SolarCity: Fears Are Overblown And Valuation Is Inexpensive

| About: SolarCity Corp. (SCTY)


The price of SolarCity has plummeted by almost 29% since February, presenting a buying opportunity.

Concerns over higher operating expense and government policies on net metering and tax incentives are overdone.

Valuation is inexpensive from a retained value perspective.

The share price of SolarCity (NASDAQ:SCTY) has plunged by almost 29% since reaching its all-time high of $88.35 in late February. In my view, the significant price drop was largely due to the market's concern on the company's near-term performance as management guided a notably higher operating expense in Q1 2014 and uncertainty for government policies. However, I view the current price weakness to be a great buying opportunity given that the negative market sentiment is likely overdone and the stock valuation has become more reasonable.

In the Q4 2013 earnings call, management guided an operating expense target between $70M and $75M for Q1 2014, which is significantly higher than actual operating expense of $66M in Q4 2013 and $34M in Q1 2013 and is largely driven by higher sales and marketing expenses. The news is believed to partially contribute to the price pullback following the call. However, I view the higher operating expense guidance to be a positive as it implies a significant operating leverage in the second half of 2014. In Q1 and Q2 2013, operating expense per watt stood at $0.75 and $0.80 as a result of an operating ramp-up. Subsequently, the metric dropped to $0.59 and $0.64 in Q3 and Q4 2013 as quarterly megawatt ("MW") deployment increased substantially by 47% and 32% in Q3 and Q4 2013, respectively, compared to just 15% in Q2 2013 largely owing to the resulted operating leverage (see chart below). In all, management is trying to repeat its success from the previous year and I believe the higher operating expense for Q1 2014 should help SolarCity in reaching its annual MW deployment target between 475 MW and 525 MW. Based on management's MW deployment guidance between 78 MW and 82 MW for Q1 2014, the operating expense per watt would be approximately $0.94 in the quarter, which is higher than the highest quarterly level of $0.80 in previous year (Q2 2013). Assuming the operating expense hike would drive an average quarterly growth rate for MW deployment at approximately 30%, which is in line with the 2013 level, total MW deployment for 2014 would be 485 MW. In my view, the quarterly deployment growth rate should exceed 30% in 2014 as the effect from operating leverage should be higher in the year given the higher magnitude of operating investments and distributed solar market remains in high-growth phase. As such, management's annual MW deployment target is completely achievable.

The market's second primary concern is the uncertainty in the government's policies towards net metering and tax incentives. As a note, net metering is critical to SolarCity given that it allows customers to sell unused electricity generated from solar system to their utility company to reduce total electricity expenses. Hence, the risk is that if state governments no longer allow net metering or reduce the amount that customers can use to offset traditional electricity expenses, SolarCity's business will be negatively impacted. However, I believe this fear is exaggerated as the California Public Utility Commission recently agreed to keep the current net metering structure unchanged for 20 years for existing solar systems and new systems installed between now and 2017. Given that California is one of the major state markets for SolarCity, this should mitigate any near-term concerns and benefit the company's continued growth in the state.

In terms of tax incentive, the fear of many investors is that the expiration of tax credits that SolarCity currently utilizes to attract investors' funding (i.e. tax equity financing) would have a material impact on future expansion. Again, this concern is overdone. In November 2013, the company raised $54M by pricing its first asset-back bond ("ABS") with 13-year maturity and 4.8% coupon. The coupon rate is notably below the cost of tax equity financing generally at above 8% and is also below the market's estimate prior to the issuance. I view the successful issuance to be very positive as it has not only demonstrated strong investor demand for this type of product but also will reduce SolarCity's reliance on tax equity financing going forward. The next ABS issuance will be in April, which could be a positive share price catalyst.

On the valuation front, I believe investors should focus on the multiple of enterprise value to retained value given that retained value is best reflective of SolarCity's future cash flow profile as it measures the difference between present value of estimated future cash flows based on existing contracts (also include assumed renewals) and payments made to financing partners. SolarCity's current enterprise value of $5.9B is 5.7x the company's $1.1B retained value in 2013. In my opinion, this valuation level is not expensive as it would take slightly more than 4 years for SolarCity to reach a retained value that is equal to the current enterprise value at $5.9B with the following very conservative assumptions:

  1. My analysis assumed annual MW deployment to growth from 500 MW (mid-point of management's guidance range) in 2014 to 772 MW in 2017, representing a CAGR of only 16%, which is substantially below historical trend.
  2. Retained value per watt was at $1.90 in 2013. I assumed the metric to decline steadily by 2.5% per year to $1.72 in 2017. Although there are many factors that would adversely affect retained value per watt such as unfavorable tax incentive development or below-expected contract renewal rate, there are also some developments suggesting that this figure may trend up such as lower cost of financing (it is noted that management is using 6% as a discount rate to calculate the retained value while the recent ABS issuance was priced at 4.8%). Therefore, my declining assumption is believed to be reasonable or even conservative.

Given the above scenario, the total retained value would reach $5.7B by the end of 2017. With more aggressive assumptions including 30% CAGR for annual MW deployment and a flat retained value per watt, the company would achieve the same retained value in early 2016 (see chart below).

In summary, the price of SolarCity has been beaten by exaggerated concerns. Given that its valuation has become reasonable and industry fundamentals remain supportive, investors are recommended to buy the shares.

All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.

Disclosure: I am long SCTY. 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.