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SolarCity Corporation (NASDAQ:SCTY)

Q2 2013 Earnings Conference Call

August 07, 2013 5:00 pm ET

Executives

Lyndon Rive - Founder and Chief Executive Officer

Robert Kelly - Chief Financial Officer

Peter Rive - Founder, Chief Operations Officer and Chief Technology Officer

Aaron Chew - Vice President, Investor Relations

Analysts

Krish Sankar - Merrill Lynch

Phillip Shen - Roth Capital

Brian Lee - Goldman Sachs

Edwin Mok - Needham and Company

Pavel Molchanov - Raymond James

Operator

Good afternoon and welcome to SolarCity’s Second Quarter 2013 Earnings Conference Call. Today’s call is being recorded and we'll begin with prepared remarks followed by Q&A. Management will be utilizing a slide presentation for this call which is available now by download on SolarCity's Investor Relations page at investors.solarcity.com. At this time, all participants are in a listen-only mode. (Operator Instructions)

At this time, I would like to turn the conference over to Aaron Chew, Vice President of Investor Relations at SolarCity.

Aaron Chew

Thank you and good afternoon to all those joining us today for SolarCity's second quarter 2013 earnings conference call. Leading the presentation today will be a discussion from our two founders, our Chief Executive Officer, Lyndon Rive and our Chief Operating Officer, Peter Rive, as well as our Chief Financial Officer, Bob Kelly, after which point in time, we will open up the call for questions.

As a reminder, today’s discussion will contain forward-looking statements that involve risks and uncertainties, including forecasts regarding SolarCity’s 2013 financial and operational results. Words such as believe, may, estimate, continue, anticipate, intend, expect, predict, potential and similar expressions as they relate to SolarCity, its business and its management are intended to identify forward-looking statements.

Forward-looking statements should not be considered a guarantee of future performance or results, and will not necessarily be accurate indications of the time at or by which such performance or results will be achieved if at all. Forward-looking statements are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed and/or suggested by the forward looking statements, including risks identified in SolarCity’s earnings press release issued today and in the slides accompanying this presentation, as well as additional risks and uncertainties identified in the section entitled Risk Factors in our registration statement on Form S-1, which has been filed with the Securities and Exchange Commission. We do not undertake any obligation to publicly update or revise any forward looking statement whether as a result of new information, future development or otherwise.

In addition, during the course of this call, we will use a number of specially defined terms relating to our business metrics and financial results. We referred to definitions of these terms included in the slides accompanying this presentation, which are available on our Investor Relations website at investors.solarcity.com.

With that finally behind us, I would like to introduce SolarCity's Chief Executive Officer, Mr. Lyndon Rive.

Lyndon Rive

Thank you, Aaron. We had a great quarter, we had growth in almost every metric. Here are some highlights. So we had $19 million of positive cash flow, our residential business grew 144% year-on-year, our operating lease revenue rose 79%, contract payment increased $187 million to bring the total to over $1.4 billion. We also launched a new product called LightMount. This was a product co-developed with [indiscernible]. The product integrates the module into the roof membrane. It's a great product for commercial customers thinking of getting a new roof or that have roof weight limitations.

We launched another product called Energy Explorer. This is an interactive software that customers can use to see where is the energy is being lost in the house. This software helps customers make the best decisions and energy efficiency upgrades. We have previously charged for this but now we have included this in every solar system that we install. By doing this, we provide additional value to our customers that's hard for our competitors to match, and it provides us an opportunity to make additional revenue through software services.

As we look at creating the most compelling energy company of the 21st century, we need to have an incredible team. I'm pleased to announce Tanguy Serra as our Executive Vice President of Operations. Tanguy has incredible track record in growing operational capacity while lowering costs, [indiscernible].

Moving on to solar [indiscernible] mentioned, for the number of contracts now over $1.4 billion, we added $187 million in Q2, a dramatic increase over Q1. We also added over 8,000 new energy contracts in Q2 with 69 MW of booking being executed too, this was a good quarter. We see this momentum continue through the rest of the year as July was our highest residential booking month ever.

