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SolarCity (SCTY), a solar panel installation and finance company, is one of the more promising stories for alternative energy investors this year. SolarCity filed details of its initial public offering (IPO) on Tuesday, making it one of the few alternative energy company IPOs that investors are optimistic about. This article explains what type of business SolarCity is, lays out details of its stock rollout, and reveals important pluses and minuses for investors.

What SolarCity Does

SolarCity's product is simple; it installs solar systems for homeowners, business (including Wal-Mart, eBay and Intel) and government agencies. In many cases, there are little or no upfront costs to the client; just sign the papers and you are on your way to reduced electric bills using clean energy! SolarCity claims that it installs more solar energy systems than any other company in the U.S. Its goal is to reach every home and business to become "the largest provider of clean distributed energy in the world."

How SolarCity does this, though, is anything but simple. In most cases, the customer does not own solar system. Instead they get the benefits through either a lease, where a fixed monthly fee is paid, or power purchase agreement, where a rate is paid for the actual amount of electricity generated.

SolarCity takes these recurring payments, along with government incentives (including investment tax credits and accelerated tax depreciation), and sells them to investment funds. By doing so, SolarCity has raised $1.57 billion by working with Credit Suisse (CS), Google (GOOG), PG&E Corporation (PCG), U.S. Bancorp (USB) and others. SolarCity then uses part of the cash to cover costs of the solar installation, and reinvests the rest to grow the business.

In other words, if you want solar on your house, one or more global investment funds, with a residual interest by SolarCity, will own the solar panels on your roof. They in turn either lease it back to you or charge you a rate for its use. To complicate things more, SolarCity plans to expand its current assortment of investment configurations. These configurations now include joint ventures, lease pass-through and sale-leasebacks, but SolarCity plans to add in other debt or equity structures in the future.

The SolarCity IPO

SolarCity will be releasing 10 million shares that will be trading on the NASDAQ Global Market under the symbol SCTY before the year's end. Shares will be priced at between $13-$15. The company currently has negative net earnings, so determining a fair price for the SolarCity shares can only be based on the hopes of growing future earnings. Its prospects look good, though, as shown on the charts below.

SolarCity has a proven track record of being able to grow its business. Revenues, or sales, have been steadily climbing over the past four years. In fact, in just the first nine months of 2012, revenues came in three times greater than they were in 2009 and 2010. As the company states, its customer payment obligations "have grown at a compounded annual rate of 117% since 2009." Gross profits have also followed suit.

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This rising revenue stream is a result of an increasing customer base, which has also exploded in the first nine months of 2012. The number of buildings that SolarCity services is more than double that of a year ago, and the number of customers is almost triple.

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On the down side, SolarCity has incurred increasing expenses, which has caused losses to accelerate as well. One would expect operating expenses to be increasing as revenues rise, but the painfully widening net loss is a concern. To be fair, SolarCity has been reinvesting much of these funds to lay the foundation of its business in order to be able to grow successfully.

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SolarCity's debt levels are also growing, but are not considered excessive. Its innovative financing structure has allowed SolarCity to keep debt at bay, a huge positive for this IPO.

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Dangers of Owning SolarCity Stock

There are several risks involved with investing in SolarCity, many of which are the standard type encountered by investing in any IPO. Two, though, stand out.

First, much of SolarCity's current business relies on various government incentives, including rebates, tax credits and performance payments. The viability of these credits over the next five years is a huge moving target, which creates a great deal of uncertainty for this company. As these credits expire, SolarCity's current business model looks less attractive.

Second, the U.S. Department of Treasury is concerned that it may have over-issued grants and tax credits to SolarCity. The Inspector General issued a subpoena to see if SolarCity overvalued the panels it installed, which would have generated a bigger incentive than it was due. In addition, the IRS is auditing two of SolarCity's investment funds. The results of these investigations are a big unknown, but if Treasury adjusts the fair market value of the solar systems down, SolarCity could easily be facing repayments in the tens of millions of dollars.

Is SolarCity A Good Solar Sector Play?

Returns on solar stocks have been dismal. Of the 60 solar companies the Roen Financial Report tracks, the average company is down 13.1% for the quarter, with only 25% of companies showing gains. In fact, almost half of the companies posted losses in the double digits for the past 3 months. Much of this carnage is due to the continued oversupply of photovoltaic products, as well as the harsh business climate created by trade wars vis-à-vis the U.S., China and the European Union.

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It is these exact conditions, however, that benefit SolarCity. The downward squeeze on solar prices makes deployment of these systems more and more affordable. According to the Lawrence Berkeley National Laboratory, since 1998, installed prices for residential and commercial solar in the U.S. has dropped between 5%-7% per year on average. This means the average project cost is half of what it did 13 years ago. This trend is likely to continue, and may even accelerate as breakthroughs in photovoltaic technologies come to market. This creates a very tough environment for solar manufacturers, but it is all good news for companies like SolarCity. Though the risk of government incentives drying up is a real concern for SolarCity, dropping panel prices, along with rising energy costs, could balance out the damage to SolarCity's business model.

Also, I like that sentiment on solar is so low now. In fact, the word on the street is so negative on solar I have turned short-term bullish on the sector. Witness that the ETF Guggenheim Solar (TAN) was up over 10% in the last 5 days of trading, while the NASDAQ gained less than 2% over the same time period. SolarCity could experience a downdraft in its stock price due to negative views on the sector as a whole. However, as is often the case on Wall Street, overreaction on the sector as a whole may cause an undue drop in SolarCity's stock specifically.

Final Rundown

I do not normally suggest investors get involved with an IPO, regardless of the fact that it is difficult for retail shareholders to pick up IPO shares. Having said that, SolarCity strikes me as well positioned to expand its market share in a business area that also has a lot of room to grow. It is still a speculative company, however, and much will be riding on its continued ability to rapidly expand its customer base. It will be a company I will be tracking very closely in the years ahead.

Source: Will SolarCity IPO Offer Hope For Renewable Energy Investors?