by David J. Phillips
Though rooftop photovoltaic (PV) panel installations totaled just 60 megawatts (MW) in its recent quarter, SolarCity (NASDAQ:SCTY) commands a market cap exceeding that of established, utility-scale PV leaders like Canadian Solar (NASDAQ:CSIQ) and SunPower (NASDAQ:SPWR). Despite its rich valuation, the San Mateo, California-based solar developer has started to successfully execute on a business model that could position the upstart for continued success in coming years.
SCTY Market Cap data by YCharts
Component materials (including silicon wafers), electricity, and direct labor have traditionally comprised the substantial majority of the costs of solar energy systems for solar panel manufacturers. The capital-intensive, upfront nature of the solar business, in turn, helps to explain why SolarCity has run up an accumulated earnings deficit of $163 million through September 2013.
Founded in 2006 with the initial objective of selling solar energy systems outright, the company has since embraced the concept of being in the "energy finance" business. Avoiding utility-scale solar projects dominated by the likes of First Solar (NASDAQ:FSLR), the company now aggregates small PV residential rooftop projects into large solar leasing portfolios that offer predictable, recurring revenue streams either through power purchase agreements (where customers - residential homeowners - pay a fee per kWh based on the amount of electricity the solar energy system actually produces) or by contracted lease agreements (fixed monthly fees).
Third-quarter 2103 gross margins speak to the profit potential afforded this "finance company's" business model: gross profit of operating leases to retail customers (homeowners and small business owners) was $16.3 million, or 66% of lease revenue; the gross profit margin of PV energy systems sold was $1.1 million, or 5% of sales!
SolarCity is the U.S. leader in rooftop residential solar installations, with a market share of 26.2% -- higher than the combined share of its next 8 competitors - according to GTM Research.
Looking ahead, management predicts it will deploy 475 MW - 525 MW in 2014, up from an estimated 278 MW of installations this year. The company's prevalent business model depends in large part on the ability to finance the installation of its solar energy systems by monetizing the resulting customer receivables and related investment tax credits, accelerated tax depreciation and other incentives. Fallout from an August article in Barron's that questioned the appraised fair market value (FMV) of SolarCity's solar projects now has the company under unwelcome scrutiny by members of Congress and potential investors.
There is support for SolarCity's accounting. Thomas Porter, Professor of Accounting and Finance at the Hult International Business School, told YCharts that under GAAP, fair value is a hypothetical price that would be received to sell an asset in an unstressed transaction. "The best way to assess fair value, said Porter, "is with reference to a market transaction. That is, how much do the (uninstalled) panels sell for? That would be the best assessment of whether the FMV reported for tax purposes is reasonable."
In a November 20 blog posting, SolarCity management responded to the Barron's article: "businesses as a general rule set prices higher than their costs. The price that a willing buyer pays a willing seller is the "fair market value" of the system. Or, as Professor Porter noted in a similar analogy: "A diamond is worth a lot more than the cost to set it in a ring."
A pressing problem still remains for SolarCity and other PV manufacturers - come 2017, the 30% investment tax credit (ITC) used to attract outside financing declines to just 10% of eligible capital costs. Following the reduction, the large institutions that are typical equity investors in solar projects will have less incentive to continue investing in solar projects, raising hurdle rates.
Odds favor an extension of this ITC - or at a minimum, a change in the wording of the existing statute. Currently the ITC language reads solar projects must be in "operation" come 2017. Two House resolutions currently in committee are calling for a softening of the wording, a change from service to "construction" start. Nonetheless, the uncertainty will likely prove a near-term boon to companies like SolarCity, as the long timelines - site visits permitting - will require potential investors to put money to work now rather than be shut out come 2017.
The current uncertainty will likely lend additional credibility to SolarCity and its business model, too, as its management just completed the industry's first successful "securitization" of distributed solar energy assets, raising $54.4 million in a recent financing deal with assets backed by a pool of more than 5,000 income-producing residential and commercial rooftop PV customers.
Every megawatt of solar power generated creates value that SolarCity can use to finance capital expenditures: According to management, a typical 6.4 kW residential operating lease currently yields about $14,000 in cash flow that can be monetized in the present by the company (total of booked rental payments over life of lease, discounted at 6%). Enviable liquidity metrics, including more than $500 million in available cash and credit - plus existing contractual leases of 464 MW, worth an estimated $846 million in net present value terms - suggest SolarCity can survive in the capital challenges facing PV manufacturers.
SCTY Financial Leverage data by YCharts
Going forward, look for management to pioneer other kinds of financing deals, too - assuming tax equity rules are amended - such as "yield-co" structures (think oil & gas master limited partnerships).
SolarCity's value proposition to bullish investors rests on the following argument: the transformation of the company from a PV manufacturer to a distributor of solar power. No longer will margins be tied to the cyclical nature of supply/demand plaguing manufacturers; with only 9% of first-half 2013 new U.S. generation capacity coming from distributed solar, the energy markets are their oyster: With approximately 377,000 GWh of retail electricity currently sold in the United States per year at a price averaging at or above the company's current blended electricity price of $0.141/kWh, the implied annual U.S. market for PV electricity priced at or above $0.141/kWh is $63 billion!
Unfortunately, there are some glaring weaknesses lurking in this PV retail distribution model, including the following: attractive margins of 66% will likely attract more competitors, including First Solar and traditional utilities (all of whom have greater capital resources); three states, California, Arizona, and Colorado account for 90% of portfolio lease revenue; though historic default rates have historically run lower than even car loans (loss rate of about 2.2%), a repeat of the housing debacle of 2008 could adversely affect cash flows; and, legislative lobbying by traditional electric companies could limit returns - should SolarCity be viewed as an "energy utility," profitability could be constrained (regulated) like its new peers.
Though SolarCity will likely be a survivor in the ever-changing solar landscape, some question whether the company has outrun its fundamentals. At more than 14 times cash flow (per share), Raymond James Financial analyst Pavel Molchanov doesn't find the valuation rational.
SCTY Price to CFO Per Share (TTM) data by YCharts
SolarCity has a compelling story to tell, but like the ancient Greeks foretold in their mythology tale of Daedalus and his son Icarus: fly too close to the sun and you're sure to get burned - and plummet back to earth.
Disclosure: No positions