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SolarCity (SCTY) has been one of the best performing solar stocks this year. The company installs solar PV systems on roofs and focuses on residential and commercial customers. It offers third party leasing for the solar installations and finances these installations with privately placed bonds to large institutional investors along with its own capital. SolarCity has developed an innovative financing structure that allows its installations to benefit from several government solar subsidies. This complicated financing structure, however, makes it difficult to assess the true profitability of SolarCity for most industry analysts and investors.

To derive a reasonable valuation for SolarCity, I will try to assess the profitability level of its solar installation and leasing businesses. In this analysis, I use the information provided by SolarCity in its financial reports and other available information from companies in similar businesses.

SolarCity installs rooftop solar PV systems and offers its customers twenty year power purchase contracts at fixed prices. The systems are financed with SolarCity's own capital and funds raised through other investors. Individual solar systems produce revenue through the sale of the power they generate and SolarCity collects this revenue from individual customers on a monthly basis. These revenue streams are shared between SolarCity and the other investors. SolarCity also monetizes tax subsidies and other available incentives for the solar systems to generate revenue. By performing the installations and investing in the solar assets, SolarCity has two profit components in its installations:

- Installer margin on installations. This is generally capitalized as part of the system cost.

- Returns on capital from the solar installations by owning these assets.

I will look into these two components separately to estimate the profitability of these businesses.

Solar system installation business

Since SolarCity does not disclose its average system installation cost, it is difficult for investors to assess the true profitability of these installations. To assess the profitability of its business, I will divide the business in the two components as mentioned and try to estimate the true profitability of SolarCity.

For the solar energy systems that are sold directly to the customers after installation, SolarCity collects the full margin immediately. The selling price of such systems is largely influenced by the competitive position of installers in the regions. Typically installer margins vary from 10 to 30%. SolarCity has reported the gross margin of around 30%, 26% and 14% in 2012, Q1/2013 and Q2/2013, respectively, for this business.

in $ millions

2010

2011

2012

Q1/2013

Q2/2013

Solar energy system sales

22,744

36,406

81,046

14,899

17,341

Cost of solar energy system

26953

41,418

62,429

11789

15,247

Gross margin

-15.6%

-12.1%

29.8%

26.4%

13.7%

According to this information, we can safely assume that SolarCity's installation business has a margin of around 10-20% as seen in the other parts of world. SolarCity does not disclose the quantity of MW in solar energy systems sales; therefore, some assumptions are necessary to estimate its cost of installations. SolarCity mentioned in its IPO prospectus that less than 10% of sales were direct sales in year 2011 and up to Q3 in 2012. With the assumption of 10% direct sales, system cost comes in around $4/W by end of year 2012.

2011

2012

MW sold as system

7.2

15.7

ASP/kW in $

5,056

5,162

COGS/kW in $

5,753

3,976

SolarCity sells a large number of systems installed under third party financing programs to financial investors, while also keeping some stake in these systems. To generate the funds needed to invest in these installations, SolarCity draws on some equity and it monetizes its installation margins. As lease payments for these systems are made, SolarCity will get to keep a share of these payments for its share of equity in these systems. The selling price of such systems depends on the return expectations of financial investors. We can estimate the sale price of these solar systems by discounting the lease payments with the required return on capital for these financial investors. I have estimated the sale price by discounting the annual payments at 6%.

Annual system yield (kWh/kW)

PPA price (USD cent/kWh)

Nominal payment for 20 years (USD/kW)

NPV of nominal payments at 8% IRR (USD/kW)

System sale price for installer with 30% tax equity grant (USD/kW)

1,400

12

3,360

1,646

2,736

1,600

12

3,840

1,882

3,127

1,400

15

4,200

2,058

3,420

1,600

15

4,800

2,352

3,909

I tried to estimate the system prices for SolarCity installations from the nominal aggregate payments and the amount of new installations. However, because SolarCity does not provide the exact number of MW sold under its third party financing scheme and nominal contracted payments include revenue from booked payments, such a calculation does not provide a consistent number as shown in the table below.