Peter Rive

Peter Rive, Chief Operations Officer. Q2 was also a great quarter for us with deployments of 53 MW of total deployment, 43 MW of residential deployment which represents 144% of growth relative to Q2 2012. 144% is more than double the industry growth in the residential market and [indiscernible] increase in SolarCity's market share from past year. Deployment [indiscernible] building is ahead of schedule and has continued in Q3 with July setting a record for residential deployment and we are on track to hit our recently revised guidance which increased to 270 MW for the year.

Looking at our cost structure and our progress with our cost reduction goals, we have reduced our all-in costs by over 80% since Q2 of 2012. It's important to note that this reflects all of our costs, the direct installation costs, the panel cost, sales and marketing, everything. Again to that point, we set a goal of declining our cost by 5.5% annually and we are executing ahead of that target. Cost reductions are coming from many areas of the business as we see our volumes scale such as product improvement, gains from technology investments and better leverage over fixed expenses. It's important to note that even with module price decline stabilizing, our cost reductions have been exceeding our plan in 2013 year to date.

Robert Kelly

It's Bob Kelly, CFO. Want to give you an update on the financings during the quarter. We continue to execute on our financial strategy. As you recall, the objective is to increase the source of the capital for the business and at the same time drive down the cost of capital of the business. There are three main financial activities, there is an initial tax monetization, secondly there is a short-term capital raise which we call aggregation facility, and the final piece is on that long-term financing.

Starting at the beginning, on the tax monetization, as of October 1, we had 169 MW of capacity. For the quarter and through August 1, we added three new funds including two new investors. What we have seen in the marketplace because of the SolarCity business model, where we have full control of quality, customer experience, and historic performance, this is a key differentiator when we are dealing with the past equity investors. We spend a lot of time with the investors and on the business model and the vertical integration, and this is reflected in our success in this area.

We also achieved a pretty significant milestone in the quarter with the cumulative funds raised are sufficient to deploy over $3 billion of solar systems. Another milestone in the quarter was the closing of the aggregation facility up to [$150 million] (ph) with an initial minimum of $100 million. Under these facilities, we collateralized our solar lease cash flow streams, we don't provide security of the systems, it was pretty unique in the marketplace. The cost of capital of these transactions are around 3.5% which going back to the strategy of driving down the cost of capital.

On the long-term financing front, we continue to work with the rating agencies on our securitization of some of our solar systems. We achieved another milestone with our independent engineering report during the quarter. It concluded we have outperformed our pre-construction estimates by 5% and validated the vertical integration model of SolarCity.

We've been getting a lot of questions about the status of our convertible note offering. As you may have seen, we filed amendments to the registration statement last week in response to the SEC comments. Even though we expect to get through the process this month, it's a quiet time in the markets in the last couple of weeks of this month, we'll wait until after Labor Day to take a look at the capital markets at that time.

Moving on to the financial performance during the quarter, starting with the GAAP statement of operations, and the first line, the operating lease revenue increased 1.8 times year-over-year for the comparable period to around $21 million. Operating lease cost of revenues of $7.2 million, that resulted in a 64% gross margin for the operating lease activities. These revenues represent the building blocks of the future. As Lyndon mentioned earlier, the nominal contracts remaining of $1.4 billion, these numbers will flow through this line over the next 20 years providing a strong foundation for the Company.

I also want to mention that you'll see upcoming in the Q4 as we move from a 1603 tax credit environment to an investment tax credit, you'll see the investment tax credit for our non-partnership funds running through the revenue line annually over five years as the recapture positions lapse.

Moving down to the bottom of the income statement, the sales and marketing and the G&A, as you aware, for SolarCity this primarily reflects the development expenses for the future megawatts. One thing I forgot to mention, the solar systems sales, the gross margin of that business was 12% for the quarter compared to 9% for the last year.

