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SolarCity (NASDAQ:SCTY)

Q4 2013 Results Update Conference Call

March 3, 2014, 8:00 a.m. ET

Executives

Aaron Chew - Vice President of Investor Relations

Lyndon Rive - Chief Executive Officer

Bob Kelly - Chief Financial Officer

Peter Rive - Chief Operations Officer, Chief Technology Officer

Analysts

Krish Sankar - Bank of America Merrill Lynch

Phillip Shen - Roth Capital

Patrick Jobin - Credit Suisse

Edwin Mok - Needham & Company

Ben Kallo - Robert W. Baird

Vishal Shah - Deutsche Bank

Brian Lee - Goldman Sachs

Paul Coster - JPMorgan

Pavel Molchanov - Raymond James

Operator

Good morning, and welcome to SolarCity's conference call. Today’s call is being recorded and will begin with prepared remarks followed by Q&A. Management will be utilizing a slide presentation for this call, which is available now for download on SolarCity’s investor relations page at investors.solarcity.com.

[Operator instructions.] At this time, I would like to turn the conference call over to Aaron Chew, vice president of investor relations at SolarCity. Please go ahead.

Aaron Chew

Thank you, operator. Good morning to everyone joining us today for SolarCity's fourth quarter 2013 update conference call, particularly in light of the short lead time and potential scheduling conflicts. Leading the presentation today will be a discussion from our CEO Lyndon Rive and our CFO Bob Kelly, after which point in time we will open up the call to a brief Q&A.

As a reminder, today's discussion will contain forward-looking statements that involve risks and uncertainties including statements regarding the date of SolarCity’s anticipated filing of Q4 and full year 2013 and restated 2012 financial statements, the anticipated impact on our 2012 and 2013 financial results, full year 2014 megawatt deployment, estimated nominal contracted payments remaining, forecasted retained value under energy contrasts, forecasts of cash flow in 2014, and all assumptions related to the foregoing.

Forward-looking statements should not be considered a guarantee of future performance or results and will not necessarily be accurate indications of the time at or by which such performance or results will be achieved, if at all.

Forward-looking statements are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in or suggested by the forward looking statements, including risks identified in SolarCity's press release issued today and the slides accompanying this presentation, as well as additional risks and uncertainties identified in the section entitled Risk Factors in our quarterly report on form 10-Q, which has been filed with the Securities and Exchange Commission.

We do not undertake any obligation to publicly update or revise any forward looking statement, whether as a result of new information, future developments, or otherwise. In addition, during the course of this call, we will use a number of specially defined terms relating to our business metrics and financial results. We refer to definitions of these terms included in the slides accompanying this presentation, which are available on our Investor Relations website at investors.solarcity.com.

And with that finally behind us, I will introduce SolarCity's Chief Executive Officer, Mr. Lyndon Rive.

Lyndon Rive

Thank you, Aaron. Thank you, everybody for joining this call today. Last week when we spoke to you, we mentioned we would have the financials ready for you today. Just as a reminder, there were two primary reasons for the delay. The first reason was the additional associated workload from the two acquisitions, and then the second reasons were challenges with overhead allocation. So we have now completed incorporating the financials of Zep and Paramount Solar.

This week, as we looked at completing the 2013 year-end financials, our internal controls discovered an overhead allocation error. What brought it to light was the large volume increase in Q4 of our solar lease systems. Once we identified this overhead allocation error, we discussed it with our auditors, and they agreed that a correction was needed.

That being said, I want to apologize for the error and the delay that this has caused. Let me give you a quick summary of this error of misallocation. What this is is we’re taking overhead from the balance sheet to the income statement. Total overhead has not changed. I think that’s a really important point to mention. Total overhead has not changed, we’re just moving it from the balance sheet to the income statement.

Nothing has changed with the business, net capital has stayed the same. There is no impact in the core business operations. In fact, the business has never been healthier. Contracted payments are still at $2 billion, retained value is at $1 billion. The bookings, as I mentioned, have never been stronger.

