Description

The market has been remarkably generous to some questionable stocks over the past year, and we believe SolarCity (“SCTY”) is one of the most distorted situations of them all.  After struggling to go public at $8 per share just 16 months ago, SCTY benefited from the rush into momentum and story stocks during 2013 as investors aggressively bid up the shares (stock is up 600% since IPO, the market cap is nearly $6 billion and valuation exceeds 20x revenues).  We believe SCTY investors and analysts are asleep at the switch and the shares represent a tremendous short opportunity as the momentum unwinds.   Investors are seemingly excited to own shares in what they believe is a dominant, high-growth clean tech company with a recurring revenue model.  In reality, SCTY shareholders own a fairly mundane, capital intensive and highly competitive solar panel installation and finance business trading at 20x tangible book with mediocre returns on capital that is facing growing challenges ahead.  The company will assuredly lose money for the foreseeable future so the company will be forced to raise capital or will see its tangible book value turn negative.

The financials are complex here and SCTY research analysts have been about as lazy as we have ever seen, generally failing to properly understand the economics of the business and crafting price targets based on a flawed framework provided by management.  Investors are so enamored with top line growth that they have lost sight of how disconnected the valuation became from the economic realities of the business (much like Rackspace in recent years and mortgage originators several years ago).  For example, SCTY put out a brief press release last fall outlining a target for some heady top line growth in 2014 that led to a quick doubling in the stock price (right before a capital raise).  Remarkably, no guidance was given on the economics of achieving this growth… it isn’t all that hard to install a lot of solar panels, but the real question is:  how profitable is it? 

To put the stock in perspective, SCTY has around $300 million of tangible book value, loses around $200 million per year (we estimate they will have no tangible book value by middle of 2015), requires a tremendous amount of capital to grow the top line and generates mediocre returns on incremental invested capital… yet the stock trades at nearly 20x tangible book value.  We estimate fair value of $10 to $15 per share based on generous growth assumptions, which would represent around 75% to 80% downside in the stock.

DISCLAIMER:  We currently hold a short position in this security.  We may change our position at anytime without posting an update.  The views expressed here are merely the opinion of the author.  Please do your own research.  Also, please note Elon Musk is the Chairman and largest shareholder and his cousin is the CEO, so the trading in the stock could at times be tied to sentiment around Musk more than actual fundamentals.  Musk does not have a managerial role in the company and he rarely talks about SolarCity publicly (perhaps for good reason), so we don’t think this is a huge risk anymore.

THE BUSINESS

SCTY’s business model is purchasing solar panels from third party manufacturers and installing the panels on rooftops (simply picture workers driving around in trucks installing solar panels: http://electricnick.com/wp-content/uploads/2009/01/solar_boost_ev_pickup.jpg and http://chenected.aiche.org/wp-content/uploads/2011/06/2011-06-20_1637-google-solar-city-screen-grab.png).  If you Google “solar panel installation,” you will quickly notice that there are dozens of companies (Sunrun, Sungevity, etc.) that can do this.  This is not some unique high tech, high barrier business.

SCTY allows the customer to purchase the panel outright, but the company has increasingly focused on a lease option whereby the customer makes lease payments over a 20-year period (with an option for a 10-year renewal thereafter).   This has led to opaque accounting and uncertainty in how to value the stock.  SCTY actually makes negative gross margins on outright solar panel sales, so if they did not lease systems, we doubt this would have ever amounted to much more than a penny stock.  But it is harder to measure performance when the cash flows are extended over many years and SCTY has convinced the Street that they have created a money machine by allowing customers to lease the panel. 

A basic transaction will involve SCTY spending around $4,000 per customer in overhead and marketing and then spending $17,000 on the installation of the panel.  Ideally, the cost (customer acquisition and installation costs) is predominantly financed through third-party funding.  Since SCTY and their funding partners are bearing the upfront cost of the panel, the business is extremely capital intensive.  SCTY’s primary funding comes from so-called tax equity investors who provide SCTY capital in exchange for a preferred, fixed return that is funded by customer lease payments and the flow-through of federal tax deductions designed to encourage increased adoption of solar power.  These investors get to take a tax credit based on 30% of the fair market value of the solar panel (falling to 10% at the end of 2016) as well as a depreciation deduction. 

