Rarely will one ever find a multi-billion dollar company conceived in a drug induced orgy at the annual Burning Man festival. But, according to SolarCity's (SCTY) financier Elon Musk and co-founder Peter Rive, this was exactly what took place during the formation of their company in 2004. Shockingly, they came up with a solar idea in the middle of a desert...
Up until only recently, market optimism has been the highest we have seen in recent years, with giddy retail investors jumping into the fray of newly minted questionable IPOs. Things have become so optimistic lately, it seems many hedge funds with large short books have been running for the door, covering massive short positions in a panic. Typically, these transactions are private; but with a fairly decent network of investment professionals in New York, it is easy to uncover which funds are feeling the heat. It has become even more apparent, that many of the best performing stocks during the last ten months have been heavily shorted names. Our view on this short-term phenomenon of irrational short covering is that it has falsely pushed these bubble stocks even farther into the stratosphere. The euphoria is selectively reminiscent of the late 90s, with many investors pinning their hopes on so-called "get rich quick stocks."
Investment Thesis Overview:
In a myriad of questionable IPOs, one company is the perennial forerunner: SolarCity. For those unfamiliar with SolarCity, it is basically an installation company that sells and provides leases for solar panels to residential, commercial, and governmental customers. SolarCity competes in an increasingly competitive market for solar panel installations, using complex financing arrangements varying from no payment to minimal initial down payments. Coming public in late 2012, SolarCity was forced to reduce its IPO price down to $8 per share in order to entice investors. Ever since the IPO, SolarCity has been on a stampede- up more than six fold since trading began.
While the shares have been on a rocket ride since December, we have been growing ever more skeptical of the praise lauded by the sell side community and retail investors. The sell-side analysts value SolarCity as a high growth play in the attractive green energy space, while in reality, we believe SolarCity is the equivalent of a commonplace equipment leasing company that combines questionable accounting with aggressive financial assumptions to maximize government subsidiaries.
The company's history of long-term shareholder wealth creation has been mediocre at best, given the lack of organic growth when taking into consideration SolarCity's financing partners and troubling shareholder dilution. Two recent acquisitions in the past couple of months sound more alarm bells, where management used almost all stock proceeds to pay for the deals, possibly signaling to the market that the share price is overvalued. We find many times management teams use dilutive acquisitions as a reason to cover up slowing growth and/or slipping margins. From our perspective, SolarCity's stock is pricing in explosive growth for many years to come, and sell-side analysts are modeling a long-term future through rose-colored glasses. We estimate SolarCity's fair value in a highly competitive capital intensive environment at somewhere close to net tangible asset value. Unfortunately, for investors, even that number has been under scrutiny.
Catalyst for the outsized gains?
We attribute the lion's share of the run this year due to the hype surrounding Tesla (TSLA) and Elon Musk. The last earnings report for Tesla, which was the first ever "profitable" quarter, saw shares rally briskly. Meanwhile, SolarCity made a double digit percentage move solely based upon the hype surrounding Tesla, which is in a completely different industry. SolarCity, unlike Tesla, has virtually no proprietary technology that is not already being offered by competitors.
Lack of competitive moat
Any time we see a company trading at 20X+ sales, we are always intrigued by what type of business would garner such a massive premium. We are even more intrigued when a company such as SolarCity is trading around 37x sales (fully diluted ttm). It would be natural to infer this kind of company has some sort of competitive advantage [i.e. Qualcomm (QCOM), Intel (INTC) during the 90s] with an almost monopolistic positioning within the industry. We recently wrote about a similar situation with regards to ExOne Systems (XONE), which, at the time, had a price to sales ratio over 25X; this multiple was ultimately not sustainable and since then the stock has lost approximately 25% of its value (19X sales now) since our piece.
Viewing SolarCity's competitive positioning in the same light, we consider a few variants on how attractive the sector is from a top down perspective. The industry in which SolarCity participates is highly competitive, and fragmented with dozens of regional and local players. SolarCity currently only has about 17% market share (prior to acquisitions) of the installation market.
