The Problem With SolarCity

Apr. 9.14 | About: SolarCity Corp. (SCTY)

Summary

SolarCity has been a darling of financial analysts and momentum investors. But does it really deserve its valuation?

Without the edge in financing, SCTY essentially becomes an installer. It is unlikely that SCTY will continue to enjoy a competitive edge in terms of financing.

As the cost of solar installations continues to decline, an educated consumer will likely buy a system, as opposed to leasing it.

SolarCity (NASDAQ:SCTY) had a great run in the last year, and has been a darling of financial analysts and momentum investors. But does it really deserve the current valuation? What is SCTY's long-term future? To understand this, one has to look at the key value-add of SCTY.

SCTY's claim to fame is its highly successful solar lease program. Without an appealing lease program, SCTY essentially becomes yet another energy contractor. The financial community has rewarded SolarCity's financing edge by giving SCTY a lofty valuation. To its credit, SCTY's management has used its rich valuation to make some smart acquisitions to build scale and barriers (ex: ZEP Solar) and have created some key business advantages. However, SCTY's core business, without the financing magic, is that of an installer/contractor.

If you were to agree that financing edge is the key to SCTY's valuation, then the question becomes if SCTY can continue with its financing magic. With that question in mind, here are some key pros and cons of investing in SCTY:

On the plus side:

- Solar energy is an excellent long growth industry - solar energy technology just hit the bottom of the S-curve, and has a long sustained run ahead of it. Being the largest player of its kind, SCTY is going to be a beneficiary of this trend.

- Federal tax credits and subsidies create compelling value creation options for the customer base. SCTY is a proven innovator of solar leases, and let's give credit to the management that it will continue to provide innovative financing paths. While we believe this is unlikely to be sustainable, it is difficult to write off a proven management team.

- SCTY has established an unrivaled footprint and brand name in the US. The name recognition reduces marketing costs and gives SCTY visibility into opportunities that its smaller rivals may not see.

- And, most importantly, the lifetime of installed systems is longer than duration of the lease, providing SCTY with some cushy back-end revenue streams.

On the minus side:

- Barriers to entry are small. There is nothing technically that SCTY does that cannot be done by any other major player. New players, small and large, continue to enter the space. With increasing competition, the industry is likely to get more fragmented.

- Once SCTY's first-mover advantage on financing dissipates - SCTY will start losing market share and become yet another energy contractor.

- SCTY has no pricing leverage - Smaller, lower overhead contractors will increasingly become a bigger part of the market and compress margins for the bigger players.

- Financing magic will be difficult to create when government incentives reduce or disappear.

- Continuing reductions in cost of solar technology means that the deployed systems are progressively more affordable to customers, thus reducing the incentive to lease and increasing the incentive to buy - this is one dynamic that is not well understood by the market.

- The further you go out in time, the more likely it is that an educated consumer will buy, as opposed to lease - this is an extremely important metric that is not being discounted by analysts.

On the "unknown" side:

- Tax credits and MACRS could end abruptly in 2017 or soon thereafter, crimping SCTY's ability to continue with financial magic.

- Utilities and other energy players could offer lease or other energy alternatives to consumers by offering fractional ownership into the much more cost-effective utility-scale farms. This can be a huge threat to the margins in the current SCTY lease model.

- Given the nascency of solar panel deployment, industry players do not have data on what it takes to operate solar farms over a 20-30 year period (especially on rooftops). Things could go wrong in unanticipated ways, and support costs and losses could mount to un-forecasted levels. SCTY could have a significant latent liability.

So, with the above stated risk profile, does SCTY deserve the valuation multiple that it is being afforded? Should you consider it to be a part of a long-term portfolio at the current levels? We do not believe so.

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.