We’re looking forward to March, and for the next few weeks we’re going to be 100% focused on delivering the updated financials on March 18. I’m now going to hand it over to Bob Kelly, our CFO, to walk you through the details.

Bob Kelly

Thanks, Lyndon, and good morning everybody. Let’s start on slide five, by walking through the overhead allocation process, what we do here at SolarCity. First, we determine the amount of overhead which can be allocated. These are non-direct expenses such as warehouse rents, safety services, fleet expenses, etc. Any costs along the lines of panels and [girders], installation labor, these are easily identifiable to a particular job as a direct expense.

Next, we determine the allocation, allocable overhead divided by direct expenses to get a burden ratio. The burden ratio is the key driver in the process. The burden ratio is applied to direct expenses to determine the overhead allocation for operating lease assets.

Next, we subtract the expenses capitalized in the operating lease assets on the total expenses to determine the cost of solar system sales. Moving forward to slide six, I want to walk you through a schematic on the flow of the overhead allocation through the financials. The allocable overhead is applied to an operating lease asset or a system sale.

The operating lease asset is the core part of our business. These are the rooftop solar installations which have been contracted for up to 20 years. All costs are capitalized on the balance sheet, the depreciation is amortized over 30 years, and it flows through the income statement as part of the cost for operating leases.

On the right side of the chart, overhead is allocated to the cost of solar system sales, or what we call cash jobs. Cash jobs represent a very small part of our business. The overhead allocation is expensed through the income statement as part of cost of solar system sales during the period incurred.

Moving on to slide seven, I want to outline the issue. As we worked through Q4 and year-end financials, the gross margins of system sales appeared inconsistent. During the application of internal controls and procedures, our reconciliation confirmed the issue. There was an allocation a year ago and back to Q1 2012.

The calculated burden ratio was the root cause of the misallocation. The miscalculation of the burden ratio came from jobs spanning multiple quarters. Prior period overhead was included in the numerator, and prior period direct costs were excluded in the denominator. The net impact was an overallocation to operating lease assets and a resulting underallocation to cost of system sales.

We should have caught this earlier. It came to light as a result of our substantial growth, especially in Q4 deployments in 2013 and our newly implemented controls relating to SOX compliance.

I truly apologize for this misallocation error its effect and delay in our financials. It’s very important to note that this is an allocation. Total costs have not changed.

Slide eight outlines the impact to the financials. Starting with the balance sheet, the primary impact is that the operating lease asset will decrease as the allocated amount is now lower. Currently, we expect decreases of $16 million to $20 million in 2013 and $20 million to $23 million in 2012. We are evaluating the materiality of 2011.

These numbers will also flow through the income statement. Operating lease costs will decrease, which over time will result in higher gross margins as you depreciate a lower cost on your books. Costs relating to solar system sales will increase, resulting in lower gross margins relating to cash jobs. Consolidated operating loss will increase as you move allocations from the balance sheet to the income statement.

Let’s analyze what’s happening here. As you allocate overhead to system sales, current period expenses and operating loss increases. However, as a result of lower install costs, our core operating business is more profitable over time. Essentially, the allocated expense is recouped over the depreciation period.

This highlights the challenges in using the income statement to evaluate the health of SolarCity’s business. The balance sheet, representing low cost, high quality assets, and the cash flow statement, should be used as a better indicator.

Turning to the cash flow, while there will be movement among the various categories, most importantly, net cash remains unchanged. While there are movements throughout the GAAP statements, the overhead allocation has no impact on any of the key operating metrics of the business.

On slide nine, contractual payments of almost $2 billion remains unchanged. Retained value of over $1 billion is not affected. As stated before, net cash flow doesn’t change. We were cash flow positive in Q4 and our year-end cash balance was $577 million.

As we did last Monday, we again are confirming our deployment guidance for this year of 475 megawatts to 525 megawatts.

I now would like to open up the Q&A portion of the call, after which Lyndon will wrap it up with closing comments.