Let's move on to the cash flow statement of the Company. Just to reiterate, we see the recurring predictable cash stream with each new energy contract. Our strategy is to maximize the retained value for the shareholders, recover our investment activities with cash from operations and from financial activities.

For the quarter, operating cash was a healthy $74 million. Included in this number is around $21 million from the monetization of the ITC which will be recognized as revenue over the next five years, and there was also some normal working capital activities. Additionally in the quarter, there were warrants exercised where we received $8.4 million and about $4.8 million of stock options exercised. The total increase in cash for the quarter was over $32 million.

Lyndon Rive

Turning to the retained value forecast, the retained value forecast increased to $662 million. Just as a reminder, the retained value is before [indiscernible] discounted cash flows coming to SolarCity after distribution to equity investors and operating and maintenance costs. On a dollar per watt, it had increased from $1.25 to $1.27. This number includes negative funds [indiscernible] the majority of the cash flow to the net equity investors.

Now if we look at new funds that we have recently closed, this in a broader range depend on the asset type, so for commercial it's $1 per watt to $1.50 per watt and for residential it is around $1.50 per watt to $2.70 per watt. So looking at the incremental dollars per watt, on a quarter-on-quarter it will be volatile depending on the asset mix. For example, if we have a large commercial amount, the retained value on a dollar per watt will be lower but the total retained value per watt will increase significantly.

Let's move on to the guidance for Q3, so Q3 megawatts installed we expect from 70 MW to 77 MW, operating lease revenues $21 million to $23 million, total system sales $15 million to $25 million. The gross margin is 30% to 40% which is due to the large mix of cash sales. Core operating lease margins will be in line with previous quarters. Operating expenses $45 million to $50 million. And then this would be the first time that we are forecasting EPS and the forecast will be a non-GAAP EPS. For the forecasting, we are forecasting the net income before non-controlling interest. Our forecast is negative $0.30 to negative $0.60 per share in Q3. For 2013, we spoke to, we are very confident about 270 MW and we feel confident that we'll be cash flow positive in Q4 and maintain cash flow positive rates.

So operator, we are ready now for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Krish Sankar from Merrill Lynch.

Krish Sankar - Merrill Lynch

I have a couple of them, the first one is, we look at the potential emergence of direct ownership of solar systems with bank loans, does this present a competitive objective in the midterm or is that something you can benefit from in terms of raising cash and boosting revenue?

Lyndon Rive

If the customer wants to buy a cash system, we'll absolutely sell them on the cash system. In my experience is even if they do have the cash available, the disposable cash, is that it's better for them just to buy cheaper [indiscernible] electricity. So we just don't see this as a threat to the business.

Krish Sankar - Merrill Lynch

Got it, alright. And then when I look at your megawatts deployed for the full year, it looks like you will have to install in excess of 100 MW in Q4, is this something you guys can do, is it something you have the capacity to do today, and are there any risks of weather-related issues that could push that out?

Peter Rive

This is Peter Rive here. We feel very confident about that 100 MW under the [indiscernible] total for the year. We have been kind of ramping the operational capacity of the Company over the past couple of quarters in preparation for it. When we look at our capital cost and all of our operations spend, we always include some weather related risks. So weather related risks are specifically contemplated in our forecasted numbers.

Krish Sankar - Merrill Lynch

Got it. Just as a final one, for Bob, the 169 MW of undeployed tax pre-financing capacity, I don't know if you guys spoke about how long it's going to take you to work through that on a bookings basis or installation basis?

Robert Kelly

Just so you understand, tax equity business is a continuous business as we deploy and – raise tax equity and deploy the funds into the tax business. It's really probably six months to an annual financing business. So you see that go up and down over time, and as I said in my comments, 169 is a pretty good number and the backlog flow in the business is pretty good.

Lyndon Rive

Just to add additional color there, when we raise the fund, in most cases, we have a 12 months to 18 months deployment. So we are going to continue raising the funds as we deploy the volume.

