"In efficient markets it is possible to find investments offering high returns with low risk. These arise when information is not widely available, when an investment is particularly complicated to analyze, or when investors buy and sell for reasons unrelated to value. It is also commonplace to discover high-risk investments offering low returns. Overpriced and therefore risky investments are often available because the financial markets are biased toward overvaluation and because it is difficult for market forces to correct an overvalued condition if enough speculators persist in overpaying. Also, unscrupulous operators will always make overpriced investments available to anyone willing to buy; they are not legally required to sell at a fair price." - Seth Klarman, Margin Of Safety
At a fully diluted market cap of approximately $7.75 billion, a price to sales multiple at 53x (LTM), and price to net tangible assets at 38x, SolarCity's (NASDAQ:SCTY) stock qualifies as an egregiously "overvalued condition". While we believe the public has been enamored with the green energy phenomenon, the hype and hysteria are overlooking significant negative developments in the actual business (not the stock). We last wrote our critical thesis in October here, and have since become increasingly skeptical of the business ever since the last earnings (or lack thereof) disappointment. Over the past few months, there has been a bevy of sell-side analysts upgrading SolarCity for no significant reason or catalyst. Strangely, sell side research departments with underwriting relationships seem to be the most bullish on SolarCity. For instance, in just over a year, SolarCity has delivered investment banking fees on the initial public offering, the purchase of Paramount Solar, the purchase of Zep Solar, the 3.6 million share secondary issue, the $230 million convertible issue, the recent $54 million asset backed notes, and numerous other deals. This dubious and controversial sell-side research is akin to a Henry Blodget hatchet job during the last tech bubble. The deal flow arising from SolarCity's massive need for financing is a proverbial goldmine for investment banks, but comes at the high expense of naive shareholders.
- Comparisons to some of the most overvalued tech names pushes the borderline of sustainable price multiples. The business is selling for almost unheard of multiples; 56x EV/sales, 38x tangible assets given a backdrop of three sequential quarters of gross margin declines.
- Recent bullish sell-side research reports appear inadequate, given the laundry list of conflicting interests between the research department and investment banking.
- The Treasury Department investigation is likely to conclude SolarCity altered fair market values of solar systems in order to falsely obtain higher tax credits. SolarCity's recent blog disclosure in response to Barron's seems to only further cloud the landscape. It also appears more than coincidental that significant gross margin declines correspond with increased scrutiny over SolarCity's fair value calculation methodologies.
- SolarCity's entire business relies on cheap financing, which management does not disclose to shareholders. We estimate total cost of capital north of 10%, while SolarCity continues to discount future cash flows at an incredibly aggressive 6% figure.
- The retained value assumptions are highly suspect at minimum, with SolarCity management assuming a 100% customer retention rate for ten years (10% discount), after a 20 year lease.
Overvalued in a Sea of Froth:
While most retail investors think higher stock prices beget even higher prices, we continue to view the recent tech IPOs madness as a massively unsustainable bubble-- eventually, lower prices will give rise to even lower prices.
SolarCity is pricey, but it appears expensive even against other high flying tech peers such as Twitter and FireEye, who have not even done one secondary equity offering yet, let alone passed the insider lock-up dates. We also should explain that both Twitter (NYSE:TWTR) and FireEye (NASDAQ:FEYE) have not seen a 20% gross margin compression like SolarCity has in just the past twelve months. Another noteworthy point is that Twitter has massive barriers to entry as well as FireEye, whereas with SolarCity is a capital intensive commoditized business. We have yet to find a sustainable competitive advantage in SolarCity's business model; in fact, even utilities are now entering the solar market.
So why would the sell-side community be so bullish on SolarCity trading at obscene multiples? Amongst the conclusions we've reached, it just so happens that tens of millions of dollars of underwriting fees are at stake for the likes of Goldman Sachs, J.P. Morgan, Credit Suisse, Merrill Lynch, and others. SolarCity is a very capital-intensive business, providing all the up front costs associated with installing expensive solar panels and inverters, and requires constant capital injections. All these capital injections garner extremely profitable underwriting fees that have attracted many unscrupulous bankers. For example, just on secondary stock issues, management has diluted shareholders with equity capital to the tune of $1.06 billion (inclusive of the convertible notes) in the past twelve months. To demonstrate how much money is at stake here, Lee, Lochhead, Ritter, and Zhao (1996) found that secondary equity offerings (SEO) cost on average about 7%. If that is the case with SolarCity, the investment banks have received fee income north of $74 million on just the SEO's alone.
