SOLARCITY CORP SCTY S
April 09, 2014 - 6:27pm EST by
hawkeye901
2014 2015
Price: 57.51 EPS -$1.61 -$1.94
Shares Out. (in M): 101 P/E NM NM
Market Cap (in $M): 5,800 P/FCF NM NM
Net Debt (in $M): 0 EBIT -180 -200
TEV ($): 5,800 TEV/EBIT NM NM
Borrow Cost: NA

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  • Solar
  • Competitive Threats
  • Misunderstood Business Model
  • Complex Accounting
  • Sell-side Research Errors
 

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):         

Retained Value   Disclosed on 12/31/13 (Source:    Investor Presentation)

 

$1,051

Less:  Retained Value in Backlog (Years 1-30)

     

(384)

Retained Value   Deployed

 

 

 

 

$667

Less:  Renewal Rate Reduced to 50%

     

(110)

Retained Value   Deployed (Years 1-30)

 

 

 

$557

Less:  Discount Rate Adjustment from 6% to 9% (35%   impact)

 

(195)

Adjusted Retained   Value Deployed (Years 1-30)

 

 

$362

Less:  Taxes @ 40%

         

(145)

After-Tax Adjusted   Retained Value Deployed

 

 

 

$217

               

Cumulative Operating   Loss Since January 1, 2010

 

 

$341

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. 

WHAT IS THE STOCK WORTH?

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.   

             

2014

2015

2016

2017

2018

 

Cumulative

MWs Deployed (A)

 

 

 

 

 

500

750

1,000

1,100

1,200

 

4,550

% Growth

           

50%

33%

10%

9%

   
                           

After-Tax Adjusted   Retained Value per Watt (B)

   

$0.62

$0.62

$0.62

$0.25

$0.25

   
                           

Beginning Retained   Value

       

$217

$527

$992

$1,612

$1,887

   

Add:  Incremental Retained Value (A x B)

     

$310

$465

$620

$275

$300

   

Ending Retained Value   (C)

 

 

 

 

$527

$992

$1,612

$1,887

$2,187

   
                           

Estimated After-Tax Overhead   Expenses not Included in Retained Value

$25

$35

$45

$55

$65

   

Multiple

           

12x

12x

12x

12x

12x

   

Deduction from   Retained Value (D)

 

 

 

$300

$420

$540

$660

$780

   
                           

Ending Retained Value   Net of Capitalized Overhead (C - D)

 

$227

$572

$1,072

$1,227

$1,407

   
                           

Ending Retained Value   Net of Capitalized Overhead per Share

$2

$6

$10

$12

$14

   

% Upside/(Downside)   from Current Price

   

(96%)

(90%)

(82%)

(79%)

(76%)

   
                           

Average System Size (kW)

       

6.4

6.4

6.4

6.4

6.4

   

Customers Required

 

 

 

 

78,125

117,188

156,250

171,875

187,500

 

710,938

                           

Solar Systems Capex

 

 

 

 

$1,316

$1,973

$2,631

$2,894

$3,158

 

$11,972

                           

GAAP EPS

         

($1.94)

($2.35)

($2.49)

($1.78)

($1.51)

   

Tangible Book   Value/Share

       

$1.37

($1.00)

($3.52)

($5.42)

($7.12)

   

  

Incremental Retained   Value per Watt Generated in Q4 (Source:    02/24/14 Call)

$1.90

Less:  Renewal Rate Reduced to 50%

     

 ($0.31)

Incremental Retained   Value per Watt (Years 1-30)

 

 

$1.59

Less:  Discount Rate Adjustment from 6% to 9% (35%   impact)

 

($0.56)

Adjusted Incremental   Retained Value per Watt

 

 

 

$1.03

Less:  Taxes @ 40%

         

   ($0.41)

After-Tax Adjusted   Incremental Retained Value per Watt

 

 

$0.62

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. 

As shown above, we believe SCTY is only creating $0.62 of value per watt.  After a reasonable estimate of overhead expenses (not captured in our Retained Value calculation), we believe the company is only generating marginal shareholder value over time.  We would highlight we are giving the company the benefit of the doubt on growth and we think our overhead assumptions could prove low.  After 2016, the economic viability of the leasing business is thrown into doubt.  Beginning in 2017, this tax credit is scheduled to fall by two-thirds, which will significantly increase the company’s future cost of capital.  We believe that the reduction in the tax credit could reduce the after-tax Retained Value/Watt on new installations by over 50% as cash flows to financing partners will increase.   
 

