SolarCity: Where From Here?

| About: SolarCity Corp. (SCTY)

Although the U.S. Solar panel installation market is highly fragmented, SolarCity (SCTY) is leading the race in residential solar installation, commanding 17.4% market share in 2012. The company provides end-to-end solar solutions ranging from design of customized solar panels, financing the project, solar panel installation, and system monitoring.

U.S. solar energy is one of the fastest growing renewable energy segments, with an installation expectation of 4.4 GW of solar panels this year, a 33% year-over-year growth from 2012 installation. Falling prices of solar panels and government backed incentive programs for solar installation on household and commercial roofs are among the biggest growth drivers for this market. This growth has created bright prospects for SolarCity, which is aiming to increase its customer base from the current 68,000 to 1 million by 2018.

Important initiative for the 1 million goal

In a step towards achieving its goal of 1 million customers, SolarCity has completed acquisition of Paramount Solar, a direct marketing firm and subsidiary of Paramount Equity. The deal is valued at $120 million, with SolarCity paying $116.3 million in stock and the remainder in cash. Reduction in solar panel prices and presence of stiff competition in the installation industry has resulted in the growing demand of marketing efforts for brand promotion. Paramount Solar has been an important channel partner for SolarCity; it has been signing deals with customers for solar installation and then directing them to solar retail service providers like SolarCity. Guthy-Renker, one of the leading direct to customer marketing companies, owns the majority of Paramount Equity. Therefore, this acquisition will give SolarCity the marketing expertise of Ben Van de Bunt, CEO of Guthy-Renker, who is expected to join SolarCity's board of directors later this year.

This acquisition will strengthen SolarCity's current sales efforts. The company directly approaches homeowners to sell its solar devices, while Paramount Solar uses direct mail, online ads, and radio spots to reach consumers. We believe this is an important move for increasing the customer base, and looking at Paramount Solar's backlog of the uninstalled solar panel customers, SolarCity has updated its installation forecast for 2013, to 278 megawatts, or MW, from an earlier 270 MW. As per the Hayes Barnard, Paramount Equity's CEO:

Paramount Solar has been inking contracts at a rate of roughly 600 per month, and it saw over 200% growth in the number of signed contracts between the second quarter of 2012 and 2013.

Benefit from vertical integration

After the acquisition of the marketing firm, SolarCity has continued its vertical integration trend, through acquisition of its solar panel mounting equipment provider Zep Solar. The deal is worth $158 million payable in SolarCity stock. Zep Solar is one of the leading providers of residential solar panel mounting systems in the U.S. With this acquisition, SolarCity will benefit from the company's product portfolio, which provides cost effective and quick ways of installing solar panels on the roof. Zep Solar has already been a key supplier for SolarCity in the residential installation business in 2013, and with the Zep Solar's technology, SolarCity has been installing more solar panels per day. The acquisition transaction is expected to close by December this year, and with the vertical integration, the company is expected to benefit from the cost savings being reflected in the operating margin.

SolarCity has set a target of annual cost reduction of 5.5%, and the acquisition of Zep and Paramount Solar are both aimed at achieving this target. Paramount Solar's selling expertise will help SolarCity reduce its own marketing expenses, while the Zep deal will provide cost savings through vertical integration.

An exclusive collaboration for expanding commercial footprint

In an important bid to expand its commercial footprint, SolarCity has teamed up with North America's leading energy and energy-related services provider, Direct Energy, to create a $124 million solar fund. This fund will finance commercial and industrial, or C&I, solar projects, with Direct Energy's contribution amounting to $50 million of the total fund corpus. Due to this partnership, Direct Energy's C&I customers will now benefit from availability of green energy at a lower price than utility companies previously charged for this renewable energy option. This reduction will come from SolarCity's power purchase agreement, or PPA. This is an agreement in which an establishment buys the solar panel with low upfront cost and generates electricity that can be sold to the power purchaser, like a utility company, for excess electricity generation. This ultimately reduces the customers' electricity bills.