Most recent Convertible Senior Note offering:
Aggressive sell-side price targets:
- J.P. Morgan: $68 PT, stock at $52
- Credit Suisse: $75 PT, consistently upgraded here and here.
- Goldman Sachs: Interesting conviction buy, $80 PT, has had a ten year history getting fees from SolarCity, and lead on most recent offering. Also provides Elon Musk his margin loan on SolarCity shares.
- Merrill Lynch: $70 PT, stock at $59
- Deutsche Bank: No current underwriting relationship, but we think Deutsche Bank is vying for future underwriting business by upgrading the stock so aggressively. $90 PT, with a "bull-case scenario" $150 PT.
Every optimistically bullish sell-side research report we've read has been long on hype and short on substance. This includes J.P. Morgan's Paul Coster who upgraded SolarCity in October; Coster made a case for a $68 share price based upon a number of faulty assumptions, which will be expounded upon below.
"Rooftop solar could contribute 3.5% (121GW capacity) of US electricity by 2030, 6% (240GW) by 2050, from a base of under 0.1% today. SolarCity's 2018 target of 6GW (0.5GW today) looks easily attainable, with 2013 penetration rate at under 0.2% of 41 million home TAM . . .Solar City dominates roof-top solar with ~20% share of installations, and largest installed base of 0.5GW, or 75,000 customers. Competitive advantage originates in nationwide sales and distribution, purchasing power, vertically integrated delivery, and access to low-cost finance," said Coster.
"Accumulated value by 2018 could be very significant. The firm's 2018 target of 1 million customers and 6GW of capacity imply 5-year MW CAGR of over 60%, new contract growth of over 50%, and 2018 'retained value' of nearly $13 billion, representing ~$98/share on a present value basis," added the analyst.
Coster cited almost verbatim SolarCity's "featured event" (slide 7) and regurgitated it back as an original investment thesis. We think someone with the CFA designation would spend a little more time developing a more well thought out and plausible thesis. We find the upgrade reliant on the management's forecast absurd, especially given management's failure to deliver on Q3 2013 numbers. In his comments, Coster also fails to address the fact that the federal investment tax credits (NYSE:ITC) will expire at the end of 2016, changing the entire dynamic of SolarCity's business model.
"Our business currently depends on the availability of rebates, tax credits and other financial incentives. The expiration, elimination or
reduction of these rebates, credits and incentives would adversely impact our business.
The federal government currently offers a 30% investment tax credit under Section 48(a)(3) of the Internal Revenue Code, or the Federal
ITC, for the installation of certain solar power facilities until December 31, 2016. This credit is due to adjust to 10% in 2017." 10-Q
Regarding the "competitive advantage" Coster cites, we are quite unconvinced, given the reality that there are hardly any barriers to entry and traditional utilities are now beginning to enter the marketplace as direct competitors. A prime example of just how competitive the solar installation market has become is evidenced by SolarCity's rapidly declining gross margin trend. At the time of the IPO, SolarCity had gross margins of roughly 55%; as of the last quarter, margins have come down almost two thousand basis points to the mid 30s. SolarCity's gross margins have been down every quarter sequentially since it came public in December 2012.
Coster's assumes "cheap financing"; however, we think the total financing costs (including underwriting fees) for SolarCity is in the 10% range. As Barron's pointed out last August, tax equity financing costs were estimated to be between 8-14%, which happens to be where SolarCity gets most of its current financing. We actually think the tax equity partner route may be the best investment structure here -- as the equity partners get priority payments over shareholders, plus a portion of the tax credit.