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.

I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

Unwind of momentum, continued operating losses, capital raises, investors focusing on tax credit changes in 2017, increasing competition, investors digging more into the economic model, additional fees from utility commissions
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    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):         

    Retained Value   Disclosed on 12/31/13 (Source:    Investor Presentation)

     

    $1,051

    Less:  Retained Value in Backlog (Years 1-30)

         

    (384)

    Retained Value   Deployed

     

     

     

     

    $667

    Less:  Renewal Rate Reduced to 50%

         

    (110)

    Retained Value   Deployed (Years 1-30)

     

     

     

    $557

    Less:  Discount Rate Adjustment from 6% to 9% (35%   impact)

     

    (195)

    Adjusted Retained   Value Deployed (Years 1-30)

     

     

    $362

    Less:  Taxes @ 40%

             

    (145)

    After-Tax Adjusted   Retained Value Deployed

     

     

     

    $217

                   

    Cumulative Operating   Loss Since January 1, 2010

     

     

    $341

    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. 

    WHAT IS THE STOCK WORTH?

    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.   

                 

    2014

    2015

    2016

    2017

    2018

     

    Cumulative

    MWs Deployed (A)

     

     

     

     

     

    500

    750

    1,000

    1,100

    1,200

     

    4,550

    % Growth

               

    50%

    33%

    10%

    9%

       
                               

    After-Tax Adjusted   Retained Value per Watt (B)

       

    $0.62

    $0.62

    $0.62

    $0.25

    $0.25

       
                               

    Beginning Retained   Value

           

    $217

    $527

    $992

    $1,612

    $1,887

       

    Add:  Incremental Retained Value (A x B)

         

    $310

    $465

    $620

    $275

    $300

       

    Ending Retained Value   (C)

     

     

     

     

    $527

    $992

    $1,612

    $1,887

    $2,187

       
                               

    Estimated After-Tax Overhead   Expenses not Included in Retained Value

    $25

    $35

    $45

    $55

    $65

       

    Multiple

               

    12x

    12x

    12x

    12x

    12x

       

    Deduction from   Retained Value (D)

     

     

     

    $300

    $420

    $540

    $660

    $780

       
                               

    Ending Retained Value   Net of Capitalized Overhead (C - D)

     

    $227

    $572

    $1,072

    $1,227

    $1,407

       
                               

    Ending Retained Value   Net of Capitalized Overhead per Share

    $2

    $6

    $10

    $12

    $14

       

    % Upside/(Downside)   from Current Price

       

    (96%)

    (90%)

    (82%)

    (79%)

    (76%)

       
                               

    Average System Size (kW)

           

    6.4

    6.4

    6.4

    6.4

    6.4

       

    Customers Required

     

     

     

     

    78,125

    117,188

    156,250

    171,875

    187,500

     

    710,938

                               

    Solar Systems Capex

     

     

     

     

    $1,316

    $1,973

    $2,631

    $2,894

    $3,158

     

    $11,972

                               

    GAAP EPS

             

    ($1.94)

    ($2.35)

    ($2.49)

    ($1.78)

    ($1.51)

       

    Tangible Book   Value/Share

           

    $1.37

    ($1.00)

    ($3.52)

    ($5.42)

    ($7.12)

       

      

    Incremental Retained   Value per Watt Generated in Q4 (Source:    02/24/14 Call)

    $1.90

    Less:  Renewal Rate Reduced to 50%

         

     ($0.31)

    Incremental Retained   Value per Watt (Years 1-30)

     

     

    $1.59

    Less:  Discount Rate Adjustment from 6% to 9% (35%   impact)

     

    ($0.56)

    Adjusted Incremental   Retained Value per Watt

     

     

     

    $1.03

    Less:  Taxes @ 40%

             

       ($0.41)

    After-Tax Adjusted   Incremental Retained Value per Watt

     

     

    $0.62

    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. 