Question-and-Answer Session

Operator

[Operator instructions.] Our first question is coming from the line of Krish Sankar of Bank of America Merrill Lynch.

Krish Sankar - Bank of America Merrill Lynch

Number one, do you guys expect to be net cash flow positive in Q1?

Bob Kelly

When you look at the business, the volume of the jobs is really a high working capital business, as we increase our sales, increase the installations. We’re very confident on being cash flow positive for the full year, but the swings in the volume and the installations will move throughout the quarters. So it’s very difficult to say, on the first quarter you were cash flow positive given some of the working capital requirements for growing so fast.

Lyndon Rive

One other thing I’d add is that as we look at [unintelligible] securitization, we don’t know exactly the timing on when that may hit. So that may hit in Q1 or hit in Q2. And so that of course will swing it quite heavily.

Krish Sankar - Bank of America Merrill Lynch

And then when you look at the business long term, and you’re eventually expanding growth beyond the U.S., how does the economics of the model work when you start looking outside the U.S. and look at international expansion. Should we think about similar margins, or is it going to be different because you have to set up infrastructure out there? Any kind of color would be helpful.

Lyndon Rive

We are looking at different countries, and looking at the margins associated with it. I still like the business model of owning the assets and doing the long term PPA. I don’t know exactly how the margins will look, because every country, the economics vary quite dramatically. But places like Japan, the margins still look pretty good.

Operator

Our next question is coming from the line of Phillip Shen with Roth Capital Partners.

Phillip Shen - Roth Capital

Just a quick question, for modeling purposes, on the GAAP side of the business. It looks like gross margins on the cash position were negative in ’13 and ’12. Do you expect margins to remain negative in ’14? And what will it take to get to positive going forward?

Lyndon Rive

That’s a great question on the overhead allocation of our [cap system]. You know, cap systems help carry the overhead. Another way you can look at it is, if we didn’t have any capital systems at all, we’d still essentially have the same overhead. So I think we will still continue with cap systems. Fully burdened, with the overhead, I expect them to stay at negative gross margins.

Operator

The next question is coming from the line of Patrick Jobin with Credit Suisse.

Patrick Jobin - Credit Suisse

Just want to make sure I’m thinking about this correctly. Is there any risk that there’s a liability change with your tax equity funds or how you approach fair market value given the shift in cost allocation?

Lyndon Rive

There’s no change in the fair market value. The total overhead has stayed exactly the same. So we always look at total overhead. In terms of our funds, we’re still analyzing if there’s any impact there, but we don’t think there’s much impact there.

Patrick Jobin - Credit Suisse

And just one last question on 2011. You said the error popped up Q1 of 2012, but you’re evaluating 2011. Have you ruled out any risk to 2011 at this stage? Or is it unclear?

Lyndon Rive

The error was identified and goes back to Q1 2012, but there is carryover from Q4 2011. And right now, we’re just reviewing the materiality of that.

Operator

Our next question is coming from the line of Edwin Mok with Needham & Company.

Edwin Mok - Needham & Company

Just to understand the mechanics here, for the change in the overhead allocation, shouldn’t that have, in this case, actually a positive effect on the cost of leasing systems? And I thought that would have an effect on how you calculate retained value? Am I incorrect on that? Can you talk us through that?

Bob Kelly

The first part of your statement is correct. You have a lower install cost of the system under the operating lease, so from a book or GAAP perspective, you have a higher gross margin, because your revenue you get over time, and you’re depreciating a lower installed base, so you have better gross margins.

It has no effect on retained value, because retained value is the forecast of the revenue, and it’s the cash that’s left over after distributions to the tax equity funds. What it does affect a little bit, it’s a calculation of your return on your investment. You’re getting cash from contractual sales, and that return is over a lower installed base, so in theory you have a higher ROI, but it doesn’t affect retained value.

Edwin Mok - Needham & Company

And then I’m trying to get a little better understanding of the plan for the battery solution. You guys have announced one for commercial, but I understand you guys [unintelligible] on residential as well. Where is battery right now? Should we expect more systems with battery installed on the residential side? Any color you can provide.