Coster's 2018 forecast of 6.0 giga-watt implies a twelve fold increase from today's 0.5 giga-watt installation base by 2018. If that "easily attainable" forecast doesn't signal red flags, don't worry: it gets even worse. What Coster implies next is that SolarCity is essentially able to grow the "retained value", which is currently at $846 million to $18 billion (21 fold higher) without any significant corresponding dilution to shareholders. If the last twelve months is indicative of the pace of equity dilution we find equity dilution could be as high as $1 billion in for every 0.5 giga-watts. Meaning the equity dilution would far outstrip any meaningful progress in retained value growth.
The entire problem we have with this huge assumption is that SolarCity, and apparently Coster, both assume that 100% of customers will renew after twenty years. A massive 41.4% ($350M/$846M) of the total retained value is attributed to this 100% renewal assumption (at a 10% discount). Our view is after twenty years, the existing and antiquated solar panels will be virtually worthless. But to be fair, let's meet in the middle, with 50% of the customers renewing after twenty years; that change alone would equate to ~$2.7 billion less in retained value by 2018, not to mention the additional costs required to repossess the solar equipment that 50% of customers no longer want. We also feel using a higher discount rate (9%) would be more appropriate than the fairy tale 6% rate currently used by management. Given these are subordinated cash flows (received after equity partners are paid) and the cost of capital we believe is actually north of 10%, a discount rate of 9% seems quite optimistic. Finally, if a 20% discount rate is assumed at the end of the contracted period, as SolarCity originally projected in its IPO road show, there would be a drastic drop in retained value. By just adjusting these assumptions slightly to bring them more in-line with reality, the total retained value figure plummets by approximately 60%.
Retained Value Forecast:
"We have guaranteed a minimum return to be received by an investor in one of our financing funds and could be adversely affected if we are required to make any payments under this guarantee.
We have guaranteed to make payments to the investor in one of our financing funds to compensate for payments that the investor would be required to make to a certain third party as a result of the investor not achieving a specified minimum internal rate of return in this fund, assessed annually. The amounts of potential future payments under this guarantee depends on the amounts and timing of future distributions to the investor from the funds and the tax benefits that accrue to the investor from the funds' activities. Because of uncertainties associated with estimating the timing and amounts of distributions to the investor, we cannot determine the potential maximum future payments that we could have to make under this guarantee. We may agree to similar terms in the future if market conditions require it. Any significant payments that we may be required to make under our guarantees could adversely affect our financial condition." 10-Q
Fully Diluted Share Count:
Although we have seen numerous investors quoting Yahoo Finance (or other financial news websites), the actual market cap and corresponding shares outstanding are reported incorrectly. We have also read some sell-side research reports with the incorrect fully diluted share counts.
"We have filed registration statements for a convertible note offering and a concurrent common stock offering. Following the completion of these transactions, we had approximately 87.0 million outstanding shares of common stock based on the number of shares outstanding as of September 30, 2013 and assuming no exercise of outstanding options after September 30, 2013." 10-Q
In total, there are 87.0 million outstanding shares inclusive of the equity dilution of 3.7 million in September, plus 14.2 million stock options outstanding and the additional 3.4 million shares issued in October to acquire Zep Solar. Upon examining the outstanding stock options, we want to check the weighted average exercise price. Given that the average strike price is only $11.96, it is essentially a certainty that almost all the stock options will be converted into common stock. The reason the stock options are not being included is due to the anti-dilutive properties. The massive losses from SolarCity would actually be lower on a per share basis when including the extra share count from the options. As absurd as we deem this to be, this is exactly how it is currently being reflected in the financials.
Therefore, summing all the outstanding shares (treasury method) gives a total share count of roughly 104.6 million, for a total market cap of almost $8bn (Yahoo Finance reports $6.25bn). These are calculations that should be performed correctly by the sell-side; but apparently in an effort to push out "high quality" research, they overlook this simple fact.
It is becoming more apparent the Chinese firewall used to separate investment banking from research is only utilized from a regulation perspective to give the appearance of non-biased research. We think these enormous conflicts between sell-side research and public shareholders plays out in the typical fashion, with an eventual multitude of class action lawsuits once the share price starts falling.