Year

Contracted nominal payment for 20 years (USD/kW)

2011

3900

2012

4995

Q1/2013

3792

Q2/2013

4735

From the above two tables, I can safely assume that the nominal payments are in the range of $3,500-5,000 per kW which implies the system sale price of around $3-4 per W in today's dollar terms. Solar system prices in the US have been coming down significantly over the past year and recently average prices have been estimated at approximately $4 for non-residential and $5 for residential customers. Since typical installer margins are around 10-20%, as also shown by SolarCity's system sale business, one can estimate the installer margin on systems sold under third party financing model by SolarCity.

SolarCity is targeting to deploy around 250MW of systems this year. At the average sales price of $4 and installer margin of around 20%, this will result in $200 million profit margin from the installation business. In the future, if SolarCity is able to ramp the installation business to 100MW installations per quarter, this would result in around $240-320 million gross profit at the average sales price of $3-4 and the gross margin of 20%. Though system costs are likely to go down in future, competitive pressure in the installation business will limit the margin potential.

Solar system leasing business

For the second part of business, under which SolarCity invests the money into the leases and collects the payment over the course of its lifetime, SolarCity can generate excess returns if it can finance the systems at lower cost of capital than the returns on these projects. Since I estimated the above sale price at 6% discount rate, which is quite low, there is limited opportunity to generate the extra margin on these installations. Given the higher cost of capital for SolarCity, it is not likely to generate higher return on equity even after leveraging these cash flows with cheaper financing.

In the solar asset business, if SolarCity can generate its cost of capital, then valuation of this business will be equal to the amount of equity invested in that. Considering that it is unlikely to generate significant higher return than its cost of capital on the invested equity, I will use its book value as the current value for the solar system leasing business. This will give it the valuation of around $300 million.

Competition and business outlook

The solar industry in the US has been growing steadily, with the residential solar market leading the way in last few quarters. SolarCity has been the pioneer in the residential market and has capitalized on this trend. As with all successful businesses, however, it has also attracted a lot of competition. Also, since its business is still dependent on government subsidies, there are various factors in play which will determine the future of this industry and of SolarCity. I have listed below the most important factors that will determine the future of SolarCity and this industry.

Net metering regime: Most customers of SolarCity are able to feed excess electricity into the grid during day and get it back later when needed. This arrangement can be seen either as a feed-in-tariff at the price of electricity or as a free storage medium for its customers. In many states, utilities have started questioning the net metering set up and the debate on this matter is heating up in several states, as utilities' customers with no solar installations are paying the bill for the subsidies. Furthermore, in many states, regulation limits the availability of net metering to a certain penetration of solar into the grid. With solar installations ramping up fast, the penetration limit will soon be reached and without an extension for the net metering scheme, the economic attractiveness of solar installations will be reduced.

New competitors: Many companies have launched third party financing programs for solar installations in the last few quarters and competition seems to be heating up; new financing deals that are similar to SolarCity's are being announced almost every week. SolarCity has the strongest brand name and the biggest network in this industry, but fast growing competition will increase its customer acquisition cost and reduce the power purchase contract price it can offer its customers. Not surprisingly, several utilities are also entering into this business. With their existing relationships with the customers and strong brand names, SolarCity might not be able to capitalize much on its brand strength in areas where it will have to compete with the utilities.

Tax equity after 2016: Under current legislation, tax subsidies will be reduced to 10% from the current 30% after 2016. With reduced solar system prices and fast growing solar installations in the US, it is unlikely that there will be changes to this plan. This reduction in tax subsidies will reduce the attractiveness of third party financing and hence will increase the competition with local installers for installation business.