The structure is similar to a securitization whereby SCTY originates the transaction and third-party investors put up senior funding, leaving SCTY (the originator) with longer-date subordinated cash flows.  The economics currently work due to the fact that SCTY can deliver tax credits in lieu of cash to the tax equity investors for most of the funding cost.  When the tax credits fall in 2017, the overall cash cost to SCTY will go up considerably, thereby pressuring the economics in these deals.

THE BULL CASE 

The bull case on SCTY is rather straightforward and goes as follows:

Solar panel installations are set to soar as solar panel prices have declined such that solar energy is cost competitive with electricity from the grid.  SCTY is one of the best ways to play this trend as they are the country’s leading solar panel installation company and they are rapidly growing market share.  As SCTY grows, it will progressively lower its customer acquisition cost and cost of funding, giving it a big edge over the competition.  SCTY can amply fund these installations through clever tax equity financing, leaving them with a predictable lease stream after paying back those investors. Management helps investors value this complex stream by providing a valuation metric called “Retained Value.”  Retained Value is the present value of leases in backlog assuming 100% of customers stick with the company for 30 years (yes, the contracts are only for 20 years and no company in history has 0% churn for 30 straight years, but those are just details).  SCTY suggests discounting those net cash flows at 6% and income taxes should be ignored (while 6% does seem rather low for a subordinated stream of long duration cash flows and excluding taxes might be a bit aggressive, who are we to question management?).  As SCTY rapidly increases its installed base in the coming years, we can see a path to Retained Value being $80 per share.

This is pretty much nonsense as this write-up will attempt to explain.  If nothing else, remember these points: 

1. For any company in the world to trade at 20x its tangible book value, the economics better be awesome and sustainable.  The economics of leasing a solar panel to someone will always be limited by the fact that the customer can just buy the panel outright by paying cash or by drawing on their mortgage.  SCTY makes negative gross margins on panel sales, showing how brutally competitive this business is.  Buying the panel is a better deal for the consumer and there is no shortage of discussion of this topic on the Internet, including the following web site:  http://solarleasedisadvantages.com/.
2. Solar panel installation will always be competitive with many regional players just like any other home renovation or remodel service.  As I mentioned above, a Google search on “Solar Panel Installation” shows no shortage of companies willing to install a panel on your roof.  In our conversations with competitors, they expressed doubt that SCTY is even “making money” on their installations.
3. The Retained Value concept which underpins SCTY’s valuation is extremely flawed and does not even remotely represent the economics of the business (see discussion below).
4. Looking at the stock chart and reading analyst research, you would think SCTY has executed flawlessly when in fact the reality couldn’t be further from the truth.  The current estimates for 2014 operating losses of $200 million are more than double what analysts had estimated at the time of the IPO (Goldman actually expected a $58 million operating profit).  While higher losses are partially due to higher installation numbers (expenses are incurred upfront), 2014 consensus opex per watt deployed is unchanged from estimates at the time of IPO ($0.61/W) despite higher installation estimates, showing that the business has not demonstrated the operating leverage that would have been expected.  Furthermore, the company had to delay its Q4 2013 earnings report because of accounting errors that understated expenses by $20 million.  This “error” was discovered just after raising capital.
5. The tax credits allowable under federal law are set to drop dramatically in 2017 (30% down to 10%).  These credits are basically SCTY’s reason for existing right now as they use them to raise tax equity to fund the panel installations.  In addition, SCTY appears to be abusing these tax credits by writing the value of the panel up as much as 100% above cost (see discussion below) and federal investigators have already taken notice (http://watchdog.org/137076/feds-to-troll-SCTY-books).

THE MYTH OF RETAINED VALUE

SCTY’s business model and financials can be rather opaque.  Management has pointed investors and analysts to a metric it created called Retained Value.  As mentioned above, Retained Value is a calculation of the net present value of any existing lease contracts after payments to tax equity investors.  Analysts and investors have increasingly focused on this metric to value the stock.  At the end of Q4, this figure was $1.05 billion or $1.51 per watt deployed.  The stock trades at nearly 6x Retained Value.  Let’s dissect the Retained Value metric and see what it really is:

