Does SolarCity Have More Room To Shine?

| About: SolarCity Corp. (SCTY)

Elon Musk-backed energy provider SolarCity (NASDAQ:SCTY) has vaulted to new heights in the past two weeks, and has been the standout performer in the solar energy field. Much like the solar industry as a whole, the stock's meteoric rise has been somewhat baffling to many investors. The company reported wider-than-expected losses in its last earnings report on May 13 and its stock sold off, only to be revitalized by the announcement of a deal with Goldman Sachs which will see the investment bank provide over $500 million in financing for rooftop solar systems that will be completed by SolarCity later this year. This year has also seen the threat of tariff- and quota-enforced reductions in Chinese solar exports to the United States and Europe, markets in which Chinese companies had dumped prices and oversupplied markets due to excessive subsidization of their operations.

The threat (and institution) of protectionist measures alone has not necessarily opened the door for American and European solar power operations. The low prices of photovoltaic cells and related products and services brought on by Chinese operations were undoubtedly linked with increased demand for them. SolarCity is unlike most standout performers in the solar industry, in that it does not manufacture solar cells or panels, rather the company provides design, installation, and other value-added services.

Somewhat paradoxically, SolarCity's operations currently benefit from (or are at least largely unaffected by) the current system of tariffs in place in the United States. The European Union, USA, and China have opened talks on how best to handle the over-subsidized and underpriced Chinese modules that flood foreign markets and make profitability next to impossible for the local panel manufacturers. The discussion is currently focused on removing explicit tariffs on shipments from mainland China and instead placing a straightforward minimum price to be allowed for all imported panels as well as a cap on imports.

This plan would spell trouble for SolarCity were it to be adopted. Despite the fact that SolarCity uses modules from Chinese manufacturers Trina (NYSE:TSL) and Yingli (NYSE:YGE), according to Travis Hoium for DailyFinance, SolarCity has avoided any great operational interference as these two companies have largely avoided tariffs by shunpiking through Taiwan or other, non-mainland regions. This practice would be rendered ineffective were the minimum price to be instituted, and SolarCity would see its margins fall as inputs become more expensive.

The San Mateo, California based firm also retrofits and constructs charging stations for electric vehicles. This and related services will allow SolarCity to grow in tandem with Tesla (NASDAQ:TSLA), Musk's other major 'green' involvement that has been the darling of American markets this year. Charging stations are now prevalent along California highways, and will become more so elsewhere if expectations for Tesla's growth are realized. SolarCity also installs stationary energy storage units for Tesla owners. The individual chargers are, to this point, an unprofitable venture, but margins are expected to improve over the next ten years to the point that this service will become a profitable one according to a recent Bloomberg piece. The company is scheduled to install 100 such units this year on top of the 1,950 they are said to have installed thus far. Centralized solar has been criticized for the high potential for blackouts and underproduction, and, as such, storage technologies such as these units are seen as a vital component of improving solar viability and increasing market share.

The deal with Goldman will allow SolarCity to provide their services at (relatively) affordable rates. The financing will allow SolarCity to lease rooftop photovoltaic systems to homes and businesses at little to no upfront cost, and provide an invaluable opportunity to improve market penetration, which to this point is very limited even in those 14 states in which SolarCity operates. The amount adds up to 110 megawatts worth of solar arrays. Each additional installation therefore guarantees long-term profits, but low initial margins.

The capex involved with these projects and whipsawing fluctuations in expected demand for solar and input prices have resulted in unexpectedly low EPS for the last 2 quarters. Regardless of earnings performance, the stock has skyrocketed, and is up well over 200% YTD at the time of writing. For a dose of perspective, the Guggenheim Solar ETF (TAN) is up around 30%, though many of the major holdings of this fund happen to be American and European manufacturers who have been hamstrung by Chinese market activities. The rapid rise in investor confidence in SolarCity comes as Tesla is recording similar gains, and bearish traders have dismissed the rise of one or both stocks as hero worship, or Musk-mania.

In reality, SolarCity has begun to show serious promise, to the extent that the current valuation looks like actual profit potential rather than a bubble. Not only does the company have what amounts to an exclusive agreement with Tesla, one of the fastest growing companies seen in years, it has also expanded its customer base into the public as well as the private sector by forging agreements with the Department of Defense (for residential arrays) and public school districts in California. According to a report by Josh Dzieza of the Daily Beast, SolarCity is poised to produce more than $1 billion in solar projects for the Department of Defense alone within the next 5 years. This factors into the numbers released in the last earnings report in mid-May, which showed a 106% YoY increase in the company's customer base that was based primarily in the private sector.

A positive result of exposure to the public sector, especially federal institutions, is that the federal government may be less willing to eliminate the renewable energy subsidies that are a boon to SolarCity's growth. Many fear that these subsidies will be reduced in the continuing recovery effort. In the face of recent developments, they seem sacrosanct. The Chinese efforts to dominate the solar market are unlikely to be significantly slowed by any of the proposed legislative maneuvering and the continued subsidization of installation-based operations like SolarCity acts as something of a hedge against relative weakness in American panel manufacturing. As long as no major shifts occur in the price of SolarCity's inputs, the growth potential for the company is high enough to easily justify the current share valuation.

My trade:
Buy the SCTY Jan 50-60 Call Spread for $3.20
Risk: $320 per 1 Lot
Reward: $680 per 1 Lot
Break-even: $53.20

Greeks of this Trade:
Delta: Long
Gamma: Long
Theta: Short
Vega: Long

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.