When looking at public competitors like SunPower (SPWR) and Real Goods Solar (RSOL), we had a difficult time understanding how the offerings were differentiated. In fact, we think it is reasonable to compare SolarCity to other capital intensive lease businesses such as U-Haul (UHAL) and Rent-A-Center (RCII). SolarCity has tried to establish some ancillary services such as free energy efficiency consulting with installation, but we view these as negligible differentiators. From what we have seen, competitors have basically replicated the exact same services offered by SolarCity. As shown by the below diagram, there is also a significant private solar installation presence, with a very similar offering in almost every category.
*Capital IQ, EBITDA in millions, SolarCity #s adjusted for fully diluted shares.
Gross margins in the last twelve months have been declining steadily and on the most recent conference call, management forecasted a continuing deterioration. On the call, management alluded to continued pressure on solar system gross margins and operating lease margins in line with prior quarters. The midpoint of the guidance for Q3 was for 35% gross margins on revenue of $20 million in sales, and $22 million on operating lease revenues with margins of 40.8%. Based on the guidance provided by management, we estimate that gross margins will sequentially decline for the third consecutive quarter at around 38%.
How big is the black box?
Management has repeatedly stated on the conference calls that the cash flows are "highly predictable" and very similar to mortgages. We came across an article in Bloomberg that also implies SolarCity is lowering credit standards to retain more business.
"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."
On the other hand, Sungevity, a SolarCity competitor, only accepts a FICO score of 700 or above. Even though it's currently only 20 points higher than SolarCity, it once again shows SolarCity is willing to cut corners to acquire new business. Furthermore, SolarCity management has relied on a very small sample size of lease payment behaviors (only five years) with regards to default rates. And in those five years, the economy was on a growth trajectory. Consequently, we believe that any sort of economic downturn would substantially affect the default rate probability scenarios.
In our opinion, the "Total Retained Value Forecast" is one of the more questionable parts; it basically shows how much the company is worth using a discount factor of 6% on all future cash flows to arrive at a total NPV. The bothersome part of this analysis is that almost half of the value (45%) is attributable to the "Retained Value Renewal Forecast." The problem with this forecast is that the assumption is that 100% of the customers renew their leases for another 10-year commitment at a 10% discount. We feel anyone of reasonable intelligence would immediately question this. In 20 years things will likely be drastically different and components will be worth a fraction of what they are worth now, which means that customers would be better off getting rid of the old SolarCity system after 20 years and buying or leasing a new system. For instance, in just the last couple of years solar panel prices have dropped over 60%. We would think over that time frame, solar panels built today would be almost worthless in two decades, given the turnover rate of newer technology. In our history of covering companies, we have never seen assumptions so aggressive-- and for us, to forecast retained values off aggressive assumptions 20 years into the future seems disingenuous at best.
The problems don't stop there, as pointed out by Barron's. The financing costs greatly outweigh the discount rate used to calculate the total NPV (Retained value forecast). Especially noteworthy, is that SolarCity obtains the majority of its funding through tax equity partners and not through traditional routes.
"SolarCity discounts future cash flows at a rate of 6%, but doesn't reveal its current costs of capital. Roth Capital Partner analyst Philip Shen estimates that the tax-equity financing costs SolarCity about 8-14%."
The U.S. federal tax code currently (until 2017) allows owners of solar panels a deduction on their taxes of 30% of the total fair market value of a solar system. SolarCity structures the leases as a legal ownership of the panels, which allows the tax equity partners to take the deduction on their own tax returns. Unfortunately, SolarCity's main source of funding comes from these tax equity investors, which require higher returns and priority repayments. Moreover, this tax credit is slated to decrease from 30% to 10% in 2017, which would significantly increase the overall costs of capital.