    As shown above, we believe SCTY is only creating $0.62 of value per watt.  After a reasonable estimate of overhead expenses (not captured in our Retained Value calculation), we believe the company is only generating marginal shareholder value over time.  We would highlight we are giving the company the benefit of the doubt on growth and we think our overhead assumptions could prove low.  After 2016, the economic viability of the leasing business is thrown into doubt.  Beginning in 2017, this tax credit is scheduled to fall by two-thirds, which will significantly increase the company’s future cost of capital.  We believe that the reduction in the tax credit could reduce the after-tax Retained Value/Watt on new installations by over 50% as cash flows to financing partners will increase.   
     

    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.

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    Neither I nor others I advise hold a material investment in the issuer's securities.

    Catalyst

    Unwind of momentum, continued operating losses, capital raises, investors focusing on tax credit changes in 2017, increasing competition, investors digging more into the economic model, additional fees from utility commissions

    Messages


    SubjectTax credits
    Entry04/09/2014 09:26 PM
    MemberWeighingMachine
    How likely do you think it is that SCTY could lobby to extend the favorable 30% tax credit? how would that impact the thesis/potential valuation?

    SubjectRE: Tax credits
    Entry04/10/2014 09:52 AM
    Memberhawkeye901
    Thanks for your question.  The Investment Tax Credit was approved in 2005 and extended in 2008 (with the credit falling to 10% at the beginning of 2017) as a way to induce adoption of solar panels.  Since then, panel prices have dropped substantially and the original rationale for the credit has become less relevant.  We have not seen anything to indicate that the credits will be extended (which would require an act of Congress) and our conversations with several major industry players indicate that the industry fully expects the subsidy will step down as legislated.   
     
    For what it is worth, SolarCity has also taken an adversarial relationship with the government by suing the Treasury for additional subsidies and last year's Barron's article sparked a congressional inquiry into their aggressive fair market value practices, which we think puts them in a very tough lobbying position.  We would also expect significant lobbying efforts from utilities to prevent any sort of extension of the tax credit.  When the credit was extended in 2008, solar was hardly a blip on the radar for utilities.
     
    Our thesis does not hinge on the tax credits as I think competitive forces will make this a low return business regardless of the outcome, but certainly the tax credit falling away would be a nail in the coffin for the stock.

    SubjectRE: Some questions
    Entry04/10/2014 10:26 AM
    Memberhawkeye901
    Thanks for the questions.  Our responses are as follows:
     

    1.  SolarCity has set a fairly lofty target of one million customers by 2018.  At the end of 2013, SolarCity had deployed systems to ~65,000 customers.  Their cumulative customer count of 93,000 includes ~30,000 customers in the backlog.  At an average system size of 6.4 kW, SolarCity has to deploy 6.0 GWs of panels (~$15 billion of capex) over the next 5 years, or 1.2 GWs annually, 4x 2013 deployments and nearly 2.5x the midpoint of this year's guidance.  These numbers are massive and the growth should be put in the perspective of expected industry installation growth growth in 2014 of 26% (per SEIA).  With SolarCity already at a third of residential market share, it's tough to square their projections with the realities of an already rapidly growing industry. 

    Arbitrarily throwing out such guidance should tell you something.  Imagine an insurance company saying "we are going to try to triple our premiums in the next few years" or a bank saying "we aim to grow our loan book five-fold in the years ahead" or a subprime mortgage originator saying our "goal is to grow our originations ten-fold"... you get the point.  In a capital intensive finance business, growth is only a small part of the equation, good risk-adjusted returns are certainly more important.  Imagine the massive fixed cost base SCTY would have to build to support that growth (right in the face of a major step down in tax subsidies).  Our case assumes very healthy growth, but if the company grows faster at the expense of returns, it should only lower the value of the company in our view (and expose the company to catastrophic risk).

    Separately, looking at guidance for this year, SolarCity guided to deployments of 78-82 MWs in Q1, a 20% decline versus Q4, as management cited seasonality.  What's interesting about their Q1 guidance is that not a single analyst modeled the business this way prior to the guidance, which is surprising given how in lock-step the Street has been with modeling the company based on management's guidance.  Additionally, prior to 2013, there was no seasonality in the business as Q1 deployments in 2011 and 2012 amounted to ~25% of annual deployments.  We view 2013's sequential growth throughout the year as less of a product of seasonality and more the result of an aggressive expansion of the company following a public offering.  It is possible they have trouble meeting this year's guidance based on their Q1 guide. 