Leasing vs. owning the solar systems: Customers with the access to financing and the capability to monetize tax subsidies prefer owning the system than leasing it. Most of the installations in Europe are done under such scheme with banks providing the financing directly to the end customers. Many US banks are also starting to offer solar financing products to end customers and this will most likely reduce the share of installations done under third party financing schemes. On the other hand, banks will certainly prefer installers with a solid track record and SolarCity is therefore likely to benefit as a preferred installer for the end customers.

Electricity pricing: SolarCity offers its customers fixed electricity prices lower than utility rates. Since electricity prices have been rising sharply in last few years, this was a very attractive option for its customers. With new supply of shale gas, electricity prices are not expected to rise much further in the future and this will reduce the attractiveness of solar systems for end customers.

With all the challenges mentioned above, I see more headwinds for its business in future.

Valuation

SolarCity has been growing at an amazing speed, but its operating expenses have also grown in parallel. In spite of increasing the MW deployed many fold, it still has very high OPEX per watt. With almost $800/kW OPEX, SolarCity needs a 20% margin at an average sales price of $4 to break even. With current operating expenses at around $40 million in Q3/2013, a full-year estimate is for around $180-200 million.

2010

2011

2012

Q1/2013

Q2/2013

MW deployed

31

72

157

46

53

$/kW deployed

1343

1023

763

750

802

Combining the above two businesses, I can estimate the value of SolarCity.

From the installation business, SolarCity can be expected to generate a gross profit of around $250-300 million per year in the future. With operating expenses of around $150-200 million, net profit will be only in the range of $50-150 million. With a 10% discount at mid value, the valuation of the installation business will be approximately $1B.

Adding this to the valuation of leasing business, I estimate the total valuation of around $1.3B. One significant component, which I have ignored in my analysis, is the residual value of solar systems after 20 years. Since SolarCity will own these systems after 20 years and can generate significant revenue for many years after that, these systems can potentially be very valuable at that point of time. But since this cash will come only after 20 years, any value assigned to these cash flows will be discounted heavily to the present value. I will take the value estimated by SolarCity for this to include in my valuation. SolarCity estimated the retained value from renewal of contracts to be around $300m. Adding this to the above value gives the valuation of approximately $1.6B, which is still around 45% less than the current market value of around $2.9B.

Retained value forecast

SolarCity recently started providing a forecast on the retained value from all its contracts, net of all expenses. At the end of Q2/2013, it had the net retained value of around $662 million. SolarCity added almost $100 million in the last quarter and around $125 million in the first half of 2013 to its retained value. If SolarCity continues to add to the retained value at this rate, it will require another 23 quarters or 19 half-years to make this value equal to its current market capitalization. SolarCity has already included payments for all the systems booked, but not deployed yet. This implies an even longer time-period as the current backlog will be deployed in next 3 to 4 quarters. Also I have some concerns about how SolarCity calculates the net retained value:

- SolarCity calculated the net retained value at 6% discount rate. Considering the risk in this business, I think cost of capital for SolarCity will be much higher than 6%. If I recalculate the net retained value at 8% and 10%, the net retained value reduces to $515 million and $412 million, respectively.

- Almost half of the net retained value comes from the renewal of contracts at a rate equal to 90% of the contractual rate. Solar systems might become much cheaper than today in 20 years and customers might be better off installing new systems instead of renewing the contracts in 20 years. With significant technology and other unforeseen risks, 6% discount rate looks low to me for a contract that might be signed in 20 years from now.

- SolarCity calculates value of retained payments, net of estimated operations and maintenance, insurance, administrative and inverter replacement costs. I am not sure if SolarCity also included its corporate overhead and contract renewal fees in this. If these costs are not included, this will limit the value retained for equity holders.

All the above factors make me feel less comfortable with the retained value reported by SolarCity.

Considering all the important factors and current valuation, I see SolarCity stock trading at significantly above a fair valuation and will avoid it in spite of all the hype around solar sector.

Source: SolarCity: No Way To Justify The High Valuation