Under current law, the Federal ITC will be reduced from approximately 30% of the cost of the solar energy systems to approximately 10% for solar energy systems placed in service after December 31, 2016. In addition, U.S. Treasury grants are no longer available for new solar energy systems. Furthermore, potential fund investors must remain satisfied that the structures we offer make the tax benefits associated with solar energy systems available to these investors, which depends both on the investors' assessment of the tax law and the absence of any unfavorable interpretations of that law. Changes in existing laws and interpretations by the Internal Revenue Service and the courts could reduce the willingness of fund investors to invest in funds associated with these solar energy system investments. We cannot assure you that this type of financing will be available to us. If, for any reason, we are unable to finance solar energy systems through tax-advantaged structures or if we are unable to realize or monetize depreciation benefits, we may no longer be able to provide solar energy systems to new customers on an economically viable basis. This would have a material adverse effect on our business, financial condition and results of operations. Form 10-Q
The cost of dilutive equity capital raised from shareholders, in the last 12 months SolarCity has raised over $830 million (stock issuance inclusive of Paramount & Zep Solar) of equity capital. Equity financing is typically the most expensive form of capital for companies to raise. Based on a compilation from NYU, the average cost of equity across all sectors shown is 8.53%. Now, considering the bio-tech like multiple given to SolarCity, we think a 10-12% cost of equity capital rate would be applicable. So the issue arising from SolarCity's calculations is that it is likely discounting future cash flows at substantially less than should be warranted, given normal industry metrics. Some clarity in this area is definitely warranted from management, as it doesn't actually disclose cost of capital.
Taking all this into account, though the cost of debt financing has been increasing rapidly, SolarCity management has not budged with its overly conservative 6% discount rate. If management would take into consideration the 60% increase in rates on the 10-year treasury in the last twelve months, this would certainly impact the retained value figure, not to mention raising the cost of capital on debt and to tax equity partners. In our view, most financial analysts would make relative adjustments to the recent increases in cost of capital. But for some reason, the same changes don't seem applicable to SolarCity.
We fully understand why SolarCity is hesitant to hike the discount rates upward in its financial calculations. The main reason would be to avoid large impairment charges on its fair value calculations. Per the 10-K, SolarCity has not taken any impairments on assets for the last three years. In our opinion, by not taking the necessary corrective actions in the past three years, management is accruing larger potential impairment losses down the road.
Impairment of Long-Lived Assets
In accordance with ASC 360, Property, Plant, and Equipment, the Company evaluates long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or group of assets, as appropriate, may not be recoverable. When the sum of the undiscounted future net cash flows expected to result from the use and the eventual disposition is less than the carrying amounts, an impairment loss would be measured based on the discounted cash flows compared to the carrying amounts. There was no impairment charge recorded for the years ended December 31, 2012, 2011 or 2010. -Form 10-K
It appears that SolarCity has recently been caught with its hand in the cookie jar. According to the IRS, SolarCity appears to be inflating the fair value of the solar systems by using subjective discounted cash flow metrics to measure the solar panel's value rather than the normal approach of using actual costs. Hidden in the most recent 10-Q filing, SolarCity disclosed that the IRS rejected its fair value assumptions-- in particular, funding deals which required a payment to "true-up" its partners. The IRS is continuing its audit pertaining to other deals.
