Don't Sweat The Dilution At Sunworks $SUNW
http://www.seekingalpha.com/article/3987642
Sunworks USA (NASDAQ:SUNW), formerly Solar3D (SLTD), is a controversial company. A very small (~$50M market cap) solar installer working mostly in California, it is one of the few profitable companies in the solar industry. Moreover, it is growing fast, with little debt. If you take management's forecast of $100M in revenue this year at all seriously, a rough financial estimate would look like this:
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These numbers are pretty close to those of Jeremy Blum, who wrote a comprehensive bull case for SUNW in March.
So what's not to like? Well, revenues and profits aren't the only things at SUNW growing explosively. The share count is rocketing up too:
The diluted share count doubled, from 9.5M at the beginning of 2014 to 18.8M two years later. Or if you use the 23.7M figure at the end of 2015, diluted shares multiplied 2.5 times. This rapid dilution is one element of Scott Sandridge's bear case on the stock. (It came out the same day as Blum's piece - no link because it's behind the PRO wall.)
Moreover, it's hard to determine what the "real" diluted share count is. The five million shares that disappeared between December 2015 and March 2016 are not from the company buying back stock. Rather, the stock price dropped during that time, and five million options went out of the money.
Fully diluted shares as of March 31 were 18,811,871. But in the 10-Q, we get this fabulous sentence:
For the period ended March 31, 2016, the Company has excluded 899,574 options, 2,997,000 warrants outstanding, notes convertible into 3,194,279 shares of common stock, and Series B preferred stock convertible into 1,506,024 shares of common stock because their impact on the loss per share is anti-dilutive.
And that's not all. Some options and stock grants have not vested yet, but probably will this year, and those are not counted even in these "excluded" numbers. Plus there's an incentive plan chock full of options that was ratified just recently. Sunworks has convertible debt, options, warrants and restricted stock units outstanding, in or out of the money, vested or unvested. The capital structure, frankly, is a bewildering mess.
The company is growing … so is the share count. How badly will prospective dilution impact returns from forecast growth? That was the question I wanted to answer. What follows is what I came up with. If you don't care to see how the sausage is made, skip the next section. All numbers are from recent SEC filings.
Where Are The Shares?
The Starting Point
Shares outstanding as of March 31, 2016: 18,811,871
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Options excluded as of Q1
There were 899,574 options excluded from the "fully diluted" share count because they were anti-dilutive. At a weighted average strike price (WASP) of 1.3 you might not think they are anti-dilutive in the usual sense of their exercise improving the value of your shares. But because the company ran a small loss in Q1, anything that increases the outstanding shares counts as anti-dilutive. The 10-Q tells us that 835,470 of these options have a strike at or below 2.77, with a WASP of 1.13, and thus the remaining 64,104 have a WASP of 3.51.
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Warrants excluded as of Q1
There are 2,997,000 warrants outstanding with a strike of 4.15.
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Convertible debt excluded as of Q1
The history of Sunworks' convertible debt is not pretty, with some clear cases of insider self-dealing. Some of the most toxic issues have been converted already. Still, what remains will convert into 3,194,279 shares. Those break down like this:
• A note with $1,767K principal outstanding, issued for the acquisition of MD Energy, with a conversion price of 2.6 yielding 679,487 shares
• A $750K issue, descended from a note intended for the acquisition of Sunworks United, at a conversion price of 33.8 cents yielding 2,218,935 shares
• A $100K note descended from one issued February 2014, with a conversion price of 33.8 cents again, yielding 295,857 shares
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Preferred stock excluded as of Q1
For the purchase of Elite Solar, Sunworks issued 1,506,024 shares of preferred stock, convertible into common shares. Kirk Short, formerly head of Elite and now a Sunworks insider, still holds them.
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Restricted Stock
At various points, Sunworks has issued "restricted stock grant agreements" to different stakeholders. Essentially, these are promises to issue shares contingent on the company meeting net profit targets. The CEO's target is $2M in profit in a trailing 12-month period; everybody else gets one third of their allotted total at targets of $2M, $3M, and $4M each. But since Sunworks could very well hit $4M in profits in 2016, all of this restricted stock is likely to be issued in the fairly near term. The total amount of restricted stock is 815,387 shares.
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The 2016 Equity Incentive Plan
At the most recent stockholder meeting, the " 2016 Equity Incentive Plan" narrowly passed. The plan grants options to executives and directors. All options are set at a strike price of 2.68. 480K of these options vest immediately, and 100K vest each year for the next three years, for a total of 780K options.
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So How Many Shares Is That?
Adding up every last opportunity to create a share totals 29,004,135 shares.
To estimate diluted shares for FY 2016, however, I exclude the Equity Incentive Plan options that do not vest until next year or later, and I exclude any items with strike greater than 2.77. I include all the restricted stock, however. That gives a diluted share count of 25,643,031.
Both of these numbers are considerably higher than the 18.8M diluted shares listed right now. There is an upside, however: creating all these new shares brings in expense-free income to the company. Creating the 25M number of shares would bring in about $4.8M, direct to the bottom line. Creating the full 29M shares would bring in $18.3M. So the implied EPS in each case actually goes up.
If we use our profit estimate and adjust it for income from share creation, we get these scenarios:
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Now, just because an option or a convertible note is in the money does not mean it will be exercised. So the fully diluted share count can and probably will rise without all the corresponding income being realized in a given quarter or year. Given that 2015 EPS was $0.05, however, it doesn't make a lot of difference: even if the share count maxes out at 29M and zero income is realized, SUNW still is looking at a 2016 estimated EPS of $0.14, or 180% EPS growth.
The dilution is real. But don't let it deter you from the stock.
What Could Go Wrong?
There's always the possibility that the company could issue more dilutive stock or options. That is a risk of owning a minority stake in any corporation. Aside from that generic worry, I see three more concrete ways that SUNW risks larger amounts of dilution.
First, they could reprice any of the existing convertible debt at lower conversion prices. This has been done in the past, sometimes egregiously.
Second, the 2016 Equity Incentive Plan can issue as many as 1.8M shares but only 780K options are presently allocated, leaving the issue of ~1M shares to the discretion of the plan administrator (currently unknown, but no doubt insider friendly). It looks like the main use of the plan is supposed to be to issue incentive options which are non-dilutive at the time of issue, but the administrator has pretty wide discretion to depart from this shareholder-friendly mandate. This Incentive Plan is supposed to last for three years, and then we could expect another round of equity incentives.
Third, we can expect more acquisitions at Sunworks. One of the board members, Van Slooten, is paid a hefty retainer to research possible acquisitions. Presumably that is not for nothing. Another acquisition will draw on capital somehow, and the possibility exists that it will be unfriendly to shareholders.
I believe the incentives of management are at this point sufficiently aligned with shareholders that none of these scenarios is likely to be particularly damaging to shareholder interests.
Conclusion
Sunworks has a history of dilution and it will have more. However, the effects of prospective dilution are (a) not that bad even in the worst case, given the company's growth trajectory, and (b) largely offset by income from creating shares. You may or may not like the company for other reasons, but the prospect of dilution shouldn't turn you off from investing in SUNW.
Disclosure: I am/we are long SUNW.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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