    2.  On the securitization front, the most recent deal one was a $70 million facility (30% smaller than expectations) priced at 4.59%, 21 bps lower than November's $54 million securitization.  However, the November facility had a 13-year maturity versus an 8-year maturity for the most recent facility.  We would also note that SCTY needs $10+ billion of cumulative financing in the coming years to meet growth projections.  The cash flows in the securitization are much shorter duration cash flows than SolarCity's, which are extend out to 30 years (the last 10 of which aren't contracted).  Comparing the securitization rate to SCTY's discount rate is like comparing AAA-A rated securitization bonds vs. the equity tranche yield.  The securitization is way shorter duration and lower risk than cash flows to SolarCity - much of which come after 15 years and have the risk of churn, cancellation after 20 years and rising maintenance expenses.  We think even our 9% is way too low for this risk.  

    3.  The utility was seeking a higher fee and the Commission was unanimously in favor of a fee and settled on a lower fee to start, but new customers are not grandfathered in at that fee and the Commission can revisit and raise that fee on existing customers.  If a $50 fee was put in place, solar would have essentially been over in Arizona, further underscoring how tenuous the existing business model is.  Currently, several states, including Colorado, Georgia and North Carolina are likely to introduce fees for new rooftop solar or reduce the incentives.  Additionally, incentives in California are expected to be reduced or new fees are expected to be added as the state approaches its goal for solar generation in 2014/2015.

    4.  You are correct that they won't pay taxes for a while because they won't have positive net income for the foreseeable future.  However, it doesn't change the fact that the business must be viewed based on all its potential future cash flows (taxes included, when in fact they are eventually paid). This is what we did in our valuation (we included NOL value in our target).  The analysts are just wrong on this.

    5.  Costs across the industry have indeed fallen in recent years, mostly due to falling panel prices.  Because of this trend, it is unlikely Congress will act to restore the credit to 30% in 2017.  Our point on the tax credit impact is not related to cost, but instead it will kill SCTY's abusive leasing model (which works only because SCTY is marking up the panels by 100% and pushing this credit to third parties to create cheap funding).  Remember that even today SCTY makes no gross margins on sales... it is the leasing that makes the business viable and that will have to change dramatically post-2016 even if costs haven fallen much further.  How many businesses can you think of where it is supposedly quite lucrative to lease their product to the customer, but when you go to sell it to them, you can't even make a positive gross margin? 

    Separately, with respect to operating leverage, opex per watt deployed declined ~10% from 2012 to 2013 (you need to separate panel cost declines which will likely be passed to the customer through competitive forces).  However, the business experienced negative operating leverage from Q3 to Q4 despite increasing deployments and opex per watt deployed will be higher in Q1 of this year (~$0.85 per watt) than in any quarter in 2013.  Furthermore, any incremental operating leverage will be offset by worse economics on incremental customers.  On its March 18 earnings call (the third one), management said PPA rates for its California customers was $0.18-$0.19 per kilowatt hour versus $0.09-$0.12 in newer states (which is where a lot of growth will need to come from to hit that million customer count).                    


    SubjectQuarter
    Entry05/08/2014 10:02 AM
    Memberbruin821
    Any thoughts on the quarter?  thanks

    SubjectRE: Quarter
    Entry05/08/2014 01:00 PM
    Memberhawkeye901

    The stock is bouncing sharply today following Q1 earnings after some recent weakness in the stock.  We think this is a great set-up for the short as we believe this earnings report underscores our thesis as costs are spiraling out of control.  This stock looks increasingly silly in a world where high-flying momentum stocks are coming back to earth.

    Stepping back for a second, the company has $15 million of quarterly gross profit and $82 million of quarterly expenses.  The market cap is $5.6 billion.  The business is exhibiting negative operating leverage as gross profit increased 100% and operating expenses increased 139%.  The stock trades at around 100x run-rate gross profit!!  Even high fliers like FEYE, SPLK, WDAY, etc. look like a steal by comparison (15x-25x gross profit). Remember SCTY needs to plow tons of capital into the business to generate this growth (vs. high ROIC software companies) making the comparison all the more absurd.