In its first project, it will utilize this fund to provide solar power to BJ'S Wholesale Club, a leading operator of warehouse clubs in the eastern United States. Both the companies will provide all the necessary solar power services for making the North Brunswick, New Jersey-based club location of BJ'S a solar electricity generating facility. SolarCity will install more than 1,600 panels, with a 20-year solar PPA, which includes installation of panels with a negligible upfront cost from the company, due to the $124 investment fund. Once installed, the North Brunswick facility is expected to generate 400 kilowatts of electricity, and will reduce BJ'S Wholesale Club's current utility rates by 10%. This reduction will come from North Brunswick's facility selling the excess produced solar electricity to a utility company as per PPA agreement.

This partnership is a win-win situation for both companies; SolarCity is expected to increase its C&I customer base, and Direct Energy's customers will benefit from the PPA model to use green energy at reduced rates.

SolarCity operates in a highly fragmented solar installation market. The industry has witnessed many new entrants due to market attractiveness for the increased demand for solar panel installation, which is due to reduced solar panel prices and government incentives. As per the Solar Energy Industries Association, the average price of a solar panel has declined by 60% since 2011. This decline has adversely affected major silicon panel manufacturers like SunPower (SPWR), Yingli Green Energy (YGE), etc. Both the companies have expertise in highly efficient silicon panels, and the fall in the price of basic raw materials and oversupply of solar panels coming from Chinese players have resulted in a fall in the prices. Polysilicon spot prices, a basic raw material used in these panels, have fallen from $475 per kg in 2008, to $20 per kg currently. In addition to this, oversupply of these panels from growing Chinese manufacturers, with respect to slow demand, has added more burdens to panel prices.

SunPower not only manufactures solar panels but also provides installation services. The company produces the most efficient panel in the industry, thus providing an opportunity for more conversion of electricity from sunlight. Due to its efficient technology, SunPower has the upper hand when it comes to pricing.

On the other hand, Yingli Green Energy has been expanding its footprint across the globe to increase revenue from different markets. The company is the leading solar module supplier in three of 10 key solar module markets, as per the latest Solarbuzz quarterly report. Therefore, strong global presence will help it reduce the negative impact of the reduction of solar panel prices.

Downside Risk

An important law for the solar energy sector in the U.S. is the investment tax credit, or ITC. Enacted in 2008, this law provides 30% of the total solar panel purchase and installation cost as tax credit to the person who is purchasing the solar panel. This may be a residential homeowner, commercial building owner, or solar installation company, if it is a solar power purchase agreement and the company owns the solar panel. Therefore, this credit is deducted from the payable tax of the concerned party, reducing the tax liability. This law has been an important growth driver for the solar energy business in the U.S. The ITC is set to expire in 2016, after which this tax credit will be reduced to 10% for commercial buildings, and there will no tax credit for residential buildings. Therefore, it's a potential headwind, which will adversely affect the solar installation business in the U.S.


Since its IPO in December last year, SolarCity's stock price has appreciated approximately 297%, denoting investors' positive sentiment toward the company's growth perspective. We believe SolarCity has a sound business model; instead of manufacturing solar panels, the company sells and installs rooftop solar energy systems to households and businesses. In addition, it provides the option for a solar system on lease or PPA, which has attracted more owners to install solar panels. Although SolarCity is facing an upcoming headwind from the reduction of the ITC, we believe its strong presence in the solar installation market, and its customer acquisition initiatives, will help the company reduce the negative impact from expiration of this law.

SolarCity can expect some upside from a new energy law recently passed in California. This law allows consumers to take unlimited benefit from installing renewable sources like solar energy to reduce their electricity bill. This reduction was earlier capped at 5% of each utility's peak load. California has the highest share in the U.S. solar installed capacity, and with strong presence in the state, SolarCity can expect this new law to attract more customers for solar installation.

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.

Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Rohit Gupta, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.