Peter Rive

Yes, I think if you look at the business over the long term, we aspire to eventually deploy a battery with every single solar panel system that we deploy, in such a way that we can eventually provide power at night. So I think what you’ll see is that between now and the next couple of decades, we will essentially just be increasing the number of battery systems that we deploy in all of our markets, residential, commercial, even utility. So the point is that the rate of deployments will continue to increase over time.

Operator

Our next question comes from the line of Ben Kallo with Robert W. Baird.

Ben Kallo - Robert W. Baird

Can we just talk about, I think last week you said a restatement wasn’t needed. So as you dug deeper, when did you figure out that you would have to restate?

Lyndon Rive

Let me give you a full breakdown. Over last weekend, we discovered an overhead allocation challenge. On Tuesday, we continued working with this. On Wednesday, we identified that there was an error, and then on Thursday we presented the findings. So I’d say Thursday evening.

Ben Kallo - Robert W. Baird

And can we just go back to the ITC, the impact on it? I think you said that there wouldn’t be much impact. So is that still out there, there could be a potential impact on it? And then with the securitization going forward too, how does this work? Is there going to be a material weakness in financials as we go forward?

Lyndon Rive

There’s no impact on the ITC.

Ben Kallo - Robert W. Baird

There’s no impact on past ITCs or tax equity money that you’ve raised?

Lyndon Rive

On the tax credit, there’s no impact itself.

Bob Kelly

On the securitization, it shouldn’t affect the securitization. That’s a monetization of future cash from our long term contractual cash flows. So I don’t see anything there. You correctly point out that once you get a restatement you do have material weakness under SOX, so that will occur.

Ben Kallo - Robert W. Baird

And then just to reiterate, going forward, this makes your lease business, your retained value, better. Is that what I understood?

Bob Kelly

No, it doesn’t affect retained value. Retained value is a forecast of cash from the contracts less the monies going to the tax equity fund. So it’s what’s left over after the tax funds. What it does affect is, because you have a lower installed base, you have lower depreciation over time, therefore on a GAAP basis, you have higher gross margins from the core operating lease part of the business. I go back to my comment, to net some of the challenges with GAAP, it’s indicating great gross margins in the business and a book loss. That’s the challenges with the operating lease business, where the balance sheet and the cash flow is the one to really look at.

Operator

Our next question is coming from the line of Vishal Shah with Deutsche Bank.

Vishal Shah - Deutsche Bank

I just wanted to clarify the mix of lease versus cash sales for 2012 and 2013, and what percentage of overhead was allocated to both of these different segments?

Lyndon Rive

In terms of residential cash jobs, it was roughly about 1%. In terms of commercial cash jobs, it’s probably around 25%.

Aaron Chew

You’re speaking on a megawatt basis, or revenue?

Vishal Shah - Deutsche Bank

Either. I thought it was not that material, the cash sales, and I’m just trying to figure out what kind of overhead expenses, allocation you’re thinking about for ’12 and ’13 relative to the [unintelligible] breakdown.

Aaron Chew

On a megawatt basis, cash sales, in terms of deployment, is small. Call it 5% or 10%. Just keep in mind that the way the lease business runs, you’re recognizing that revenue over 20 years, call it 120 quarters, where the sale is in one quarter. So it shows up a lot more immediately in terms of the GAAP. Just in terms of your actual economics, it’s 5% to 10% of megawatts. So it’s not really affecting the core business.

Bob Kelly

And I can’t give you a breakdown of the allocation. I sort of would go back to reiterate what Lyndon said, when you look at the business, the overhead doesn’t change. We have an operating lease business, and we allocate overhead to that business, and then when you look at the cash business, so long as there’s a positive cash contribution to fixed costs, it’s better for the enterprise. The burden, the overhead, doesn’t change in the business, so allocating it along the pieces is a process. It doesn’t affect the economics of the business.