    Deployments of 82 MWs matched the high end of guidance, but the operating loss of $67 million was much worse than expectations as opex increased by 139% (deployment growth was 78%).  Total opex will likely exceed $400 million this year ($250 mm of S&M and $150 mm of G&A). 

    Their "Retained Value" (using their assumptions) reached $1.3 billion (~$850 million is deployed).  Of the $850 million deployed, only about $550 million is contracted.  Incremental retained value per watt declined for the second straight quarter as a combination of competition and entry into newer states is capping the incremental economics.

    In what we imagine was an attempt to stop a downward spiral in the stock, management decided to put out aggressive guidance for 2015 of 900-1,000 MWs deployed.  We think the timing of this guidance is dubious, particularly given a slower than expected start to 2014.  Let's put this in context:  SolarCity exited 2013 with 1/3 share of the residential solar market and called for a doubling in deployments in 2014 and now another doubling of deployments in 2015.  If the residential solar market grows at a 20% CAGR from 2013 to 2015, SCTY's market share in 2015 will need to exceed 80% in order to hit their deployment numbers.  As we have said before, every aspect of SolarCity's business is commoditized so that kind of market share grab seems impossible to fathom... if not irresponsible management of the business.

    Why does SCTY need to announce guidance this early?  We are less than halfway through 2014.  Management's explanation was that investors are going to see 2015's guidance in 2014's opex numbers (ie, expect opex to continue to ratchet up heavily).  Residential deployments were actually down sequentially, which is surprising as management's claim that seasonality would slow down the business related purely to the commercial side of the business.  SCTY's Q2 deployment guidance was worse than Street expectations and now management's guidance is even more back-end loaded.  Bookings are what drive deployments and management struck a distinctly different tone on near-term bookings versus last quarter:

    Q4 Earnings Call #1:  02/24/14

    "We started making these investments in Q4. And we really started seeing the results in January. January is our record residential bookings, so definitely is going to see the results."

    Q4 Earnings Call #2:  03/03/14

    "So, last week I mentioned that January was our record bookings for the company. February, we just ended February and we beat January by a healthy margin. So, momentum is fantastic, things have never looked better."

    Q1 Earnings Call:  05/08/14

    "It's [Bookings] trending well. We don't want to get into the habit of forecasting bookings. The reason why we did it last quarter is because we gave the update so late into the quarter. What really matters is what we install and so I'd like everybody to focus on the 500 megawatts to 550 megawatts and then the 900 megawatts to 1 gigawatt."

    When they are setting records, management is happy to provide the info. It doesn't sound like April was a record month.

    Another reason for the early guidance may be that it gives CEO Lyndon Rive more time to sell shares.  As part of October's secondary offering, Lyndon Rive acquired 107,000 shares at $46.54.  Since April 29, he has sold 280,000 shares and we wouldn't be at all surprised to see the share salescontinue aggressively throughout the year.   


    SubjectRE: RE: Quarter
    Entry05/09/2014 09:28 AM
    Memberbruin821
    Thanks for  your thoughtful comments

    SubjectRE: Silevo acquistion
    Entry06/17/2014 05:15 PM
    Memberhawkeye901
    Thanks for the question.  Our view on SCTY has not changed and acquiring a panel manufacturer is an odd maneuver.  It is hard for us to find a rational explanation for today's price move.  SCTY is spending $350 million (including earn-outs) on a panel manufacturer with a single production line in China likely because SCTY is going to feel pressure from increased tariffs on panels imported from China and they are scrambling to find a solution (albeit an expensive, risky one).  The Company paid all stock which isn't surprising given the overvaluation in the stock.
     
    Manufacturing solar panels is extremely competitive and commoditized and now SCTY is committing hundreds of millions of dollars to a plant that won't come online until 2017.  Investors will see even a greater rise in capex and opex in the coming years and the financial risks facing the company cannot be overstated.  The Company is going to try to build a massive 1 GW plant with a partner that operates a single 32 MW plant in China.  Being reasonable here:  given all the costs and risks facing SCTY already, why would they ever want to bother sinking a ton of money into solar panel production?  It is rather amazing that shareholders in a Company with a $300 million operating loss (and on a path to having virtually no tangible book value) think this is a good idea.
     