Operator

Our next question comes from Phillip Shen from Roth Capital Partners.

Phillip Shen - Roth Capital

My first one is on the converts, can you provide us a sense of some of the potential characteristics of the convert, what kind of interest rate in conversion price are you targeting? I realize giving direct commentary about the raise may not be possible, but I'm sure you guys are aware, I'll just note that [indiscernible] due to convert at 600 million or $600 million convert at 1.5%, so if you could comment in general about what the market is bearing right now?

Robert Kelly

Unfortunately, Phil, we can't comment at all, we are in the FCC process and just can't answer those questions.

Phillip Shen - Roth Capital

Okay, that's fair. In terms of marketing costs, how have your customer acquisition costs trended through the year and where are they now? I think earlier in the year you indicated that they had declined from the $2,500 level, so can you give us some color on that?

Robert Kelly

So when we look at our cost reduction and when Peter mentioned the cost reduction of 5.5%, that includes fully loaded costs which includes acquisition costs. So we are not going to break down explicitly but we are on target with reducing our cost across the entire Company including acquisition of 5.5%.

Phillip Shen - Roth Capital

Okay, and then just a quick follow-up on that, obviously new module prices have troughed and this question is kind of tied to that 5.5%, but in that reduction, where do you see the greatest opportunities to lower your system costs over time?

Lyndon Rive

They'll come from a variety of areas. I mean I think that SolarCity has invested heavily over the past six years in infrastructure, so the more volume that we take to our infrastructure, the lower costs. We're seeing a variety of process improvements, technology improvements, kind of work automation as well as [indiscernible] hardware. So it is coming from a variety of applications. In our line of business, it isn't just one [indiscernible], it's just making kind of hundreds of improvements in like dozens of areas. So it comes in a variety of different locations.

Phillip Shen - Roth Capital

Okay, great. And then one last one and I'll jump back in queue, Bob, what kind of progress are you guys seeing and making with the rating agencies, what's the update there?

Robert Kelly

We continued to work through the agencies, this securitization is a new asset class, solar system, annualized cash flows, 20 year contracts, et cetera, it is methodical and we are working through the process. As I said in my comments, we achieved a pretty good milestone in engineer getting all that data, the background on the systems, the customer data, et cetera. So we continue to work through the progress. I don't have any set timeline, we're not under any time pressure or anything like that, we want to get it right and work through the process with the agency.

Lyndon Rive

But I do encourage anybody, if you're interested in doing something that's fun, to go through that process.

Operator

Our next question comes from Brian Lee from Goldman Sachs.

Brian Lee - Goldman Sachs

Hadn't you went on financing in those couple of net metering, first off I guess how should we think about the trend in your cost of tax equity, I guess if we compare to last year for example, and then what are the implications for what cost would be in an increasing interest rate environment?

Lyndon Rive

So the [indiscernible] slightly decreased in the tax equity pricing. In terms of the interest increase, if you go back to 2007, the tax equity cost was roughly 5% to 6.5%, that's when interest rates were very high. So the asset risk doesn't met the existing interest rate or the [statistical] (ph) rate. So as demand gets addressed and more investors get into the market, as they cater to the extremely low investment, I expect that the yields will not increase even with the interest rates increasing.

Brian Lee - Goldman Sachs

Okay, fair enough. And then on the net metering, two quick things, I guess one, I'm just wondering can you quantify in percentage terms what your average consumer both resi and commercial consume locally versus feeding back to the grid?

Lyndon Rive

So for commercial for the most part, very little. Now schools are different, schools because they are afternoon in the summer, they do net meter, in 30% to 40% range, 30% to 40% of the energy is exported on average, so I mean these are kind of in general terms it's about 30% to 40% exports.

Brian Lee - Goldman Sachs

That's for both commercial and residential?

Lyndon Rive

For commercial, there's not being exports at all.