If the Internal Revenue Service or the U.S. Treasury Department makes additional determinations that the fair market value of our solar energy systems is materially lower than what we have claimed, we may have to pay significant amounts to our financing funds or to our fund investors and such determinations could have a material adverse effect on our business, financial condition and prospects. -Form 10-Q
As we previously disclosed in our Form S-1 dated June 18, 2013, from time to time the U.S. Treasury Department has determined in some instances to award us U.S. Treasury grants for our solar energy systems at a materially lower value than we had established in our appraisals and, as a result, we have been required to pay our fund investors a true-up payment or contribute additional assets to the associated financing funds. Subsequent to our Form 10-K filing, the U.S. Treasury Department has made similar determinations with respect to additional grant applications. As a result of these actions by the U.S. Treasury Department, based on the number of such systems that we have placed in service and that we plan to place in service using funds contributed by investors to our financing funds currently, we estimate that we would be obligated to pay the investors approximately $10.7 million to compensate them for the anticipated shortfall in grants. -Form 10-Q
Deferred Investment Tax Credits Revenue
The Company's solar energy systems are eligible for investment tax credits, or ITCs, that accrue to eligible property under the Internal Revenue Code. The Company is able to monetize these ITCs to investors who can utilize them in return for cash payments made through various arrangements formed by the Company. The Company considers the monetization of ITCs to constitute one of the key elements of realizing the value associated with solar energy systems. The Company therefore views the proceeds from the monetization of ITCs to be a component of revenue generated from the solar energy systems.
For lease pass-through structures, the Company monetizes the ITCs by assigning the ITCs associated with the systems leased to the investor. In addition, future customer lease payments are assigned to the investors in return for a cash consideration. The Company allocates a portion of the aggregate payments received from the investor to the estimated fair value of the assigned ITCs. The estimated fair value of the ITCs is determined by discounting the estimated cash flows impact of the ITCs using an appropriate discount rate that reflects a market interest rate.
The Company guarantees its fund investors that in the event of a subsequent recapture of the ITCs by the taxing authority due to the Company's noncompliance with the applicable ITC guidelines, the Company will compensate the investor for any recaptured credits. -Form 10-Q
Risks to bearish case
We must consider the possibility that management has valid underlying reasons to make such aggressive assumptions in their financial calculations. We feel if management was to provide more clarity on the total cost of capital methodology for fair value calculations on solar systems and resolve the investigation by the IRS, these could be positives for the shares. Investors would likely feel more comfortable paying high multiples for a growth stock if the cost of capital was indeed lower than most forecasts.
We also spoke with SolarCity management concerning the black box methodology for calculating cost of capital and retained value renewal forecasts. With regards to the cost of capital, management does not provide figures. But it was confirmed with us that so-called tax equity partners were possibly getting rates of return in the 8-14% range. However, it was also mentioned that other forms of capital came in below that level. Management would not provide a percentage breakdown of the tax equity financing versus debt and equity financing. Another point we requested clarification on was the retained value renewal forecast and why the renewal rate was 100% for the last 10 years. We were told that, basically, it is a forecast, and in totality is not a significant factor in the valuation of the business. We finally discussed gross margins and ways to look at the business, and were told the correct way to value the business was in the "total retained value forecast."
We believe the business at SolarCity is experiencing increased competition as evidenced by the slumping gross margins, which should hit a new low of 38% in Q3 2013. Given SolarCity is not forecasted to make any profits in the foreseeable future, we are highly skeptical of the lofty valuations awarded by the fast money crowd. When taking into consideration the subordinated structure of shareholders to tax equity partners, we find very few benefits accrue to the shareholders in the first third of the operating lease. Even more alarming is the main source of financing for SolarCity is from these so-called tax equity partners; it is estimated to have an average cost of capital in excess of 10%, not to mention the continued aggressive shareholder dilution.
In our view SolarCity is a capital intensive business with no real proprietary technology to garner higher than average industry returns. The business is very difficult to differentiate from its peers, and competition has few barriers to entry. We see real competition from banks and resellers of solar systems that finance solar systems, which enable the homeowner to keep all of the 30% tax deduction. Frankly, with the cost of capital continually exceeding the returns from capital, we don't think SolarCity has justifiable value at these levels. Especially considering in 2017 the tax credit is scheduled to fall by two-thirds, from 30% to 10%, which will cause the future cost of capital to increase significantly. We would refer to management suggestions- to value the business based on the "total retained value forecast." If that is the case, we would put the black box value of the overall business on a fully diluted basis in the $6-7 range.
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