Markets

Buy These Solar Stocks Before They Snapback

Sometimes the market hands you a gift. And it would be foolish not to take it. Thanks to general market weakness, along with instability in the energy sector, the leading solar stocks have stumbled badly in recent weeks. The Guggenheim Solar ETF (NYSE: TAN ), for example, has slid more than 20% since late August and many individual solar stocks have fared even worse. As I'll note in a moment, a few names now stand out as compelling bargains.

The Oil Connection

At first glance, investors may mistakenly think that a drop in crude oil creates trouble for solar companies. It's true that a sharp plunge in natural gas prices in the spring of 2012 created legitimate concerns that sharply reduced electricity costs would undercut the economics of solar.

The same can't be said for crude oil because it is not a prevalent input in global electricity generation. In fact, analysts at Merril Lynch note that the leading solar companies are seeing solid business momentum right now. "Strong 2H14 solar demand, stable equipment pricing, falling financing costs and robust U.S. residential market growth could lead to strong 3Q/4Q14 reports across the value chain."

That's what makes this sector sell-off so strange.

In the limited history of solar power stocks, the industry has been heavily dependent on government subsidies, both in the United States and around the world. Yet a steady stream of technological advances has enabled solar to reach "grid parity," which means it is just as cost-effective as fossil fuels for electricity production and doesn't need government support anymore. According to the Solar Energy Industries Association , the average price of a completed commercial photovoltaic project -- the technical name for a solar panel -- in the second quarter dropped by 14% year-over-year and more than 45% since 2012.

There are still incentives in place to switch to solar, which has helped fuel robust growth for the industry this year, but those perks are going away. Further gains in the underlying technology should help solar to eventually become more cost-effective than fossil fuels. Electric utilities are unwittingly aiding solar adoption. According to the Energy Information Administration, the average retail cost of electricity rose to $0.12 per kilowatt hour last summer from $0.11 per KWh at the start of 2011. The ongoing increases come even as natural gas prices, a key cost input, have trended back down this year.

While consumers (such as myself) and retailers (such as Wal-Mart Stores, Inc. (NYSE: WMT )) have begun to take the solar plunge, the most promising trend can be seen among the power companies themselves. In recent months, both Duke Energy Corp. (NYSE: DUK ) and Southern Co. (NYSE: SO ) announced plans to install roughly 800 megawatts worth of solar power equipment to support their power grids.

In light of the disconnect between industry share prices and the industry outlook, it's time to focus on the emerging buying opportunities. Solid rebound candidates include:

SolarCity Corp. (Nasdaq: SCTY )

This company prospered greatly from the era of low interest rates, which enables it to offer very attractive lease rates to customers. Customers see reduced power bills, while the company generates a roughly 40% gross margin on the contracts.

The appeal of the business model is self-evident: Sales have grown to a projected $250 million this year from $129 million in 2012. Analysts expect SolarCity to generate roughly $800 million in sales by 2016, by which time gross margins are expected to reach 50%. To handle that growth, the company is building a massive manufacturing facility near Buffalo, New York with a generous $750 million tax package offered by the state to help fund the factory's construction.

This is a hard stock to value on the basis of near-term earnings because the company is currently spending heavily to build out the business model. That factor may explain why investors have grown anxious, pushing shares down 40% from the 52-week high. Yet over the long haul, there is a clear path to profits thanks to those robust gross margins. Merrill Lynch pegs fair value for this stock at $100 (90% upside), using 14% cost of capital, and calculating terminal value based on the average of a 3% growth rate and a seven-times earnings before interest, taxes, depreciations and amortization multiple.

Canadian Solar, Inc. (Nasdaq: CSIQ )

For investors that prefer to focus on companies with positive earnings in the near-term, check out this company, which makes and installs solar panel modules. The company generated roughly $1 billion in sales in the first half of 2014, but thanks to rising backlog, is expected to deliver another $1.7 billion in sales in the final six months of this year. Equally important, net income is now soaring. The company blew past second quarter profit estimates -- earning $0.95 a share -- and is expected to report more than $1 a share in the third and fourth quarters.

In the past month, shares have fallen to $30 from $40, meaning they are valued at around nine times projected 2014 profits and around seven times the projected 2015 earnings per share of $4.20.

The pullback in shares has come at a time when the company is inking a wave of new contracts. In just the first few weeks of the third quarter, Canadian Solar announced six separate large-scale solar projects. When investors pivot back to solar stocks, they're likely to note that this is one of the most inexpensive stocks in the group (in relation to profits) and also one of the fastest-growing companies in the industry.

There is even a clear near-term catalyst in place for these stocks. The annual Solar Power International conference is being held all this week in Las Vegas, Nevada, which is often filled with positive industry announcements and a cause for renewed investor interest. "The SPI has historically been a stock-moving show, particularly in the past two years where U.S. solar stocks have risen roughly 15% around the event," note analysts at Goldman Sachs.

Risks to Consider: Although investors are mistakenly correlating solar power demand and oil prices , a further slump in crude prices could keep this sector from rallying.

Action to Take --> SolarCity and Canadian Solar have very different business models, but hold equal appeal. Investing in both stocks gives investors the chance to profit from the industry's lease contract approach and also the industry's shift towards large-scale installations.

Solar power dominating the utilities industry is a game-changer. If you would like more trends that have the capability of moving the markets and changing the world, then check out our latest research " The Hottest Investment Opportunities For 2015 ." For more information on how to gain access to this report -- and our favorite game-changing ideas -- click here .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.