1. Retained Value includes contracts in the backlog that have not yet been deployed.  At the end of Q4, we estimate SCTY has roughly $384 million (202 MWs) in its backlog (note recent deployments have been coming on at higher levels due to a mix shift between residential and commercial installs).  The backlog accounts for 35% to 40% of this metric, and this amount must be deducted from the disclosed Retained Value to calculate Retained Value actually deployed.
2. Management assumes that 100% of contracts are renewed after 20 years for an additional 10 years at a 10% discount to the prevailing lease rate.  Approximately 35% of the calculated Retained Value is derived from these contract renewals.  Recall the initial payments are weighted towards third-party tax equity investors, so SCTY investors are basically long these far out cash flows.   It is highly unlikely a customer will renew a contract in 20 years without SCTY having to spend capital to install a new panel (the panel will be old and worn by then and technologies will likely have improved considerably). 
3. Cash flows are discounted at a rate of 6% in determining Retained Value.  Given that tax equity partners demand returns in the high single digits, we find it odd that management would discount a stream of subordinated, long-duration cash flows (much of which won’t even be collected for another 20 years) at such a low rate.  We believe a high-single digit or low-double digit rate is more appropriate.  Management likes to equate this stream of solar cash flows with those from a 30-year mortgage.  This is a misguided and misleading comparison.  The average lifespan of a 30-year fixed rate mortgage is only about seven years due to refinancing activity or homeowners selling and moving.  Additionally, a mortgage is over-collateralized by a generally appreciating asset, and by comparison, SCTY basically has no collateral as it is unlikely there will be any meaningful value in a used solar panel.  Simply put, the cash flows to SCTY are highly unpredictable and risky and using a 6% discount rate on them is out of context.
4. Retained Value completely excludes income taxes.  It is unbelievable to us that virtually all sell-side analysts have built their valuation models without any income taxes in their projections.  If you believe the sum of the future earnings of SCTY is significant, then the IRS will come calling.  Making this very clear and correct adjustment would reduce analyst price targets by 40%. 
5. Management assumes no churn whatsoever.  Of course, some customers will default over such a long period of time, and SCTY’s only recourse is to try to reclaim a used solar panel.    
6. While management says they include some level of maintenance and overhead in their calculation, we believe the company might be significantly underestimating this cost. As we tried to replicate the company’s Retained Value calculations, it appears to us that they barely set aside enough expense to cover the costs of replacing the solar inverters let alone what will likely amount to significant customer maintenance, billing and service costs along the way.   There are countless complaints on the Internet (Yelp and elsewhere) highlighting how bad the SCTY customer service is and indicating they may have considerably underinvested in this area.

Making just a couple simple and reasonable adjustments has the following impact on Retained Value ($mm):         

As you can see from above, SCTY has generated a $341 million cumulative operating loss to create a deployed cash flow stream worth only $217 million, indicating that SCTY has actually been destroying shareholder value.  This is consistent with competitor comments that we have heard that they doubt SCTY is “making money” on these deals.  Also, recall this stock trades at nearly 20x tangible book. 

As discussed above, SCTY’s Retained Value ended 2013 at $1.05 billion, but after making the adjustments above, we believe the more realistic Retained Value figure is only $217 million.  As shown in the chart below, even in the blue-sky growth scenario perpetuated by sell-side and management, we estimate that SCTY will have only $14 per share in Adjusted Retained Value by the end of 2016 employing our basic assumptions on discount rate, renewals and taxes.  Even if the stock traded at a modest premium to our Adjusted Retained Value at that time, this would indicate the stock is likely worth around $10 to $15 per share in present value terms (including around $2 per share in present value of NOLs), roughly 75% to 80% below today’s share price.  Furthermore, SCTY will need to raise $12 billion of external capital, double its current market capitalization, just to fund the next five years of growth.   

Note:  On its first Q4 earnings call (02/24/14), management said that each incremental watt deployed equates to approximately $1.90 of Retained Value.  We adjusted this number using our more reasonable parameters. 

Other Major Concerns

Abuse of the Investment Tax Credit.  Our discussions with industry participants have indicated that SCTY has engaged in a systematic, flagrant abuse of the tax deduction.  SCTY appears to be inflating the fair value of the solar system for the purpose of calculating these tax deductions by using a subjective discounted cash flow analysis to measure the solar panel’s value rather than the obvious approach of using the panel’s actual cost.  Buried in its first quarter 2013 10-Q filing, SCTY disclosed that the IRS rejected its fair value calculation in certain of its funding deals requiring the company to reimburse its partners for $15.6 million, and the IRS is continuing to audit several other deals.  While this number may seem small, the amount equated to approximately 10% of the Retained Value Deployed and Contracted disclosed by management at the time.  The following articles highlight just how tenuous SCTY’s business model is and how dependent it is on a favorable subsidy and tax environment: 

http://watchdog.org/130737/SCTY-stock-skyrockets/ 

http://watchdog.org/130098/SCTY-horror-stories/

http://news.heartland.org/newspaper-article/2013/06/13/SCTY-sues-federal-government-more-subsidies