The Truth Will Set You Free:
One topic worth discussing has been Barron's aggressively negative stance on SolarCity. Management, it seems, got tired of the constant accusations and posted a short few rebuttals on November 20th via its blog, dismissing the Barron's article as "misinterpretation of fair market value" while conveniently avoiding some of the main concerns with regard to the ongoing Treasury Department investigation into the company's fair market value procedures. As we pointed out in our last piece, SolarCity has already been caught bending, if not breaking, the law and already had to make mandatory changes to its fair value calculations. The SolarCity blog response to Barron's article (here) doesn't answer any of the difficult questions that still remain. The blog dismisses Barron's work without providing any significant evidence to the contrary. One would think if the claims are so outrageous, SolarCity would provide more substantial evidence outlining quantitative facts that support its stance. In fact, SolarCity claims to have educated the Barron's staff regarding their "misinterpretations", yet fails to provide a convincing counter-argument. Barron's went ahead and posted a subsequent article in response to the SolarCity blog here. In the response, Barron's continues its attack on SolarCity on certain aspects in its rebuttal--basically implying that SolarCity management was hiding facts and details that were crucial in proving its point. While from the outside, no one can say for certain that SolarCity has been manipulating its fair value calculations, the Treasury Department's investigation should uncover the truth regarding the complex financing arrangements with fund investors going forward. We contacted SolarCity on multiple occasions we have yet to receive a response.
An example of SolarCity's past deficiencies:
"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.
We and our fund investors claim the Federal ITC or the U.S. Treasury grant in amounts based on the fair market value of our solar energy
systems. We have obtained independent appraisals to support the fair market values we report for claiming Federal ITCs and U.S. Treasury grants. The Internal Revenue Service and the U.S. Treasury Department review these fair market values. With respect to U.S. Treasury grants, the U.S. Treasury Department reviews the reported fair market value in determining the amount initially awarded, and the Internal Revenue Service and the U.S. Treasury Department may also subsequently audit the fair market value and determine that amounts previously awarded must be repaid to the U.S. Treasury Department or that excess awards constitute taxable income for U.S. federal income tax purposes. Such audits of a small number of our financing funds are ongoing. With respect to Federal ITCs, the Internal Revenue Service may review the fair market value on audit and determine that the tax credits previously claimed must be reduced. If the fair market value is determined in these circumstances to be less than we reported, we may owe our financing fund or our fund investors an amount equal to this difference, plus any costs and expenses associated with a challenge to that valuation. We could also be subject to tax liabilities, including interest and penalties. As we previously disclosed in our Form 10-K dated March 27, 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 $12.2 million to compensate them for the anticipated shortfall in grants." 10-Q
Gross margin trend:
The gross margin collapse seems to tie in with the thesis that SolarCity has flagrantly abused the fair value of a solar system for the purposes of calculating tax deductions. Ever since the Treasury Department started aggressively investigating the fair value methodology of SolarCity, gross margins have been in a steep descent.
Not only is there an alarming trend in gross margins, but it may get even worse in Q4 and Q1, given the seasonality experienced by solar power producers. As mentioned by SolarCity in the most recent filing, it has "energy output performance incentives", meaning if the solar system does not produce the contracted rate of energy, SolarCity will make a payment to the lease owner.
"The amount of operating lease revenue that we recognize in a given period is dependent in part on the amount of energy generated by solar energy systems under power purchase agreements and by systems with energy output performance incentives, which in turn are dependent in part on the amount of sunlight. As a result, operating lease revenue has in the past been impacted by seasonally shorter daylight hours in winter months. As the relative percentage of our revenue attributable to power purchase agreements or performance-based incentives increases, this seasonality may become more significant." 10-Q
Asset backed solar financing, really investment grade?:
Credit Suisse recently did a small solar asset backed bond offering of $54.4 million, which Standard and Poor's immediately rated as investment grade. We find an investment grade rating borderline criminal, especially since there has only been a few years of operating history--and that short operating window has been in a healthy economy.
Even Fitch Ratings has some concern about the investment grade rating on these types of asset backed bonds.
"You're looking at, from most of the proposals we've seen, 10-, 15-year bonds," said Michael Dean, a managing director at Fitch Ratings. "Two years of history, three years of history doesn't cut it for us."