    Also, this transaction presents an interesting question (conundrum) for the Company:  If SCTY believes that Silevo has higher quality, more efficient panels than other manufacturers, then does this mean existing SCTY customers have been purchasing less efficient, potentially obsolete panels?  If so, please explain why those customers are expected to renew their lease on their existing panels in 20 years?  Because if they don't, SCTY may be a donut.

    SubjectRE: RE: Silevo acquistion
    Entry06/18/2014 09:01 PM
    MemberMiamiJoe78
    I saw the Roth analyst raised his price target by $15 ($1.38bln of market cap) because of the transaction even though details about the acquisition were "sparse" -  a great example of a euphoric "tulipmania" analysis.  The name should crack eventually and thanks again for your insightful write-up.

    SubjectRE: RE: RE: RE: Silevo acquistion
    Entry06/25/2014 09:31 AM
    Memberhawkeye901

    SCTY's market cap is now around $7.2bn pro forma for the Silevo shares.  The stock has tacked on about $2bn in mkt cap as a result of this tiny acquisition for which no financial data was provided.  This acquisition is predicated on an unproven technology and a plant that not only does not yet exist, but will require significant capital (~$1 billion) to construct... capital that SolarCity does not currently have.  Additionally, the economics in solar manufacturing have proven so uncompelling that the market has rewarded even large established producing panel makers with valuations close to their tangible book value.  Also, bear in mind that this acquisition was in response to increased tariffs on Chinese panels that will hurt SCTY's bottom line.  As a result of these pressures, our overall view of value is actually lower than it was just a month ago.

    Also, as I mentioned in my prior post, this acquisition (which is supposedly based on a next generation panel technology) almost ensures that current SCTY customers will have outdated panels and it is therefore unlikely they would renew their leases at the end of the 20yr term (they will simply demand SCTY or someone else installs a brand new panel first - which crushes SCTY's economics on the deal).

    Separately, Draper Fisher Jurvetson (#2 holder) distributed ~600,000 shares to investors last week.  While it’s a fairly small amount relative to their total holdings of 13 million shares, they continue to decrease their position size, which peaked at over 16 million shares.   Over the last several months, CEO Lyndon Rive has also been a seller through a 10b5 plan.

     


    SubjectA new subject line
    Entry06/25/2014 10:04 AM
    MemberWeighingMachine
    This was on Bberg the other day:
     
    http://www.bloomberg.com/news/2014-06-23/rooftop-solar-leases-scaring-buyers-when-homeowners-sell.html
     
    If the panels are indeed inferior, this could become a more significant deterrent to leases.  Also, some resi re markets in the SW (such as LA) are white hot so this isn't an issue now but could potentially be significant in a softer market.  
     

    SubjectRE: Blackstone's Vivint going public
    Entry08/06/2014 06:35 PM
    Membersidhardt1105
    Or rather investors will buy more SCTY to show underwriters how commited they are to the sector to argue for a better allocation...

    SubjectRE: hawkeye
    Entry08/08/2014 09:44 AM
    Memberhawkeye901
    Thanks for the question.  This is definitely an odd stock.  Coming into this quarter, the stock tacked on about $2.5bn of market cap on the heels of an acquisition of a small Chinese solar panel company for which no financial details were provided.  Additionally, we learned there will be increased tariffs on Chinese imports that will pressure SCTY's costs.  Finally, the CFO abruptly was replaced a week ago (and this is about as complex an accounting beast as you will find).  The market cap of this company is now over $8bn.
     
    Now to the quarter:
     
    *  Revenues came in at $61mm, $2mm below consensus
    *  MW deployed came in at 107, midpoint of guidance (although GS has been talking up the stock in recent weeks on the notion that MW would be high end of guidance)
    *  Operating expenses were $97mm slightly below guidance
    *  Q3 revenues guidance of $54-$63mm compared to $82mm consensus (due to a sharp drop in panel sales)
    *  Operating expenses of $115 to $125mm (up around $25mm sequentially)
    Most shocking number:  company burned $469mm before financing flows YTD...  importantly, the company has abandoned its statement that it will now be cash flow positive after financing inflows.  This was a target the company highlighted repeatedly in the last year and now it won't be happening.  Net debt is rising.
     