http://watchdog.org/137076/feds-to-troll-SCTY-books

Additional Fees From Utility Commissions.  Traditional utility companies have a fixed expense base and a variable revenue base.  As consumers put up solar panels, their bills from the regulated utility decline.  In order to earn its regulated return, traditional utilities end up charging non-solar customers more.  In November, the Arizona Public Utility Commission (PUC) approved a $5 monthly incremental fee on customers who install solar residential solar systems.  This was touted by SCTY bulls as the fee was less than expected.  However, it is important to note that the PUC was unanimously in favor of implementing a new fee and the two dissenting votes believed a higher fee was necessary.  Additionally, this fee can be increased at the discretion of the PUC, potentially jeopardizing the savings from solar.  To further underscore how tenuous the existing savings are to customers in Arizona, Lyndon Rive, the founder and CEO of SCTY told the Arizona Republic that the average SCTY customer saves $5 to $10 each month.

Capital Requirements.  In 2013, SCTY spent more than $700 million on capital expenditures.  In order to achieve the midpoint of next year’s deployment guidance, SCTY will spend $1.3 billion on capital expenditures.  The entire tax equity funding market for the relevant tax credit is estimated to only be $5 billion, implying that SCTY will need to account for a disproportionately large amount of that market to fund its guidance.  There’s been some recent enthusiasm about potentially accessing the securitization market and bulls have convinced themselves that securitizations will revolutionize the business and offset the negative impact of the reduction in the ITC, but it’s actually more expensive than tax equity because SCTY has to deliver cash lease payments to pay down the securitizations whereas the majority of payments to the tax equity partners are delivered through government subsidies and credits.

Customers’ Option to Buy vs. Lease.  Households can always finance purchases of solar panels using home equity loans and hire installation crew to set up the panels.  Since the household will own the panel, they can keep the tax credit for themselves and finance a solar system at a much lower annual cost than what SCTY and other lessors offer.  As customers learn it is a much better deal to buy the panel and as home prices continue to trend upwards, we expect more households will purchase the systems outright, thereby pressuring SCTY’s leasing economics.

Increasing Competition.  Our calls with industry experts have described a competitive environment that is only getting more challenging with SCTY spending as much as it possibly can to gain market share.  SCTY bulls seem to mistakenly view this as a winner take all market, but the panel installation business is inherently regional and fragmented.  Given the lack of a real technology as well as a business model predicated on supplying two commodity products (financing and solar panels), the market is likely to remain fiercely competitive.  Not only are solar panel manufacturers aggressively pursuing the space (SunPower), but so are alarm companies such as Vivint (http://articles.latimes.com/2014/feb/12/business/la-fi-solar-desert-20140212/2 ) and roofing companies.  NRG has gotten more aggressive in the space as well, recently acquiring Roof Diagnostics Solar, the eighth-largest solar installer in the United States and has been offering two years of free electricity in New Jersey (http://www.energychoicematters.com/stories/20131218a.html).  SunRun recently acquired REC Solar’s Residential Division (solar sales, design and installation), AEE Solar (distribution) and SnapNrack (mounting systems).  These transactions make SunRun a vertically integrated solar installer and financier with a direct sales force like SCTY.     

Poor Internal Controls and Accounting Restatements.  Earlier this year, SCTY may have set a public company record when it held 3 separate earnings calls for its fourth quarter results.  On the first call, they announced their financials weren’t ready due to accounting issues.  A week later and on the second call, management updated investors with the news that the financials still weren’t ready as internal controls identified material weaknesses and financials would be restated.  The third time was a charm as they provided investors with their full fourth quarter financials revealing they had basically hid $20 million of annual expenses by inappropriately capitalizing them on the balance sheet. 

Infrastructure/Fixed Cost Risk.  As SCTY expands aggressively to take market share, one of the unmentioned risks in the business is the extraordinary fixed cost base they are developing.  Much like a non-bank mortgage originator, SCTY will be very vulnerable to a decline in volumes and it could even jeopardize the financial viability of the company as the actual cash flows from existing customers will mostly go to the tax equity investors and the company will likely be developing a fixed cost base of $300 million to $400 million in the coming years.  We think volumes are likely to decline sharply in 2017 (after the tax credit steps down), and SCTY will likely be in trouble as it is wholly reliant on origination volumes and the capital markets to fund its business.

Catalyst