"Mr. Dean said utilities have had low default rates among customers because "they can turn your electricity off if you don't pay." But the solar companies "don't have that same hammer," he added, because the customers are still connected to the grid and can turn back to the utility for lost power if the solar company repossesses its equipment."
SolarCity even warns investors of its limited operating history.
"It is difficult to evaluate our business and prospects due to our limited operating history.
Our limited operating history, combined with the rapidly evolving and competitive nature of our industry, may not provide an adequate basis for you to evaluate our operating and financing results and business prospects. In addition, we only have limited insight into emerging trends that may adversely impact our business, prospects and operating results. As a result, our limited operating history may impair our ability to accurately forecast our future performance."
We fundamentally believe that the extremely small size ($54.4m) asset back notes combined with the announcement of retail asset backed offerings, signal a lack of demand on the institutional side. We think less sophisticated retail investors will have trouble gauging the risks associated with the solar asset backed pool. It seems SolarCity is trying hard to lower the cost of financing; however, it appears that the institutional money has caught on to the potential risks associated with this type of offering. Clearly, the risks associated with a solar asset backed offering with practically no default history or operating metrics should garner a junk rating.
"Rising interest rates could adversely impact our business.
Changes in interest rates could have an adverse impact on our business by increasing our cost of capital. For example:
rising interest rates would increase our cost of capital; and
rising interest rates may negatively impact our ability to secure financing on favorable terms to facilitate our customers' purchase of our solar energy systems or energy generated by our solar energy systems.
The majority of our cash flows to date have been from solar energy systems under lease and power purchase agreements that have been monetized under various financing fund structures. One of the components of this monetization is the present value of the payment streams from the customers who enter into these leases and power purchase agreements. If the rate of return required by the fund investor rises as a result of a rise in interest rates, it will reduce the present value of the customer payment stream and consequently reduce the total value derived from this monetization. Rising interest rates could harm our business and financial condition." 10-Q
"The seeming precision provided by NPV and IRR calculations can give investors a false sense of certainty for they are really only as accurate as the cash flow assumptions that were used to derive them.
The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful analysis, even for the most haphazard of efforts." Seth Klarman, Margin of Safety
SolarCity is not forecasted to make any money in the foreseeable future; therefore, we are justifiably doubtful of the lofty price targets awarded by the incentivized sell side community. We also think there may be a tactical short opportunity with a more pronounced seasonal weakness during the winter months than the peak producing summer months. When taking into consideration the subordinated structure of shareholders to tax equity partners, we find very few benefits accrue to investors in the current capital structure. Even more alarming is that the main source of financing for SolarCity is from these so-called tax equity partners with cost of capital rates in excess of 10%. The problematic issue is that SolarCity continues to use a bogus 6% discount rate to arrive at a "total retained value" (net present value), while average cost of capital rates are clearly higher. To us, it is fairly obvious that the return on capital is substantially lower than the cost of capital, which makes one question how SolarCity will survive long-term.
In our view, SolarCity is a mundane 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 entering the space from entrenched utilities such as Integrys Energy (NYSE:TEG) and numerous regional and local players. As stated in our previous article, SolarCity management kept referring to the "total retained value" as the benchmark for what the company is ultimately worth. If that is the case, and you trust management's optimistic assumptions on a net present value basis, the shares are worth roughly $8.09 (fully diluted 104.6 million shares). If you go with our conclusions explained above, which doesn't assume a 100% renewal rate, the business has a total value of $3.24 per fully diluted share. Either way you look at it, there is a colossal disconnect between the fundamental business value and the current stock price.
Disclaimer: This report is intended for informational purposes only and you, the reader, should not make any financial, investment, or trading decisions based upon the author's commentary. Although the information set forth above has been obtained or derived from sources believed to be reliable, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the above information serve as the basis of any investment decision. Before investing in a security, readers should carefully consider their financial positions and risk tolerances to determine if such a stock selection is appropriate.
At any time, the author of this report may trade in or out of any securities that are mentioned in the report as long or short positions in his own personal portfolio or in client portfolios that he manages without disclosing this information. At the time this report was published, the author had a short position in SCTY either in his personal account or in accounts that he managed for others.
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