Being a value investor I normally monitor the investment climate constantly by screening thousands of stocks a month and monitoring about five hundred of my favorite stocks on a weekly basis. I've only recently started to see some pockets of "irrational exuberance" with regards to some of the recent initial public offerings. It initially started in early 2012 following the IPOs of Groupon (GRPN) and Zynga (ZNGA), I kept thinking to myself that these prices don't seem rational given the fundamentals of the companies. They initially were trading at ridiculous multiples, based on hype, which I didn't think could be sustained over the long haul given the competition entering their respective markets. Now in mid 2013 after a 473.6% rise from trough to peak, I'm having a deja vu feeling all over again, this time in regards to SolarCity (SCTY).
Those of you not familiar with SolarCity, they describe themselves as: "SolarCity Corporation provides homeowners, businesses and government organizations cleaner, more affordable alternatives to their utility bills- we call this Better Energy. Our long-term relationships with customers allow us to provide them clean distributed energy, as a result of the demand for Better Energy we have installed more solar energy systems than any other company in the United States."
First off, why the big run up in SolarCity? Well in my view it is mostly due to the success of Tesla Motors (TSLA) and the association with Elon Musk and really nothing to do with the fundamentals of SolarCity. In fact on their most recent conference call [see transcript] they announced Q1 earnings well below the street, and lowered guidance for Q2 2013. They have consistently lost money for investors during the past 12 months (- $97.94 Million TTM), and have kept the business afloat on debt financing alone. In fact the $500 million in debt financing from Goldman (GS) will bring their debt load up to approximately $725 million. Keep in mind that $725 million in debt was roughly the size of the entire market capitalization at the initial IPO price. Also on the conference call management stated that they would be net cash flow positive in Q2 2013; unfortunately that is inclusive of their $500 million in debt financing.
While it seems most of the IPO investors in SolarCity are not paying any attention to the fundamentals, I think it is important to compare SolarCity to their closest competitor Real Goods Solar, Inc. (RSOL). Real Goods Solar, Inc. has been around since 1978 and offers many similar services as SolarCity Corporation. Comparing the two companies below on some basic metrics you begin to see how frothy SolarCity's share price is compared to its biggest competitor. For instance, in the most recent full year reporting period, Real Goods Solar had sales of $92.89 Million and SolarCity Corporation had sales of only $128.62 Million, while SolarCity Corporation is afforded a market capitalization of $2.87 Billion versus Real Goods Solar's paltry market cap of only $70.74 million. If SolarCity Corporation was valued on the same sales metric as Real Goods Solar, SolarCity Corporation would be trading at roughly a $97.95 Million market cap or a price per share of approximately $1.29.
|Price/sales||EV/Revenue||Profit Margin||Operating Margin|
*All data from Capital IQ
While the fundamental disconnect may be clear as day, the financing and underlying assumptions in SolarCity's sales & long-term pricing methods are quite complex. Most of the recent demand for the product from SolarCity are from the no payment upfront leases, meaning SolarCity is fronting the costs of all the equipment and installation costs, while getting paid back over a 20-30 year time horizon. The major assumption with this process is that there will be a low default rate, something CEO Lyndon Rive commented on:
"We hope it sends a signal that solar is a stable and reliable asset to invest in," Rive said in an interview. "These aren't luxury yachts we're talking about, it's your energy, and the default rates are lower than mortgages."
That is quite an interesting comment given that if you call the company and get details on the payment plan of a leased system you are offered a plan that includes paying the utility company and a separate payment plan to SolarCity. While this sounds fairly low risk, the problem I see is what happens when someone stops paying the SolarCity bill and continues to pay the utility bill? Unlike most situations where a utility would be able to shut the power down until payment is received, SolarCity has no ability to forcefully halt power to the customer. So while the utilities can control most of their defaults in payments by shutting down the power, SolarCity on the other hand will have no ability to enforce anything, they will not be able to cut the power or turn off the solar panels upon default of a customer. Which comes to an interesting conclusion that the default rates SolarCity uses are likely calculated upon faulty assumptions based on significantly lower utility company default metrics.
Another final point to make is that SolarCity is purposely lowering their credit standards to spur demand even further; this in my opinion is a recipe for disaster in the long-run, as more and more customers begin taking on solar panel systems many of which can't actually afford the systems. On top of that, the salesperson mentioned that there is an annual increase in the lease payments of 2.9% per year. I assume they must disclose this to the buyer, but I did not confirm this with the salesperson. This financial engineering SolarCity is utilizing also fails to mention to the buyers/leasees that in a few years it is likely that solar panel prices will be significantly cheaper, thereby locking them in at current higher prices for 20-30 years.
"When we started you needed a FICO score of 720 or higher," Rive said. "Now it's more like 680 and I suspect in the near term we'll be at 650."
Overall, I think the huge valuation attributed to SolarCity Corporation is a very temporary phenomenon. Prices should continue to move lower as more people realize that the current valuation is pricing in perfect execution, constant hype, extremely low default rates, continued government subsidies, and cheap long-term financing.