Brian Lee - Goldman Sachs

They have very little net metering, okay. And I guess the follow-up on that would just be, we've heard a lot around net metering pushback and there are a couple of states which are key solar states, I think that's in proposal, so wondering what your strategy of pricing might do if we do see some customer – do customer economics get negatively impacted by whether if we could access these lower net metering rates, just any thoughts there would be helpful?

Lyndon Rive

Just to know, there have been some net metering debate, [indiscernible] and Louisiana had a debate, and the state decided to continue with net metering. That was a significant favorable act for the solar industry. In terms of the current debates that are occurring, we think that it will turn out to be optimistic but you just don't quite know, and if it is negative, the way we'd have to address it is we'd have to reduce our price, and we won't know that until we see the final outcome.

Operator

Our next question comes from [indiscernible] from Maxim Group.

Unidentified Analyst

Looking at your 3Q guidance for the operating lease revenue, does that include any of the amortization of the ITC that you discussed, there is some reason why that doesn't really hit until the fourth quarter?

Robert Kelly

When you look at the ITC, it's on an annual basis, basically 20% annually for the next five years. So that will happen in Q4 which is reflective of the investments we made in Q4 last year.

Lyndon Rive

Just a reminder, last year for the first part, [indiscernible] using the program, and so in Q4 that we start deploying ITC.

Unidentified Analyst

Okay, and for some reasons, the one year – I knew that the ITC started a little bit – sort of just in the first quarter of this year that was put through into the ITC as opposed to the draft, that won't start to be – that won't show up in the revenue line for one year after it was deployed, is that what you are saying?

Robert Kelly

Yes, that's correct.

Unidentified Analyst

Okay, and if I just one quick, the gross margin on system sales has bounced around a lot but it's lower than it has been in most quarters at least, and it looks like you are guiding for it to stay somewhat low with the 30% to 40% overall guidance. Is that a new level that we should think about going forward, that low double-digits?

Lyndon Rive

For cash systems sales, yes, but our primary focus is just to make sure there is no [indiscernible] on operating leases show in the total systems that we own.

Operator

Our next question comes from Edwin Mok from Needham and Company.

Edwin Mok - Needham and Company

So I guess the first question is what drove I think overall leasing, so was there some revenue that was above your guidance this quarter, what drove that?

Lyndon Rive

Can you say the question again?

Edwin Mok - Needham and Company

Yes, if I look at your operating lease in solar systems on a GAAP financial rates, there will be [indiscernible] lease revenue and also solar system sales, both of them were above your guidance for the quarter, what drove that sizeable line item?

Lyndon Rive

It's a combination of early deployment and then a couple of actual production that was higher in the quarter than perhaps we were originally forecasting but there were deployments that were happening early in the quarter that pushed it.

Edwin Mok - Needham and Company

So there was some seasonal benefit you had because of some of the projects you guys owned producible energy that drove that?

Lyndon Rive

It basically came online for producing energy earlier.

Edwin Mok - Needham and Company

Okay, that's helpful. And then second question on the capacity, the deployment capacity, I think if you guys could talk about capacity constraint but your guidance has implied somewhat soft, but is there a way we can think about how much capacity can you guys deploy on a per quarter or per year basis, you guys are already round up to just I think 90 MW or 100 MW per quarter level or are you guys continuing to add to that capacity, we just want to get a sense in terms of how the capacity is trending?

Lyndon Rive

So the capacity is trending in line with the full cost that we are putting out there. So [indiscernible] transfer question, I mean if we look at next quarter, 70 to 77, that's quite a bit more than this quarter, so it's just continued increase of capacity.

Peter Rive

I mean what happens is residential will be consistently increasing, I think commercial will be slightly depending on the plant. But the residential will be a base load that just grows and continues to grow and I think commercial just fluctuates depending on where the system is pausing and what caught up.

Edwin Mok - Needham and Company

That's helpful. And then I guess a question just on cost of capital, as I remember I think it was back earlier on this issue you guys talked about there were some funds that you guys have lowered the cost of financing, right, other kind of source, I think those are the first two funds right, from 8% to I think it was 0.5% or something like that, right. Should we expect more of that to come in the coming quarters as some of those funds have gone through the equity part of it and is there a way we can think about that?