    Let's step back a second:
     
    *  Based on Q3 guidance, the company will have $200mm in run-rate lease revenues w/ around 50% GM or $100mm of annualized gross profit.  The market cap is now over $8bn so the company trades at 80x gross profit.  80x would be a high multiple even on net profits but the company is spending around $500mm per year in opex to generate this $100mm of gross profit. 
    *  Expenses continue to grow faster than revenues and operating leverage is murky at best (loss of $74mm this quarter vs $35mm a year ago)
    *  The company has $3 per share of tangible equity (which will approach zero in a year w/o a capital raise)
    *  Tangible equity is $328mm vs. tangible assets of $2,875 so the company is levered at 9x... but with $300mm in annual losses, leverage is quickly rising
     
    The market cap of this company is now over $8bn...  80x gross profit and over 25x a declining tangible book value.  Annual losses are over $300mm and growing.  I can't think of many (if any) stocks out their as distorted as this.  If anyone has any thoughts or a positive read on the company, I'd love to hear it.
     

    SubjectRE: RE: RE: hawkeye
    Entry08/08/2014 03:25 PM
    Memberhawkeye901
    I think it's mostly muppets.  Stock regularly trades 10% of its float in a day so the shareholder situation is akin to DDD.  While DDD has been and still is very silly (we have been short that too), one key difference here is the massive cash burn, balance sheet intensity and commoditized nature of the business that makes this excitement perhaps even more difficult to sustain - not to mention $8bn is a lot of market cap.  I think any serious bull case revolves around what I put forth as "The Bull Case" in my write-up.  I have not heard any adequate answers to any of my questions from the many bullish analysts that cover this company.

    SubjectRecent Developments
    Entry10/16/2014 01:49 PM
    Memberhawkeye901

    We wanted to highlight 5 recent developments that are very supportive of the SCTY short:

    Groundbreaking on Silevo Facility

    In late September, SolarCity broke ground on its new 1 GW fab in New York.  While sell-side analysts touted the higher than expected upfront investment by the state of New York of $750 million, SolarCity announced that it will “spend or incur approximately $5 billion in combined capital, operational expenses and other costs in the State of New York during the 10 year period following full production,” an amount equivalent to the current market cap of SolarCity.  We know that SolarCity doesn’t currently have and won’t be generating the capital needed to fund this expense.  The risks in this project and investment are enormous and we see an interesting parallel in the recent collapse of GT Advanced Technologies, an aggressive and promotional company with no real manufacturing experience that attempted to build the largest sapphire fab in the world.  A year after breaking ground on its facility and spending more than $500 million, GT Advanced Technologies declared bankruptcy last week.

    Recent Convert Offering

    SolarCity tapped the convertible markets in September, issuing $500 million of notes.  Most sell-side and retail investors do not appreciate how levered SolarCity is becoming.  Since going public last year, SolarCity’s debt has increased by over $1 billion and total debt is $1.4 billion.  The company also issued $200 million in stock last October.  The increase in debt roughly matches the increase in deployed retained value (under their assumptions of 6% discount rate and no churn) over the same period of time, so we must again question the economic value being created for investors.

     

    Cut in California Prices

    This weekend, Barron’s highlighted something that should be a real concern for shareholders of SolarCity: 

    “Deep in SolarCity’s latest investor presentation, on page 17, keen-eyed analysts noticed that the company chopped its forecast for the cash flow it expects from a typical rooftop installation by 20% from levels claimed in earlier presentations…Reporting its second-quarter results in August, SolarCity figured future receipts were worth $5.47 a watt in present value. Net of expenses, it counted $2.19 per watt in “residual value” for stockholders…Those numbers fell sharply when SolarCity updated its investor presentation in September. The per-watt present value of the typical project dropped from $5.47 to $4.75, while the residual value after expenses fell from $2.19 to $1.75.”

    This change was the result of SolarCity’s move to a fixed price of $0.15 per watt in California versus the prior average of $0.17 per watt.  Keep in mind that California is their largest and most profitable market and the economics just got cut by 20%.  According to JPMorgan, the company stated the change was not for competitive reasons.  Right.

