of other states. The market doesn’t have great prospects, so casino operators would probably be better served by investing in international markets.

Fig. 3

Fig. 3

The gaming industry is in an interesting situation. While the US market is mature and lacklustre, global opportunities (Japan, at the moment) could be a major source of growth in the years to come. Casino operators should focus heavily on competing in these new markets to maintain growth and diversify their businesses. Macau was a defining investment for Las Vegas Sands, and Japan could pose a similar opportunity for the companies that are successful there. The growth this fresh market would deliver can’t be matched by online gaming or casinos in the US. Time will tell if MGM or Caesars seize on the moment.

Disclosure: In early 2015, I took positions in Las Vegas Sands Corp and Caesars Acquisition Corp.

Mulberry: the perils of lowering prices

The company must not succumb to profit-chasing through lower prices.

ImageMulberry Group plc

Mulberry Group plc’s latest profit warning comes with a promise to regain market share through lower-priced products. The company has had a rough period, losing two-thirds of its market value in the last two years. The blame has fallen squarely on Bruno Guillon, the company’s former CEO who stepped down in March. Mr. Guillon, previously at Hermès International SA, attempted to price Mulberry’s products further upmarket with broadly negative results.

As the company pledges to roll out less-expensive product lines, I am compelled to point out the significant risks to this strategy. Mulberry has emphasised its intention to offer lower-priced handbags and accessories while maintaining its most expensive lines unchanged. This strategy risks devaluing the brand, squeezing margins, and depressing long-term growth.

The best example of a cheapened brand is Coach, Inc. This company has chased profits by offering handbags and accessories across a broad range of consumer segments. Indeed, one can buy a Coach bag for as little as $100, and shoes can be had for even less. This strategy has made Coach a highly visible brand among high school girls and less-affluent young women. This demographic has driven plenty of growth, but the company’s margins have remained stagnant or shrunk in the last years (see Fig. 1).


Fig. 1 (Google Finance)

Fig. 1 (Google Finance)

Another factor tarnishing the Coach brand is the company’s distribution. Outlet stores make up over 20% of the company’s direct retail presence, and Coach products are sold in Macy’s, Zappo’s, and other relatively low-cost retailers. Pursuing the affordable luxury segment is a competitive struggle, and Coach has sacrificed the appeal of its flagship high-margin products in its thirst for growth. In the race to capture this market, Michael Kors and Kate Spade have fared demonstrably better. Just look at stock appreciation over the last two years (Fig. 2).

Figure 2 (Google Finance)

Figure 2 (Google Finance)

Mulberry’s situation isn’t too bad overall. Operating income soared in 2011 and 2012, and the 1.92% dip in revenue seen in 2013 was pretty minor. Cost of sales had the biggest impact on the bottom line, increasing by 6.42%. This can be attributed to the company’s high-end strategy under Guillon, which required more expensive storefronts in prime locations. I should note that working capital and net current assets have been increasing steadily despite the fluctuations in bottom-line performance.

One brand that has successfully offered products at a range of prices is Burberry Group plc. This retailer divides its offering into three segments: Burberry Brit at the lowest end, targeting a younger demographic; Burberry London, featuring traditional luxury formalwear; and Burberry Prorsum, which features the brand’s runway styles at the highest price point. This strategy has yielded margins above 20% for the last three years and growth has been very steady (Fig. 3).


Source: Burberry Group plc

Mulberry is a relatively small company, and it may be unfair to compare it to these giants. That being said, the impression that the brand makes among global consumers as it becomes more well-known cannot be easily mended. I would advise Mulberry to lower prices enough to bring back antagonised customers, and no more. Expanding the company’s offering to low-cost segments could be done in the future through acquisitions (this would be infeasible under the company’s current size and cash position) Alternatively, the company could be an attractive acquisition target. Regardless, Mulberry should stay true to its identity. Cheapening the product may drive some growth in the short term, but value lies in the long-run success of the brand.


Guitar Center: The Last Song?

Seeing my old stomping ground Guitar Center in the news a few months ago was a major blast from the past. I instantly remembered spending hours in the store on San Mateo Street down the road from Coronado Mall in Albuquerque. I remembered buying my used Epiphone Explorer with the upgraded pickups and poring over the walls crammed with guitars of every kind. I am admittedly sad to see the company struggling today.

Guitar Center provides a great case study of how a leveraged buyout (LBO) can go quite wrong. With $1.6 billion in junk bonds outstanding – much of it originating from the company’s takeover by Bain Capital in 2007 – the company is struggling under its tremendous debt load and amid poor sales performance. As the company has slipped into the red over the last year and its cash pile has shrunk, the prospect of making interest payments has dimmed. In other words, the company is very close to bankruptcy.

What went wrong at Guitar Center, then? At the time of the deal, Credit Suisse analyst Gary Balter said the transaction seemed “like the perfect LBO.” He cited the company’s “dominant retail position” while pointing out that earnings still lagged behind other “high service” retail business segments. This was a good opportunity for Bain Capital to leverage (no pun intended) the strong Guitar Center franchise to improve the company’s operational performance.

The problem with Guitar Center is that it has clung to an antiquated business model, with 373 storefronts (as of December 2013) across the country according to CFO Tim Martin. To make matters worse, guitars don’t sell as well as they used to. Think about that one – does Kanye use a guitar? What about Katy Perry? Now that music can be made with a computer, expensive physical instruments have certainly lost some appeal.

Mr. Martin seems to be under the impression that he is not accountable for the company’s financial troubles. Of the impending crisis he says, “you can take a look at the financing aspect of it, but at the end of the day, that’s the owners of the company’s problem.” He goes on to argue that the company’s cash flow-positive stores would prevent creditors from seeking to liquidate the company.

The negotiations with Ares Management (owner of most of the debt) to take over Guitar Center are no doubt indicative of the long-term promise this company has. However, if the current executive team hasn’t made proper strides to modernise the company, they may all be sacked very soon. It’s also very likely that the new owners will close underperforming stores, leading to significant job losses.

It’s safe to say Bain Capital’s takeover of Guitar Center has fallen short of expectations. While the company might have appeared stable enough to handle $2.1 billion in debt in 2007, changes in the consumer market for music instruments have made survival of GC in its current state all but impossible. Now, it could be Ares’ turn to revitalise this retailer. If they take the right steps to bring this company into the 21st century, we may yet live to visit a Guitar Center well into the future.