Robert Kelly

I think that we'll it through with the financial strategy that we are putting in place. As we deploy the tax equity, get the mostly efficient capital there, there will not be asset base into short-term facilities which drives down the cost of capital, and then work very hard of educating the marketplace on future investment on the long-term value of these assets. I have said many times that the market is, they should, the energy payment is made before the household payment. So these assets should equate to below or right on top of 20 or more potentially. We are starting to see a trend between 4% and 6% and I think you'll see over time that start approaching that number. And if we have any opportunities for historical assets on your question, Edwin, that we would if it's accretive and we could refinance on that lower cost of capital, the model is set up to easily achieve that by just adding them on any one of the financings that we are doing.

Lyndon Rive

It was a key milestone that we needed to achieve just to be able to finance the capital of encumbering the asset and we approved that amount in the second aggregation facility.

Edwin Mok - Needham and Company

So that leads to my last question, so on the aggregation facility, any way you can kind of quantify how much is it more you can do towards the end of this year or in 2014, and if so, any way you can kind of quantify how much you think in aggregate?

Robert Kelly

So I think the way to look at it is an aggregation is about 75 MW, about $100 million, so if you run to the 270 where we're at today and 75 MW you can just figure it out that you can get there mathematically.

Lyndon Rive

So we are going to continue to raise aggregation facilities and then take it out to the long-term up to get the rating.

Edwin Mok - Needham and Company

Great, that was really helpful. Thank you.

Operator

Our next question comes from Pavel Molchanov from Raymond James.

Pavel Molchanov - Raymond James

Can I just take a step back and ask you broadly about the competitive landscape, it seems like every week now one of your peers, either standalone or part of a larger enterprise, raises hundreds of millions in leases, I'm curious to your thoughts on the amount of capital flowing into your space and where you think the competitive environment, how it is evolving?

Lyndon Rive

I could not be more excited about the additional capital coming into this space. Remember our top competitors are existing energy providers, just not necessarily the solar companies. So as more solar companies that get into this there are more capital lines, and the more the entire industry proceeds towards transforming our existing energy infrastructure to a new balanced energy infrastructure. So, we like that. Now when we actually compete in the end for the actual customer, the better product will win. So the company with the lower cost and higher quality will essentially get to the customer. So our job will be to continue offering additional differentiation of the highest quality and then provide it at the lowest cost.

Pavel Molchanov - Raymond James

Okay, the energy efficiency business, can we just get a quick update on how that stands and what your plans are for the rest of the year on this?

Lyndon Rive

So as we covered very briefly in our review, we launched a product called Energy Explorer which is going to be included with every single solar customer's contract and we do a quick energy audit and then run a massive simulation on the energy for the home and the produce those results and finding interactive way in the customers' web account, so they can log on and you can go and look at it you can actually read on the web there are a couple of good reviews that's been done on it. So what we're doing here is we're essentially getting the customers to perform upgrades and select those upgrades from within the software application and then we'll get a percentage of the revenue for the work that has been done that the customer has selected. So we are really excited to better expand the reach than the past, we are seeing call it about 40% to 50% of customers that's offering energy efficiency audits that now we're doing with every single customer today, that should expand that reach of customers that will potentially perform upgrades with this new software at least.

Peter Rive

Remember, you have got to take a 20, 30 year view on the customer's end demand, with respect to how the customer make the change, what upgrades they need to happen and doesn't necessarily have to happen today or a year from now, it can happen three years from now.

Lyndon Rive

And it also provides us with arguably one of the world's best databases in terms of residential energy which is kind of will be important to us over the next couple of decades.

Operator

Thank you. This does conclude the Q&A portion of today's call.

Lyndon Rive

Thanks guys and thank you very much everybody for joining the call.

Operator

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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