SolarCity (NASDAQ:SCTY) has been talking for several quarters now about retained values. More recently, SunEdison (SUNE) has also been talking about retained values. Retained value seems to be becoming a mantra for these and other players in the industry. The basic premise of retaining value is that by keeping solar projects instead of selling them, the companies can gain a massive amount of value that otherwise would not be captured. And it appears that the market has bought the story hook, line, and sinker. The proof is that SCTY and SUNE stocks are now trading at multiples of retained value.
While there may be significant value to holding projects to gain additional cash flow in some specific situations, the data that is being presented in terms of value add needs to be scrutinized. SCTY tells us that they are capturing a retained value per watt up to $1.37. SUNE tell us that it is capturing about $1.28 per watt in incremental retained value on their solar deployments (see SunEdison's Capital Markets Day 2014). So, is this level of retained value sustainable? For reference, First Solar (NASDAQ:FSLR) is forecasting a system cost of under a $1 per watt for utility scale deployment including a tracker by 2018. Can a deployment with $1 per watt system cost support $1+ per watt retained value? (We don't believe in tooth fairies.)
Setting aside the sustainability of the retained value, do we really understand this retained value game? When a solar company sells a project, it captures the profit and moves on to the next one with no residual risk on the sold project (other than the warranties). But by keeping the project on the books, the company also keeps the risks associated with the project. A time period of 20-30 years is very long time to be managing risks and to be predicting interest rates and energy rates. This is even if we ignore that no one in the industry has any experience with long-term issues and O&M costs of solar farms (especially the high risk rooftop variety). Do we understand the risks of this retained value game? Are we being too nonchalant about the risks of this game?
In assessing retained values, here are some risks that investors should take into consideration:
What happens if the energy prices go down?
One of the fundamental assumptions in the solar industry today is that energy prices will stay stable or continue to rise. Solar leasing companies routinely tell customers how much they save in the future years because energy costs will continue to increase by X% over the lease period. This is based on a history of regulated utilities increasing energy prices steadily over the last several decades (the lease companies tilt the data to their favor, but that is a different discussion altogether).
Can this past price trend continue? This is a very large and real risk that is not being accounted for in the solar industry today. With the continuing drops in costs, LCoE of solar deployments have been dropping at a rapid rate. If a solar asset has a systems cost of $1.00 a watt in 2018 compared to $1.50+ a watt today, what does that mean to LCoE? What happens when the system cost drops to $0.50 per watt? What will be LCoEs of the competing systems be in five or 10 or 15 years from now?
What happens if the off-taker defaults?
Off-taker default is generally not seen as a big problem if you assume that the energy output remains highly valuable even if the off-taker is in trouble. However, what would the risk to cash flows be if the energy output of the power plant is no longer that valuable? Or if the power plant itself is seen as being undesirable?
How stable and predictable is the energy output?
For a gas or coal or nuclear plant, we know that you put the raw material in at one end and the energy comes out at the other. Not too many unknowns in that equation. However, with solar energy, the situation is a bit different. Solar panels rely on absorption of sun's energy to make power. What happens if long-term weather patterns or other environmental issues reduce the energy output? What are the costs and penalties? How does that affect the retained value? Will the O&M go up to increase the energy yield?
How predictable is the O&M over the forecast life time?
This is one of the unknowns in the industry, especially in the rooftop segment. Add to that uncertainty the likelihood that many of the panel, inverter and other component vendors may not be around to honor their warranties 20 or 30 years down the road. Should something go wrong, those truck rolls are mighty expensive!
What happens if interest rate changes cause the financing to not pencil out?
Does the retained value depend on the long-term stability of interest rates? Does the financial model depend on capital costs being lower than the rate at which energy revenues are being discounted? If so, can this be predicted with any level of accuracy over a 20- or 30-year period?
The bottom line here is that the sustainability of the high level of retained values at SCTY or SUNE or any other solar company is questionable. And there is a risk in the back end cash flows that is neither being comprehended nor being discounted.
Solar Industry is an excellent industry to invest in for the next decade but buying companies at valuations based on unrealistic risk profile would be a losing proposition. Proper valuation of the companies' gaming retained values requires that investors understand the risks of the underlying cash flows.
Disclosure: I am long FSLR. 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.