    MyPower Loan Product

    SolarCity recently announced MyPower, a loan product, that CEO Lyndon Rive said will account for half of volumes by next year.  By selling and financing panel sales, SolarCity would no longer be eligible for the tax credits and subsidies that allow this business to exist.  Without these tax benefits, SolarCity, even under their extraordinarily generous assumptions, would generate a negative NPV on every install.  If this is where the market is moving, SolarCity won't be able to compete against larger and well capitalized financial institution with much cheaper sources of funds. 

    Vivint Solar IPO

    Vivint Solar, one of SolarCity’s largest competitors, went public on September 30.  Since going public, VSLR shares have declined by over 30% and has an EV of $1 billion versus $5.5 billion for SCTY.  VSLR employs the same Retained Value assumptions as SolarCity and, as of June 30, Vivint’s Retained Value was $310 million, implying that Vivint trades at 3.2x Retained Value.  To their credit, Vivint, unlike SolarCity, does not include backlog in its Retained Value calculation.  SolarCity’s Retained Value at June 30 was $1.8 billion, but includes our estimate of $750 million in backlog.  Excluding backlog, SolarCity trades at 5.2x Retained Value, a 60% premium to Vivint.  Considering Vivint’s faster growth and higher Retained Value per Watt, SolarCity should probably trade at a discount to Vivint.         

     


    SubjectRe: Roof replacement
    Entry04/16/2015 01:36 PM
    Memberhawkeye901

    Thanks for the question.  Below is SolarCity’s definition of Retained Value Under Contract:

    “Retained Value under Energy Contract” represents our estimate of the forecasted net present value at a discount rate of 6% of Nominal Contracted Payments Remaining for all lease and PPA Energy Contracts (excluding consumer loan energy contracts) and estimated performance based incentives and contracted solar renewable energy certificates allocated to us, net of amounts we are obligated to distribute to our fund investors, upfront rebates, depreciation, renewable energy certificates, solar renewable energy certificates and estimated operations and maintenance, insurance, administrative and inverter replacement costs, based on contractually agreed amounts as well as historic expenses. This metric includes all lease and PPA Energy Contracts for solar energy systems deployed and in Backlog."

    There's no explicit mention of roof replacement costs, but we agree this could be a very significant cost down the line.

     


    SubjectRe: couple of dumb questions
    Entry04/16/2015 04:31 PM
    Memberhawkeye901

    1.       The seller has to convince the buyer to take over the lease and it would be part of the negotiation as part of any home sale.

    2.       I do not believe SCTY has recourse beyond the panels themselves.

    3.       The panels can be insured against damage and theft.

    4.       There are two major types of lease that a customer enters into with SCTY.  One is based on performance/power-provided and the other is a fixed fee with annual escalators.  To the extent performance deteriorates for whatever reason, the performance-based lease will experience stagnating or declining payments. 


    SubjectRe: TSLA/SCTY
    Entry06/22/2016 02:14 PM
    Memberhawkeye901

    Honestly I think the deal is ridiculous.  There is no strategic rationale one could credibly come up with for putting an electric car company together with a solar panel manufacturing and installation company.

    I strongly believe SCTY is destined to fail on its own (probably very soon).  Musk obviously knows this and this was a desperate attempt to save himself from the embarrassment of a Chpt 11 filing at SCTY and the deal has the added benefit for him of paying his cousins tens of millions of dollars.

    I have stopped posting here on TSLA because so much is written on the company already.  But if you can't tell by now that something really stinks with this company, then you haven't been following thigns too closely.  A few months ago Musk says TSLA doesn't need cash and is cash flow positive (every time he says this an equity deal is in the works).  Then weeks later, he raises a bunch of equity and cashes out millions of dollars of stock for himself.  And then, after getting TSLA investors to pony up more money, he immediately turns around and tries to buy one of his other companies that is hemorrhaging cash (a deal that was obviously contemplated when he raised equity).

    The whole Musk situation reminds me of Eike Batista, an energy and mining magnate from Brazil, who was on his way to being the richest guy in the world... until he wasn't and now he is broke.  Once upon a time, he could raise as much money as he wanted just by snapping his fingers - he could do no wrong.  And then, the empire suddenly showed some cracks, and his access to capital was cut off and the whole thing fell apart.

     

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