Lyndon Rive

The other way I like to look at it is, if we didn’t have any cash jobs at all, overhead would stay the same.

Vishal Shah - Deutsche Bank

And then on the margin front, you said you expect margins to be negative, at least in the near term. At what point, and what volumes do you think you start seeing some positive margins in your cash business?

Lyndon Rive

It all depends on the overhead, and how much the cash job gets burdened. It may swing from quarter to quarter, but I expect it to be low margins, once it carries the burden.

Operator

The next question is coming from the line of Brian Lee with Goldman Sachs.

Brian Lee - Goldman Sachs

Not to harp on this topic, but I just want to clarify, on the potential impact, if any, to prior treasury cash grants and/or ITC credits that have been awarded, I guess what I’m trying to understand is, I know that the overall overhead number doesn’t change, but the fact that you’re allocating differently, where your operating lease costs are now going down, and some of the fair market value has been based, my understanding is, off of the costs that you’re providing here, how is that expected to have no impact at all? I guess I’m just trying to understand that better.

And then also, on the securitization impact, wondering if there’s any timing delays that this could present in terms of working with the ratings agencies?

Lyndon Rive

On the fair market value, it won’t have any impact. The reason is that there’s three different approaches. You have income cost and markets. We will look at the total cost. We’d have to discuss this with our appraisers, and they are looking at this and don’t think it will have any impact either.

Bob Kelly

The securitization, I don’t see a delay in the securitization. We had targeted late this month, early the next quarter. We continue to work through with the rating agencies. I don’t think this will affect it at all. The process is going amazingly quickly compared to the first time we did it, so I’m very encouraged about that, and looking forward to completing it very shortly.

Operator

Our next question is coming from the line of Paul Coster of JPMorgan.

Paul Coster - JPMorgan

First of all, are there any one-time expenses associated with lawyers and accountancy that you can call out in the current quarter? And secondly, are there any changes to the sales practices, PPA pricing methods, and training required of your staff?

Bob Kelly

On the first one, I don’t expect any material legal or auditing expenses as a result of this.

Lyndon Rive

Not as a result of this, but do know that implementation of SOX will definitely increase our auditors’ fees. And then the second part of your question, nothing’s changed on the sales side. PPAs are still the same, training’s still the same. We’ve added additional training resources, just based on the [ramp] period, but nothing has changed.

Operator

Our next question is coming from the line of Pavel Molchanov with Raymond James.

Pavel Molchanov - Raymond James

Going back to what I think Brian asked a few minutes ago, but in relation to the crowd funding arrangement, there’s no direct linkage, but obviously the accounting for something like this is going to be exceedingly complicated, I imagine. Is this potentially something you would push off into the future?

Bob Kelly

No, not at all. And I’m not sure I agree the accounting is that complex. The crowd funding is just bringing a solar asset in a very effective, on a technology platform, and a very cost effective way, to the common investor. Nothing will change.

It’s no different than doing a securitization with institutional investors. You’re creating solar products for the individual investor and running it through our technology platform. I’m very optimistic. We’ve been working through the platform here in the first quarter, and working through more regulations than you could ever think of in getting it up and running, and looking forward the second quarter here. And that should work really, really well. I’m really optimistic there.

Lyndon Rive

Just one thing, just maybe for clarity, and this may be the reason why, I think, the accounting would be complicated with the crowd funding, none of the individuals owned any piece of the asset. It’s just financing the cash flow. It’s very similar to our securitization. If they had ownership interest in the actual assets, then it does increase the complexity, but now they’re just financing the cash flow.

Operator

This does conclude today’s question and answer session. I would now like to turn the conference back over to Mr. Lyndon Rive for any concluding comments.

Lyndon Rive

As mentioned, nothing has changed with the business. I do want to end the call on really positive, exciting news. So, last week I mentioned that January was our record bookings for the company. We just ended February, and we beat January by a healthy margin. So momentum is fantastic, things have never looked better. So thank you very much for joining the call today, and enjoy the rest of your day.

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